Too Long at the Fair: Time to retire the US/Emerging Markets barbell for a while
Summary. I have recommended since 2009 that equity investors overweight the US and Emerging Markets, and underweight Europe and Japan. The excess returns from such a strategy when applied to regional MSCI equity indexes have been enormous over that time frame. However, the time has come to retire the barbell for a while. I stayed too long at the fair, and should have made this recommendation a few months ago when Europe was trading at a record 35% P/E discount to the US. A modestly brighter picture in Japan relative to China is another reason why it’s time to put the barbell aside for now.
[1] The barbell’s amazing run. The barbell’s performance since 1988 is shown in the first two charts using both a three-year and two-year performance horizon. Before its underperformance this year, the barbell had a remarkable streak1. In other words, the -120 bps of barbell underperformance over the last two years is small relative to the consistency and magnitude of prior barbell outperformance. Note that the worst period for the barbell was the golden era for Europe in 2005-2007; more on that below.
Most of the barbell outperformance since 2009 is due to US outperformance vs Europe, rather than Emerging Markets outperformance vs Japan. As shown below, the impact of overweighting Emerging Markets vs Japan was split between positive results from 2009 to 2013, underperformance from 2014 to 2019 and no material impact since 2019.
[2] Why the US outperformed Europe since 2009. The next chart decomposes reasons for US outperformance vs Europe over this period. The 5 largest factors: outperformance of the US dollar vs the Euro (illustrated in the chart above); the benefit of US sector weights which are larger in Tech and lower in Financials, Energy, Industrials and Staples; and the outperformance of US tech stocks, consumer discretionary and financials vs their European counterparts. These factors explain almost all US outperformance since 2009; only 7% of the outperformance is unaccounted for.
[3] What’s been driving recent barbell underperformance. Since September 2022, Europe has outperformed the US by ~20%. As shown below, 2/3 of this outperformance is due simply to the decline in the dollar vs the Euro. As we wrote last time (see Archives), while we do not see the dollar’s reserve currency status under serious threat, there’s room for the dollar to decline due to its prior sharp rise vs other currencies.
What else explains Europe’s outperformance? The other positive for Europe: outperformance of its Consumer Discretionary stocks vs US counterparts. The next largest factor: relative outperformance of EU financials, but it’s small in the context of overall European outperformance. That gap may widen further given US regional bank commercial real estate exposure, which we wrote about on April 10. But I’m reluctant to base a long Europe strategy on the reported strength of its banks. The April 10 Eye on the Market also showed how Credit Suisse ranked at or near the top of EU bank statistics on capital, leverage, liquidity and funding ratios and still failed. Certain risks are just hard to capture in balance sheet ratios.
What explains Japan’s 11% outperformance vs EM since last fall? One factor is a resurgence in M&A activity in Japan, which is unusual. Much of the recent rise comes from foreign investors, which is even rarer: Bain’s acquisitions of Hitachi Metals for $5.6 bn, Evident for $3.1 bn and Gelato Pique for $1.4 bn; KKR’s acquisition of Hitachi Transport for $5.2 bn; and the Fortress acquisition of Seven & i for $1.8 bn. More on Japan below.
[4] The 2005-2007 era is not a useful parallel for projecting another period of European outperformance. I’ve seen research citing Europe’s earnings surge in 2005-2007 as a reason for being overweight Europe, since it could happen again as structural banking and energy constraints fade. But I don’t buy that argument: Europe’s earnings surge at the time was heavily influenced explosive bank lending that’s unlikely to repeat itself. See the charts below: bank lending has picked up in Germany and to a lesser degree in France, but in Southern Europe it never recovered. Maybe there’s some other rationale for projecting an earnings surge in Europe; the 2005-2007 period is not it.
[5] Given higher sector weights in staples, financials, energy and utilities, Europe is essentially a value investment. I should have paid more attention to just how cheap it got, particularly after the Euro had declined by 50% vs the US$ since 2010. By September 2022, Europe’s P/E multiple hit a post-20062 low relative to the US. While there were valid concerns at the time about Europe’s energy situation, rising inflation and exposure to a shuttered China, investors were receiving an enormous discount for taking European equity exposure, and I should have paid more attention to that. Europe’s outperformance is likely to have a ceiling since US companies generate higher returns on equity and higher returns on assets, as shown in the table. But everything has a price, and a 35% P/E discount was apparently it. As things stand now, the discount is still large from an historical perspective.
