US stocks have blown past the rest of the world for years. That winning streak is about to end.
- US stocks have outperformed the rest of the world for over a decade, but that streak is about to end.
- Moves by the Federal Reserve, a weaker US dollar, trade policy from the Biden administration, and the end of the pandemic will all contribute to the US underperformance.
- Neil Dutta is head of economics at Renaissance Macro Research.
- This is an opinion column. The thoughts expressed are those of the author.
- Visit Business Insider's homepage for more stories.
US stocks have enjoyed a spectacular run over recent years, outperforming the rest of the world by a wide margin. This strong run for US stocks spans two administrations from both sides of the political aisle. However, a change may finally be upon us.
There are compelling reasons to expect US stocks to underperform the rest of the world over the next few years. This does not mean US equity indices will decline, but those with cash that can be put to work should look overseas, particularly emerging markets.
The Fed will drive this trend
The most obvious near-term case for overperformance by emerging markets is the Federal Reserve.
Recent bouts of emerging market weakness have been Fed related, and it's likely that EM improvement will be centered around the Fed too. This is because of the US dollar's role in determining global financial market conditions.
Businesses and governments in emerging markets tend to hold a higher amount of debt in US dollars rather than their local currency. If the USD weakens, that will tend to make it cheaper for those in emerging markets to pay off and access US dollar denominated debt, supporting growth in those economies. As their local currencies climb relative to the dollar, EM businesses and individuals have more collateral against which to borrow. This loosens credit conditions and supports the economy, kicking off a positive feedback loop.
This US dollar shift has played out twice in recent memory, first with the taper tantrum of 2013 and next with the run up to the Fed's first interest rate hike in 2015.
In 2013, those countries with large current account deficits saw a meaningful tightening of financial conditions, while those with a surplus did not. Our nearby figure plots conditions from May 2013 when then Fed Chairman Bernanke signaled asset purchases might be tapered to September 2013, when the Fed signaled it would continue buying at the same pace.
We show the same in the run-up to the 2015 rate hike. The message is clear: a strengthening US dollar hurts those economies with large current account deficits.
When monetary policy is looser in the US relative to the rest of the world, we can expect the USD to weaken. This is what is likely now. Recall that in 2017, all the rage was "monetary offset" – the Fed would tend to lean against a loosening of fiscal policy. Today, the Fed's has generally been asking for more.
The Fed has also signaled that it will hold interest rates in place for an extended period as the economy recovers from the COVID-19 blow.Fed leaders have also indicated that they are aiming for a modest overshoot of their 2% inflation target for a period. Mechanically, this means "passive easing" for the time being – the Fed is unlikely to react to stronger economic data by signaling tighter monetary policy. That's bearish for the US dollar exchange rate.
Biden's trade policy will reinforce the trend
Next, a signature issue of the Trump administration was a hawkish stand on trade. The imposition of tariffs, threats of tariffs, and often erratic approach to US trading relationships was not welcomed by the market.
Our nearby chart plots our news headline analysis of the stock market against the Bloomberg Dollar Index. Our news analysis tracks the cumulative daily point moves in the S&P 500 on days of significant trade news. The message is clear. When trade news gets bad, the dollar climbs. Notice as trade news improved (Phase 1 China trade deal) towards the end of 2019, the dollar weakened.
What can we expect out of a Biden administration? At a minimum, I'd expect a less erratic approach to trade policy. As a safe haven asset, the dollar is often used as a hedge against risk. If the risk premium associated with trade policy is declining, the US dollar ought to drop as well.
Moreover, there is a good chance that trade tensions can ease in the years ahead. While rolling back tariffs on China might be a tough sell given the US electorate's increasingly unfavorable opinion of the country, it might be easier for the Biden administration to roll back tariffs against traditional US allies, like the European Union. In short, an easing of trade tensions is bearish for the US dollar and good for global growth.
Stronger global growth will provide a lift to commodities. Just as we saw global growth slow universally across countries in 2020, we will see countries recover all over the world in 2021. The catalyst for the slowdown — the pandemic — was the same after all. This rebound in global growth will provide a tailwind to commodity prices.
The improvement in demand comes at a time when inventories for many commodities, such as copper, remain quite tight. The inventory situation is not especially surprising since weak prices over the last several years has led to very weak capital investment in mining related industries. At any rate, the likely improvement in commodity prices will provide a particular windfall for emerging economies, where commodities are a key export.
Big tech should do worse as economy reopens
Why would the US underperform as a whole? We think it is largely about the industries that drove the upward momentum in stocks in the last year. The sectors that did well are the ones that really benefit from people staying at home – online retailers, digital streaming services, tech hardware, social media. These sectors represent a significant chunk of the market capitalization in the US market.
By contrast, the sectors that have suffered – airlines, hotels, restaurants – represent a relative small share of the market. If the economy reopens in earnest this year, and people are at home less, it stands to reason that many of the firms that surged last year due the economy's closure will suffer now. I would not want to be long the entire US market if tech is not doing well.
In short, there are compelling reasons to increase exposure to markets outside the US in the coming years. A weaker dollar, stronger global growth, a rise in commodity prices, and an easing of trade tensions provide a nice set-up for global equity outperformance, particularly emerging markets.
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