Manager Q&A: August 2018 U.S. and Global Equity Market Update

Michael LaBella, Head of Global Equity Strategy at QS Investors

As we enter late summer, what are the dominant U.S. and global equity market narratives?

The narratives have moved from global synchronization to divergence of global equity markets, with significant deviations between U.S. markets and those overseas. This month the U.S. is flat, around 30 basis points, while developed international and emerging markets (EMs) are down close to 4 percent. The year-to-date numbers are even starker: the U.S. is up over 7 percent; but at the other end of the spectrum, emerging markets are down close to 8 percent. EMs are now trading at a discount of close to 35-40 percent to the U.S.


Do rising equity markets in the U.S. sharply contrast what is occurring overseas?

The differences are not only in the direction and magnitude of performance, but also on the leadership board. We see stark differences in factor and style performance as well.

When we look at the leadership board within each segment, we see even more divergence. In the U.S., the growth and momentum rallies continue: growth is up close to 12 percent, with momentum close behind at 11 percent. The industry laggards, from style and factor standpoints, continue to be value and dividend yield, down 1.4 percent and up 3 percent, respectively.

Momentum growth leadership is identical to 2017. These are the first two consecutive years in which growth and momentum have topped the leadership board since 1999 and 1998.

However, the best performing factor overseas, believe it or not, is low volatility. In EMs, the low volatility factor is up 2 percent. In developed markets, it is also relatively flat – and the best performing factor. This contrasts 2017, when global momentum was outperforming in unison around the world, and the stocks that had been trading well continued to do well. Global momentum started to diverge in April. In the U.S., momentum has continued to move up, but in developed and emerging markets, momentum has reversed. That has meant a significant shift in leadership.


You believe there are many differences between the dotcom bubble and where we are today?

Yes. At QS Investors we say that history does not repeat, but it rhymes. There are similarities we must consider, particularly where we are in terms of the U.S. business cycle. Also, the U.S. market continues to narrow into fewer and fewer winners – and more and more losers.

When we see this rubber band starting to stretch, we are witnessing a shift in market behavior: it is now more difficult to impress the U.S. markets, despite having finished a pretty positive earnings season. The penalty for negative surprise, on both the top and bottom line, was more than twice the reward for double-Bs. In fact, if a company posted a positive surprise on earnings alone, it traded down for the day. If that is the reaction when things are good, what will it be when news is bad? That is one of the potential risks from the turning points on this momentum rally: we start failing to recognize good news, and we overreact to unexpected bad news.


What about Turkey and other countries that might be more vulnerable?

If there is a clear outlier in terms of where we see more pronounced drawdowns, it is Turkey, particularly as the political and economic turbulence continues to mount. The Turkish market is down 18 percent in local currency terms. The Turkish lira has declined more than 45 percent year to date, although it has showed a little bit of a reprieve recently. But Turkey is not alone. The Chinese A-share market is down over 15 percent, not too far behind, having also experienced a significant deprecation in the renminbi.

One of the reasons we continue to like emerging markets is its diverse opportunity set. Even in this global environment, half of emerging market countries are positive, in local currency terms. There is still a lot of distinction between emerging markets. However, taking into account the impact of the strengthening U.S. Dollar, only about 30 percent of EM countries end up positive.


What could potentially happen to bring global equity markets back into sync?

Global economic growth continues to remain robust, and it could go back into this global synchronization story. Unfortunately, other negative things could bring us closer together.

One of those possibilities is contagion. We get a lot of questions on the ripple effects from the Turkish market troubles. We focus on three areas: economic contagion, the ability of a growth spillover or a recession impacting other countries; banking contagion, poisoning the well of financial services in other countries; and financial contagion, the classic 1998 spillover effect.

We do not see these contagions as imminent. Economically, Turkey is less than 1 percent of global GDP1. Even reliance on its close neighbors is quite small; the Turkish market tends to correlate on its own and not be heavily dependent on other countries and regions. There is a bit more banking risk, particularly in European banks, as we see with Spain, Italy and France. But it remains to be seen how big an issue it will be, or it could just be isolated in a couple of banks. Financially, EMs were not in an exuberance environment before Turkey’s bad news started. There have been outflows, but not much in terms of other metrics, such as leverage, which could bring a lot of concern.


So, this is less like the dotcom bubble burst in 1998, and closer to the 2013 “taper tantrum?”

Compared to 1998, fundamental in Ems are significantly stronger: better balance sheets; less foreign debt, especially U.S. dollar-denominated; and most importantly, we have floating currencies, a resetting component that can be a market equalizer. The lira declining 45 percent had significant repercussions on Turkey, but it can help ease the transition over time, if the currency stabilizes.

The 2013 taper tantrum situation is much closer to the current environment: a period of higher than expected rates moving a bit quicker, as we saw earlier in the year, but with continued commitment from the U.S. Federal Reserve2 to continue to increase rates. It brought short-term pain in 2013 when the market overreacted. It is important to diversify across factor and country, for those who invest that way.


Is it possible that populism could help bring financial markets back into sync?

Attention spans of U.S. and global equity markets have been short-term. Whether elections or referendums, or events or protectionist tariffs, we expect immediate results. That is not how populism works. Its effects are long-term, eroding confidence in democratic institutions and economic global norms. Turkey’s situation is the result of strong-man politics and eroding post-war economic liberalism. In the UK, we are starting to see the effects of not having a Brexit3 deal.

Will we start to see something similar with tariffs and protectionism out of the U.S.? Markets have been ignoring them, focusing instead on the dollar amounts. They trade more with us than we do with them, so we will not be hurt as much. That fails to consider the second-order effects. China accounted for 40 percent of global growth this year, while the U.S. had only about 10 percent. If the Chinese economy slows due to a harmful trade war, it could harm everybody.


How should investors approach these longer-term effects?

We advise investors not to be scared, and they certainly should not run away, but we must acknowledge there is very likely to be more volatility in equity markets. With greater dispersion, investors should ensure they are more diversified than they have been in this eerie calm of the last 18 months.

We’ve seen more and more market participants taking a more defensive approach to portfolio positioning, citing what they think is the peak in the tenure, a peak in earnings growth, and a closer to inverting yield curve as the main drivers of this view, as indicators to start rotating more defensively.


What stocks are they looking for?

They want to focus on what historically have been more defensive sectors, such as utilities, real estate and consumer staples.


Michael LaBella is the Head of Global Equity Strategy at QS Investors, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.


1 The gross domestic product (GDP) is one of the primary indicators used to gauge the health of a country’s economy.

2 The Federal Reserve is the gatekeeper of the U.S. economy. It is the bank of the U.S. government, as such, it regulates the nation’s financial institutions.

3 Brexit is an abbreviation for "British exit," referring to the UK's decision in a June 23, 2016 referendum to leave the European Union (EU).





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