A Closer Look at Europe

As we emerged from our annual Capital Market Assumption (CMA) process recently, we reaffirmed our belief in global diversification, committing to building portfolios that are positioned to take advantage of investment opportunities around the world. It was an important reaffirmation, as many investors have lost faith in global diversification amid persistent outperformance by the S&P 500. This outperformance has continued into 2019 – until recently. Although still lagging on a year-to-date basis, non-U.S. markets have delivered some outperformance.

Is this the start of something big? While market timing is always difficult, we continue to believe that non-U.S. markets present opportunities.

Here are five key takeaways for the month:

1

Market Pulse

Reversal of Fortune

After a rip-roaring August for global bond investors during which yields fell precipitously, September took back some gains. Although solidly in the black year-to-date, most high quality bond indices fell in September as the U.S. 10-year Treasury yield rose from an August low of 1.47% to 1.65% at the end of September. Global risk assets rallied, with non-U.S. equity markets outperforming the S&P 500 as non-U.S. central banks moved toward a “whatever it takes” monetary policy.

August and September Returns

Source: Morningstar Direct. All returns shown on a U.S. dollar basis

2

Macro View

Skating on Thin Ice

We are often asked why investors should own European risk assets when the economic backdrop is so challenging. It is a good question and one that deserves exploration.

First, the macroeconomic backdrop in Europe is indeed challenging. Recent data indicates that the weakness in manufacturing may be bleeding into the service economy, with composite Purchasing Managers Index data dipping below the all-important level of 50 – the demarcation between expansion and contraction. Germany, Europe’s growth engine, has been slowing for quite some time and is likely in a technical recession. Europe, and Germany in particular, is very exposed to the well-reported global trade slowdown. And although the U.S.-China trade war is often cited as the culprit, data suggest global trade was slowing prior to the skirmish.

Second, the broad slowdown across Europe has been obvious, is well known and is well reflected in risk asset prices. What may not be reflected, however, is its eventual recovery. With significant exposure to China, relief for Europe may come as a function of more stimulus out of China, which thus far has been tempered in its response to slowing growth. Relief could also come in the form of fiscal stimulus in Germany, where there remains a way but not the will. With data deteriorating so significantly, the Bundesbank may be forced to act or risk deeper recession.

3

Policy Front

Mario’s Bazooka

After signaling over the summer that monetary stimulus was coming, European Central Bank president Mario Draghi announced a series of measures in mid-September designed to address the slowing economy and stubbornly low inflation expectations. The package included lowering the already negative policy rate to -0.50%, launching a new round of bond purchases (QE), and taking other measures to alleviate the impact of negative interest rates on European banks. Pulling out all the stops, Draghi noted that monetary policy had likely reached its limits and risks being ineffective without a fiscal response.

So, will Berlin buckle? Germany certainly has the fiscal room to act, with debt-to-GDP at a relatively low 60%, a current account surplus of 8% of GDP, and a budget surplus. However, since the financial crisis, it has adopted a “black zero” policy of a balanced budget. We believe that Germany can stay true to its philosophy of fiscal discipline while providing the needed boost in an environment where the cost of funding is negative. As Mario Draghi steps down on October 31, we assume his successor, former IMF chair Christine Lagarde, will leverage her political skill to engage in direct conversation about the need for a fiscal boost.

4

Fundamental Focus

Ultimately, price matters

The outperformance of U.S. over European equities has been meaningful and long-lasting. The drivers of the outperformance were fundamental: earnings growth was higher in the U.S., and operating margins had fully recovered post financial crisis and hit a new peak. U.S. stocks have been on an incredible run since the 2009 bottom and sit at valuation levels above historical average. Conversely, European stocks sell at a slight discount to historical price-to-earnings valuations, arguably on depressed operating margins and earnings. The leverage to a global economic recovery is high.

5

Segment Spotlight

Political risk has risen

With the announcement last week that the U.S. House of Representatives would begin an official impeachment inquiry against President Donald Trump, investors wonder what impact it will have on U.S. equity returns. We can consider both the Nixon and Clinton impeachments as precedent; however, each had a different outcome for investors. The stock market rallied during the Clinton proceedings amid the dotcom boom, while rising initially during the Nixon impeachment before eventually falling amid his resignation and a spike in oil prices. The initial response to the announcement by House Speaker Nancy Pelosi was nonchalance. As with the other examples, the economy will drive market reaction, and investor focus remains firmly on a U.S.-China trade deal.

Disclosures

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.