AAM Viewpoints: Economic Problems in Europe and China Are Real – So Are The Opportunities
Valuations Still Cheap – Real Evidence of a Bottom?
Two of our high conviction best ideas for 2019 include Emerging Markets and Europe. After a dismal year for global equity markets in 2018, both markets have gotten off to a great start in 2019 roughly keeping pace with the United States. According to Bloomberg, year to date through March 15, Emerging Markets (as measured by the MSCI Emerging Markets Index) is up an impressive 9.73% while the S&P 500 outpaces being up 12.8%. Europe (as measured by the Eurostoxx 50) is up a respectable 12.87%. What should we expect for the balance of the year?
Looking at these markets, valuation metrics show that U.S. markets are much closer to their long-term average valuation with the S&P now trading around 17 times 2019 earnings estimates and are even within a few percentage points of all-time highs. Looking at Emerging Markets, they have bounced back nicely from their December lows, but still are at a level that is well below their long-term average. The MSCI Emerging Markets Index is trading at a low 12.5 times 2019 estimated earnings. Europe is equally as cheap trading at 13.5 times 2019 estimated earnings.
With the stellar returns for Emerging Markets and Europe year to date, why are they still so cheap? There remains a very negative feedback loop surrounding the day-to-day trade issues, Brexit and the Populistic political climate. This type of “noise” often can overshadow the underlying movements in the economy that can point to approaching economic expansion. It is our viewpoint that the public and private sectors will do what is in their own interest to foster jobs and growth. This is the only way that politicians can keep their office and CEOs can keep their jobs. This is simply human nature. We expect the international trade issues to eventually be resolved in a positive fashion. We think the Brexit issues to resolve in favor of both the European Union and England. We feel the financial markets are already sensing an end to these issues.
Emerging Markets tend to do well when developed markets are growing. Most countries in the Emerging Markets group have a large dependence on demand for materials and energy. A strong U.S. dollar tends to hurt Emerging Markets economies, while a flat to weaker dollar tends to favor them. What powers Emerging Markets also can be evident in the commodity markets. We would note that another one of our favorite ideas for 2019 are commodities. Year to date the Bloomberg Commodity Total Return Index is up 7.27%. If we are right about Emerging Markets, this group has the potential to do well in 2019.
Emerging Markets as a “group” has nearly 30% exposure to China. Many pundits worry that China has been slowing and should be avoided. We disagree. China, over the past year, has engaged in significant economic stimulus. The PBOC (People’s Bank of China) has cut bank reserve requirements twice and the Chinese government has cut income and VAT (Value-Added Tax) for consumers and business. These moves, along with a pending long-term trade solution that will be forthcoming with the United States, will likely propel growth in their economy for years to come.
The same central bank monetary support was recently given to European markets. At the last meeting of the European Central Bank (ECB), President Mario Draghi announced that planned interest rate hikes are now postponed indefinitely and that long-term lending programs for European banks were being rolled out. These ultra-low interest loans to banks are designed to spur lending to industry and businesses to help increase demand for goods and services. This is a very powerful tool that was invoked by the U.S. Federal Reserve (Fed) after the Great Recession. We don’t fight central bank mandates and have found it is much better to be ahead of their push rather than be behind.
Finally, according to Bank of America Merrill Lynch strategist Manish Kabra, the level of shorts in the European market is the most crowded global cross-asset trade on the planet. Massive short positions often become the foundation of the next bull market cycle as those shares must be bought to cover the position. They become the powder that can spark the next expansion cycle. According to Kabra, this could be one of those setups.
We would point to one of the most reliable lead economic indicators we follow which are the Purchasing Managers Indices (PMI). Purchasing managers are one of the first to see economic demand, or lack thereof. Purchasing managers oversee lifting or softening orders for goods and services to fill inventory demand. As can be seen in the following chart, China PMI has already bottomed and is now rising. Europe appears to be bottoming now and should return to growth this year. This chart, courtesy of Morgan Stanley, shows the three-month moving averages for both markets. The European economy tends to follow China with a three-month lag.
Source: Caixin, IHS Markit, Morgan Stanley Research
While PMI gives us a look at what future growth might look like, the financial markets tend to price future growth into markets well before the proof is evident. We would suggest the moves in Emerging Markets and Europe are also a powerful leading indicator of growth to come.
With the U.S. equity markets at close to their long-term valuation averages and Emerging Markets and Europe still selling at significant discounts to their long-term averages, we feel that full allocations to these offshore markets are warranted. We believe that the leading indicators that we follow show these markets bottoming and turning upward. Equity markets in Europe and Emerging Markets have already turned up. The U.S. business cycle has been one of the longest in our history, yet Emerging Markets and Europe are still in the middle innings of their cycle. Monetary policy, as well as fiscal policy, will serve to support growth in these markets. Political issues are a headwind, but they always tend to be. Those who believe that “reversion to the mean” being close to a scientific fact would note that if valuations in Emerging Markets and Europe were to rise to longer term averages, the upside would be significant. We think that investors would be well served to consider allocations to these markets.