International Update: Nonlinear Second Quarter

Dan Delany
July 29, 2019

After a strong and relatively linear performance in the first quarter 2019, global stock markets finished the second quarter, once again, higher. That said, performance in the quarter was anything but linear.

The MSCI All Country World Index finished up 4.00%, but experienced an intra-quarter sell-off of -6.5% from early May to early June, only to finish near highs.  International developed markets performed well relative to emerging markets, with the latter weighed down with concerns over tariffs and slowing growth in China.  The major European stock markets largely matched the performance of the United States, as low expectations have set the stage for Europe to potentially surprise on the upside.

Trade Tensions Persist 

The second quarter’s volatility stemmed largely from the on-going trade tension between the United States and China. This overhang dampened corporate and consumer sentiment and has led to a softening of earnings and GDP expectations.  While it is very difficult to call the outcome of current trade negotiations, we believe, despite the Trump Administration’s unorthodox negotiating style, the Administration is committed to structural change in the US-China relationship.  Issues such as intellectual property transfer, foreign regulatory burden and state-funded subsidization of domestic industries will need to be addressed if the Chinese want unfettered access to U.S. markets.  These issues are opposed to the PRC’s Made in China 2025 initiative, with the goal of manufacturing dominance in high tech markets by the year 2025.  A key question in this process is whether President Trump will stick to this hardline approach as we move into the 2020 election year, when a new trade deal would be a significant political advantage.  One could paint a scenario where a mutually beneficial trade deal were struck in the next 6-9 months, coupled with the Fed’s more recently accommodative policy stance leads to a continued rally in global stock markets.  We believe that underlying narrative is one of the reasons global markets, despite trade driven volatility, have been able to rally back consistently. 

Outlook

At the half way point in 2019, much of our thinking entering the year remains in place.  Converging economic growth rates in developed markets have led to equity return convergence.  Looking at the major European markets, in particular, after a weak 2017, they have largely matched U.S. equity market returns.  In spite of the good performance in developed markets outside the U.S., they maintain a valuation advantage, both on an absolute basis and relative to their historical ranges.  While a more accommodative Fed will support equity valuations in the United States, most central banks are matching these simulative efforts.  Developed markets also look particularly attractive on an equity risk premia basis.  Comparing the difference between the earnings yield (earnings/price) and the 10-year government bond in various markets gives investors a sense of how well they are being paid for taking on equity risk relative to a government bond in their home market.  On this basis, many major markets outside the United States offer equity risk premia double that of the U.S.  We believe these valuation discrepancies will resolve themselves over the short to intermediate term.  Trade remains the biggest wildcard in this resolution.  We continue to believe the Trump Administration seeks to achieve the goal of structural reform, with a strong incentive to do so in a timely manner.  Similarly, the trade impact on the Chinese economy is significant and needs to be resolved.  While the Chinese are fond of playing the ‘long game’, they now have a new consumer class that expects upward progress.  Gone are the days when the PRC can spend their way out of a slow down on infrastructure projects.  With both sides properly incentivized, we believe the near-term risk of a full-blown trade war remains low.  With global macro uncertainty high and economic conditions mixed, we continue to believe the market will reward long-term investors focused on high quality growth companies.

Dan Delany is an equities portfolio manager for CIBC Private Wealth Management with more than 20 years of industry experience.

Matt Scherer is a portfolio manager and equities analyst for CIBC Private Wealth Management with more than 20 years of industry experience.