Wrapping up. Since the valuation discount remains high, there might be some legs left in the anti-barbell trade. Another reason: Japan looks interesting again (see box), particularly relative to China which has risen to ~40% of the EM equity index and which still has a lot of problems. I wouldn’t argue for a reverse barbell, which would overweight Europe and Japan; I don’t have enough conviction in European equities for that, particularly with the ECB having more tightening to do. I also think that the US debt ceiling will be raised, one way or another3. But I do think that the barbell’s best days are behind it for a while, and believe that investors should proceed with more regional balance in global equity portfolios.
Japanese equities may benefit from the following catalysts:
- Japanese equities trade at 25%-30% P/E discount to US, as they have since 2016
- Record increase in stock buybacks driven by corporate governance reforms (i.e., Sony spinoff/buyback)
- Governance reforms: [a] ~50% of companies trade below book value and must outline a plan to maximize shareholder value and comply with shareholder, liquidity and outside director reforms; [b] 10%-20% of companies do not comply with cross-holding and free float criteria and must remedy or face delisting
- Half of Japanese companies have positive net cash positions vs <20% in the US/Europe
- Very low positioning in Japanese equities by non-Japanese investors
- A recent surge in non-Japanese LBO activity in Japan, which is extremely rare (discussed earlier)
- Lower wage pressures than US/Europe, COVID supply chain pressures easing
- Earnings expected to be flat vs contractions in the US and Europe
- The lowest real effective exchange rate in Japan in 50 years according to CEIC; the Yen has also depreciated by 30% vs the Chinese RMB, which is relevant since Japan now exports more to China than to the US
1 Professor Elroy Dimson estimates that US equities outperformed non-US markets by ~2% per year from 1900 to 2021, which translates into very large cumulative excess returns. For most of this period, higher dividends explained the difference; since 1990, higher US valuations has been the dominant factor. Jack Bogle argues that excess US returns are not random and reflect US exceptionalism with respect to deeper markets and rule of law.
2 Our European P/E charts start in 2006. Before 2006, IFRS accounting standards required European companies to amortize goodwill, and the amounts involved were at times substantial. As a result, pre-2006 P/E multiples for Europe are not comparable to post-2006 multiples, and can distort time series comparisons vs the US.
3 Yellen says it would be a calamity not to raise the debt ceiling. I wonder how she would describe the charts in our Jan 24 piece on inflation adjusted debt per capita since 1790, and on the collapse in discretionary spending due to rising entitlements. Those look like calamities too.
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Too Long at the Fair
Time to retire the US/Emerging Markets barbell for a while
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FEMALE VOICE: This podcast has been prepared exclusively for institutional wholesale professional clients and qualified investors only, as defined by local laws and regulations. Please read other important information, which can be found on the link at the end of the podcast episode.
MR. MICHAEL CEMBALEST: Good morning, everybody, and welcome to the May 2023 Eye on the Market podcast. This one’s called Too Long at the Fair. I have recommended to clients for well over a decade, actually since 2009, that they should overweight the United States and emerging markets and underweight Europe and Japan in their regional equity allocations. The excess returns from that kind of strategy, if implemented, have been enormous. But the time has come to retire this barbell for a while. I stayed too long at the fair, and I should’ve made this recommendation to put the barbell aside a few months when Europe was trading at a massive 35% P/E discount to the US. And a slightly brighter picture in Japan relative to China is another reason why it’s time to put this barbell aside.
So this month’s Eye on the Market goes into the detail; we have some charts. The barbell has actually done extremely well since 1988. It’s been 30 years that investors have benefitted from overrating the United States and emerging markets versus Europe and Japan. Most of that benefit has come from overweighting the US over Europe. The EM versus Japan thing has been profitable, but smaller and kind of hitor-miss over the last decade or so. And we have some charts in here that kind of illustrate that.
So first, why did this barbell perform so well since 2009 when we started to recommend it? We have a chart here that decomposes the reasons. And there’s five major factors. One is the outperformance of the dollar versus the euro. Another one is that US sector weights are higher in tech and healthcare and lower in financials, energy, industrials, and staples. And so there’s a sector benefit in the modern world to being overweight tech and healthcare. And then within sectors, US technology, consumer discretionary, and financial stocks have substantially outperformed their European counterparts. These five factors explain over 90% of the US outperformance since 2009.
