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.
Area chart shows the 3-year rolling barbell performance vs the MSCI All World Index for an overweight to US and EM and underweight to Europe and Japan from March 1991 to May 2023. The chart shows that performance has been positive for most of this period. However, since March 2023, the barbell has underperformed by -30 bps.
Area chart shows the 2-year rolling barbell performance vs the MSCI All World Index for an overweight to US and EM and underweight to Europe and Japan from March 1991 to May 2023. The chart shows that performance has been positive for most of this period. However, since March 2023, the barbell has underperformed by -120 bps.
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.
Area chart shows the 3-year rolling barbell performance vs the MSCI All World Index for an overweight to EM and underweight to Japan from March 1991 to May 2023. The chart shows that performance has been split - with outperformance from 1991 to 2000 and 2003 to 2013. However, since 2019, there has been no material impact.
Line chart shows the price of 1 Euro in US$ since 2010. The chart shows that from Jan 2010 to Sept 2022, the US$ appreciated by ~50%. Since then, the US$ has depreciated by ~11%.
[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.
Line chart shows US vs Europe performance on a total return basis since Dec 2009. The chart attributes US outperformance to 5 factors: outperformance of the US$ vs Euro, benefit of US sector weights (i.e., US O/W to tech), and outperformance of US tech, consumer discretionary and financials vs their European counterparts. Each factor is layered on top of another to distinguish the attribution of each additional factor.
[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 $1.8 bn. More on Japan below.
Bar chart shows the decomposition of European equity outperformance vs US from Sep 2022 to May 2023. There are 6 factors that sum to create the total Eur equity outperformance: dollar depreciation (positive), impact of US sector weights (negative), Tech: US vs Eur (negative), Con Dis: US vs Eur (positive), Fin: US vs Eur (positive), and All other factors (positive).
Bar chart shows the number of leveraged buyout deals in Japan since 2012. The aggregate deal value in US$ is also shown for each year.
[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.
Line chart shows earnings before interest and taxes for both MSCI US equities and MSCI European equities since 2000. Since 2010, US earnings have outperformed European earnings.
Line chart shows bank lending to non-financial corporations as a year-over-year change for Spain, Italy, Germany, France, and the Netherlands (since 2005). Each country has recovered from it’s low, but is off its peak.
Line chart plots the year-over-year percent change in bank lending to households from 2005 to present for five countries in the Eurozone: Spain, Ireland, Italy, Germany and France. Bank lending to households has not recovered from 2005-2007 levels.
Line chart plots the year-over-year percent change in Eurozone bank lending from 2005 to present for both lending to non-financial corporations and to households. Neither lending activity has recovered from 2005-2007 levels.
[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.
Line chart displays relative P/E discount based on forward earnings from two different data sources (Bloomberg and Datastream) from 2006 to the present. Europe experienced the largest P/E discounts versus the US over this timeframe in Q3 2022 at about 35%.
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.
