Since September 2015, we have made the case that value stocks were poised for a rally.
In late 2015, value rebounded from 20-year lows and in 2016 outperformed growth stocks by the widest margin in over a decade.
The last time value rebounded off such extreme lows was following the dotcom bubble. Value style then outperformed for the next seven years until the global financial crisis. In fact, history shows that seven years appears to be the average length of a ‘value cycle’.
With the value rally now underway, investors may ask, where is the next pocket of long-term potential opportunity? At present, selective equities outside the US appear to be undervalued and under-owned. We believe they present attractive investment opportunities and have positioned our portfolios accordingly.
Looking back, we see that value rallies have been followed by the strong performance of non-US equities. Over the past two decades, non-US stocks have tended to outperform US stocks when value starts to work.
The possible reasons for this include the higher representation of cyclical sectors in markets outside the US, and higher operating costs in these markets often due to higher fixed costs, and less flexible labour environments.
Chart 1 highlights the correlation of performance of value and non-US stocks over the past two decades. As shown, a wide divergence has opened between the two styles as value stocks rallied and non-US stocks lagged. In our view, this reflects the opportunity that exists in markets outside the US.
In addition to the resurgence in value stocks, there are a number of other drivers that support the case for investing in non-US equities now.
The first of these is valuations which are significantly cheaper outside the US. The last time non-US stocks were this cheap relative to US stocks, it preceded a rally that lasted six years and saw non-US equities significantly outperform their US peers.
The second is performance. Optimism has propelled US stocks skyward, leaving markets outside the US far behind. For example, the US stock market is experiencing the most extreme and sustained outperformance over Europe in at least half a century. This historic performance would indicate the best opportunities for value investors are among the ignored, unloved and overlooked non-US markets.
Other drivers to consider are economic fundamentals. The US economic cycle looks vulnerable as post-election reflation euphoria fades. The current US recovery has also been the weakest economic expansion since World War II, with an average annual growth rate of just two per cent. In contrast, European gross domestic product (GDP) growth has outpaced US growth over the past year and corporate profits have been accelerating. A developing economic cycle should help bolster corporate fundamentals outside the US. Tightening US policy conditions may represent a headwind for a maturing US bull market, while accommodative conditions outside the US could help a fledgling recovery gain pace in other regions.
We believe political risk in non-US markets may be exaggerated by depressed share prices. For example, recent election results in the Netherlands, Austria and France all suggest continued majority support for the European experiment.
Institutional safeguards in Europe are stronger than ever and include a €500 billion European Financial Stability Fund that should be sufficient to support the banking system if needed. Meanwhile in China, the world’s second-biggest economy, President Xi Jinping has every incentive to maintain stability ahead of this year’s Party Congress, where he hopes to use a raft of leadership transitions at the top of the Communist Party to consolidate political power.
In Japan, Prime Minister Shinzo Abe recently proposed two new governors at the Bank of Japan, who, if elected, would consolidate his influence over central bank policy and ensure fidelity to his stimulative policy agenda.
In summary, all these drivers favour non-US stocks. Like the value universe a year ago, non-US equities today look to us to be undervalued, under-owned, and exposed to positive catalysts, including improving corporate fundamentals, economic tailwinds, and political and policy support.
On the other hand, the US market currently trades at record-high levels and stretched valuations at a time when peak earnings have begun to roll over.
US political uncertainty and risk have rarely been higher in our lifetime. Various US economic indicators have been stalling, and monetary policy is tightening.
While we continue to find pockets of value in the US, we are exceedingly cautious about the expensive sectors and stocks that have fared so well over this protracted bull market. We, therefore, believe investors look outside the US for the best value opportunities.
Peter Wilmshurst is portfolio manager at Templeton Global Growth Fund.
