At its May meeting, the CIBC Atlantic Trust Asset Allocation Committee (AAC) determined that a higher relative allocation to developed international equity markets is appropriate under current market conditions.
Developed international markets consist primarily of equities in Europe and Japan, which comprise over 85% of the MSCI Europe, Australia, Far East Index (EAFE).1
As a refresher, last year we reduced recommended allocations, primarily on perceived rising political and currency risk in Europe, as well as an earnings tailspin in the emerging markets. In January of this year, we communicated that while we were sticking with our underweight position, our next move would likely be to increase allocations should some of the perceived risks dissipate. We believe they have. There are five fundamental reasons behind this recommendation.
1. REDUCED POLITICAL RISK
One of our concerns since last year was the upcoming series of elections and referenda in Europe and the rising populist, nativist, anti-euro parties throughout the Continent. While populism is not inherently bad for equity markets, recent experience suggests that existential questioning of the eurozone’s survival certainly is. From that perspective, we believe the worstcase outcome is well on the way to being avoided. In the Netherlands, Austria and most importantly France, the anti-euro candidates were trounced. Looking ahead to the German election in the fall, Chancellor Angela Merkel has surged back into the lead in polls, and the anti-euro AfD party is faltering badly.2 Meanwhile, we appear to be headed for a long, hot political summer in the U.S.
2. STRONG EARNINGS REBOUND
While the U.S. is in the midst of an impressive rebound in corporate earnings, the recovery has
been even more robust in Europe.
*Source: RBC Capital Markets, LLC. Data as of 05.15.2017. Europe represents the MSCI Europe Index.
Importantly, the U.S. earnings cycle is more mature, having risen 46% above the pre-Great Bear Market high in 2007. Meanwhile, aggregate profits for stocks in the Stoxx 600 Index, a key benchmark of European equities, remain 7% below the prior peak over a decade ago.3 Simply put, there is more cyclical upside potential in the European earnings story over the next two to three years. Though slightly less compelling, the same can be said about Japan.
3. BETTER ECONOMIC NEWS
We continue to have modest expectations for economic growth in Europe and Japan over the long term. Poor demographics and inefficient, rigid government policies are likely to cap growth potential. However, that does not preclude cyclical upswings, and one appears to be unfolding in the developed world.
*Source: RBC Capital Markets, LLC. Data as of 05.15.2017.
At the same time, there is more slack in the economy and labor markets in the EAFE countries relative to the U.S. For example, the European unemployment rate has come down a lot, but it is still more than twice the U.S. rate.4 As a result, Europe and Japan are further removed than the U.S. from the prospect of inflationary pressures. This means that while their central banks will be able to ease up on the accelerator a bit, they should not be contemplating touching the brake. Meanwhile, the Federal Reserve has already begun to raise interest rates and will likely shrink its balance sheet starting next year.
One implication of this divergence in monetary policy could be further strength in the dollar. All else being equal, this would detract from a U.S. investor’s return from overseas equities. However, the magnitude of a dollar rally is probably small—perhaps in the 5% range. This pales in comparison with the nearly 25% appreciation in the U.S. dollar over the last three years.5 At the same time, a weaker euro and yen help the export competitiveness and underlying earnings power of many companies based in those regions.
Despite year-to-date outperformance, valuations for European and Japanese equities look attractive relative to the U.S.
*Source: FactSet, Yardeni Research, Inc. Data as of 12.31.2016.
More than eight years into a bull market, we believe it is especially important to be sensitive to valuation. While we don’t share the oft-repeated view that U.S. equities are overvalued, they are fully valued. In an extended market cycle, we believe tactical rotation toward cheaper valuations is an effective way to improve a portfolio’s return profile as well as to control risk.
5. RELATIVE PERFORMANCE—COUNTRIES AND SECTORS
While things have begun to change this year, the U.S. has had a long and spectacular run relative to most other equity markets around the world. Yet, history tells us that this is a “reversion to the mean” relationship. In other words, non-U.S. equities do enjoy extended periods of outperformance, as was the case through the early 2000s, and at least once each decade over the last 40 years. There is no guarantee that the recent trend of better EAFE performance is the start of such an extended period, but for the reasons stated above, we believe it is likely.
*Source: FactSet. Data as of 04.30.2017.
Another perspective on performance is gained by looking at the composition of the S&P 500 and the MSCI EAFE indices. The chart below shows the sector differences, and in some instances, they are glaring.
S&P 500 AND EAFE INDEXES: DIFFERENCE IN SECTOR WEIGHTS
*Source: RBC Capital Markets, LLC. Data as of 05.15.2017.
By reducing U.S. allocations in favor of EAFE, an investor is essentially swapping technology exposure for more cyclical sectors like industrials and financials. With a 10-year view, we would not find this attractive. However, on a tactical basis, it is hard to describe the U.S. technology sector as undiscovered, while European financials are cheap and appear to be recovering from a stress test environment. The greater exposure to industrial companies is well-timed, given the stronger tenor of global growth.
Our recommended addition to international markets is focused on the developed countries rather than emerging markets (EM). EM stocks have been the best performers of all over the last six months, driven by currency rallies and strong economic news out of China. However, the China story is turning weaker at the same time both their monetary and fiscal policies are getting tighter. Also, widespread weakness in commodity prices has been evident in recent weeks, and if it continues, is often an indicator of softness in many EM economies. Political risks remain high in certain key countries, as witnessed by a recent 15% decline in a 5-day span due to yet another political scandal.6 There has been a powerful uptrend in these markets, but EM has a higher probability of being a short-lived trading rally while we believe the EAFE markets have more staying power.
Dave Donabedian is chief investment officer of CIBC Atlantic Trust Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.
CIBC Atlantic Trust’s Asset Allocation Committee recommendations express our views on directional portfolio shifts driven by an assessment of relative risk and reward and do not take into consideration individual suitability requirements. At our firm, asset allocation may be customized for each client, so a client’s particular portfolio allocation may not follow these recommendations. Some recommendations referenced may not be appropriate for your specific situation, so you should consult with your relationship manager regarding your unique circumstances.
1 Bloomberg, as of 03.31.2017.
2 Financial Times, 05.19.2017.
3 FactSet, as of 05.15.2017.
4 Bloomberg, unemployment rates as of 04.30.2017.
5 Bloomberg, U.S. Dollar Index, three years ending 04.30.2017.
6 Bloomberg, IBOVESPA Index as of 05.22.2017.
CIBC Atlantic Trust Private Wealth Management includes Atlantic Trust Company, N.A. (a limited purpose national trust company), Atlantic Trust Company of Delaware (a Delaware limitedpurpose trust company), and AT Investment Advisers, Inc. (a registered investment adviser), all of which are wholly-owned subsidiaries of Atlantic Trust Group, LLC.
This document is intended for informational purposes only, and the material presented should not be construed as an offer or recommendation to buy or sell any security. Concepts expressed are current as of the date of this document only and may change without notice. Such concepts are the opinions of our investment professionals, many of whom are Chartered Financial Analyst® (CFA®) charterholders or CERTIFIED FINANCIAL PLANNER™ professionals. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the U.S.
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