Now what has changed over the last few months, since September of last year, Europe has outperformed the US by around 20%. Around two-thirds of that is simply due to the decline in the dollar. Now as we wrote last time, while we don’t think that the dollar’s reserve currency status is under serious threat, there is room on a cyclical basis for the dollar to decline, given its sharp rise versus other currencies. And there’s other bits and pieces in there, outperformance of European consumer discretionary stocks, a tiny bit of outperformance of European financials. But the vast majority of what’s happened over the last few months has been the change in the dollar.
And the other interesting thing is that since last fall, Japan has outperformed emerging markets by about 10%. And to me, what’s notable is that one of the factors there is a resurgence in M&A activity in Japan, which is unusual, and some of which is coming from foreign investors, which is even more unusual. And you have seen some of these deals, but Bain acquired Hitachi Metals, Evident, and Gelato Pique. KKR acquired Hitachi Transport; Fortress acquired Seven & I. All of these were multi-billion-dollar deals. A little bit more on Japan later, but the increase in leveraged buyout activity is kind of a big deal in Japan.
Now we’ve seen some arguments that suggest that while we’re in for another period like 2005 to 2007, where Europe crushed the US, that was kind of a weird period in Europe. There was an explosion of bank lending everywhere from Germany to Spain, Netherlands, Italy, France, and I don’t think that’s going to be repeating itself, so I think that’s kind of a silly argument. We have some charts in here that explain why.
The mistake that I made is that by not recommending this a few months ago, Europe is essentially a value play, when you look at the context of its heavy sector weightings to staples, financials, energy, and utilities. And everything has a price in the value market, right. And eventually price to earnings, price to book could get cheap enough that everything has a price. And I should have been paying more attention to how cheap Europe got. By September of last year, Europe’s P/E multiple hit the lowest level on record versus the US of around 35% P/E discount. And while there were valid concerns that all of us had about Europe’s energy situation, rising inflation, exposure to China, which was still in lockdown, investors were receiving an enormous discount for taking European equity exposure, and I should’ve been more focused on that.
Now how much can it rally? I think Europe’s outperformance is capped when you look at return on assets and return on equity. In almost every major sector, the US companies are more profitable than the European counterparts. But you’re getting paid a lot of money at a 30 to 35% P/E discount to take exposure to Europe.
And let me just spend a couple minutes on Japan. There’s been discussions about improved corporate governance in Japan for probably 20 years. But just over the last few years, it seems like the government is a little bit more serious in doing something about it. There’s been a record increase in stock buybacks. Sony’s spinoff and buyback is one example of that. And now the government is really going after the 50% of companies that trade below book value. They have to outline a plan to maximize shareholder value and comply with these new shareholder liquidity and director reforms. And the 10 to 20% of companies that don’t comply with the crossholding and free-float rules may face delisting. So there’s a little bit more teeth now.
And around half of Japanese companies have a lot of cash compared to less than 20% in the US and Europe. So there’s a lot of potential benefits from a corporate governance move into Japan that has real momentum behind it. And of course, positioning is low in Japan. I don’t think I’ve ever talked about Japan on this podcast, or several years since I’ve talked about Japan in the Eye on the Market.
So to wrap up, the valuation discount for Europe and Japan remains pretty high. There might be a little bit more legs left in this anti-barbell trade. I wouldn’t argue for a reverse barbell, which would be overweight Europe and Japan. And I don’t have that much conviction in Europe to do that. Europe has a long history of grasping defeat from the jaws of victory, and the ECB still has tightening to do. But I also think the US debt ceiling is going to be raised one way or another.
But the bottom line is that after an incredible 30-year run, and after an incredible 14-year run over which time we’ve been recommending it, I think the barbell’s best days are behind it for a little while. And investors should have more regional balance in their global equity portfolios, at least for now. So thank you very much for listening, and we will talk to you next time.
FEMALE VOICE: Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market by contacting your J.P. Morgan representative. If you’d like to hear more, please explore episodes on iTunes or on our website.
This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information, which can be found at www.JPMorgan.com/disclaimer-EOTM.
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