Signs of Growth in Europe and Elsewhere Are Fueling a Resurgence in International Markets | Capital Group

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Signs of Growth in Europe and Elsewhere Are Fueling a Resurgence in International Markets

Despite the many positive trends in the equity market over the past few years, the relative underachievement of foreign stocks has been highly unusual. Even as U.S. equities segued from one new high to the next, overseas markets have been dogged by numerous ailments, including erratic growth and wilting commodities prices. That dynamic may now be shifting. Stocks throughout Europe and the developing world have spearheaded a global equity advance so far this year, even outpacing continued gains in the U.S.

The unifying theme in the overseas rally has been visible economic improvement. In Europe, the unemployment rate dipped to its lowest point in nearly eight years while a closely watched measure of economic activity swung to its highest level in six years. Some countries are experiencing notable improvement. For example, Spain’s 3.2% rise in GDP last year nearly doubled that of the eurozone as a whole.

Meanwhile, emerging markets are benefiting as livelier growth around the world bolsters demand for commodities. In China, a mix of infrastructure spending and monetary stimulus has rejuvenated an economy that appeared to be losing a step last year. All of this is coming against a backdrop of compelling valuations that has heightened the appeal of international shares.

Foreign stocks have been aided by continued acceleration in the U.S. economy. The domestic expansion is now the third longest on record, thanks to vigorous hiring, firmer wage growth and surging optimism among both consumers and corporate executives. Stocks were boosted early in the year by post-election hopes for tax cuts and infrastructure spending — the so-called reflation trade. The likelihood of immediate action on these has dimmed, but the market has been carried recently by hopes that the economy is gaining sufficient momentum on its own. That optimism was underscored by the stock market’s decidedly calm reaction to the Federal Reserve interest rate hike in March, the first of what is expected to be three quarter-point moves this year.

The red flags that normally end bull markets do not seem to be present.

The rally has left U.S. stock prices extended compared with underlying corporate earnings, but history has shown that pricey valuations aren’t necessarily a cause for concern. Despite the length of the economic upturn and the magnitude of gains in stock prices, the U.S. has flashed few of the warning signs that historically have preceded bear markets. For example, stock fund inflows, corporate mergers and initial public offerings are all subdued compared with market peaks in 2000 and 2007. Other measures are sending mixed signals. For example, investor borrowing has reached a record high in absolute terms. But when measured in relation to the market capitalization of the New York Stock Exchange, such margin debt is roughly on par with its level in 2013.

Capital Group economists believe that rising incomes and a potential rebound in industrial production may underpin the economy into the first half of next year. If capital spending and productivity pick up, growth could reach 3%, something the U.S. hasn’t achieved on an annual basis since 2005. However, economic and political risks have become more pronounced, especially the possibility of external shocks. That includes political upheaval abroad and the threat of protectionist policies in the U.S. sparking a trade war with China. And though the Fed is likely to tighten only gradually, rate hikes could come faster than the market expects.

Europe may finally be breaking out of its slump.

After a number of false starts, the European economy appears to be gaining sustainable momentum. Europe has beaten economic forecasts for the past several months, and at a greater rate than other major regions. Its 1.7% GDP growth last year slightly exceeded that of the U.S. — the first time that’s happened since the 2008 financial crisis. Though the upturn remains fragile, the region’s prospects have brightened so much that the European Central Bank is hinting at the possibility of dialing back its enormous stimulus efforts.

Aside from improvement in their home countries, overseas companies are benefiting from the interconnected nature of global markets, as many European and Japanese companies generate the bulk of their earnings in other nations. European bank HSBC, for example, does much more business in Asia than at home.

The potential monkey wrench in the European upturn is escalating political uncertainty, especially in France and Germany, which are holding elections this year. Capital Group economists and political analysts are closely following these developments. Though it is difficult to predict election outcomes, a voter rejection of populist and anti-immigrant parties could propel a further rebound in European markets.

Prospects also appear to be turning up in China. In addition to encouraging data from the government, Capital Group portfolio managers and analysts saw positive developments during a recent trip to Beijing and Shanghai. In particular, the visit showed that China is making progress toward its goal of transitioning from an industrial-led economy to a consumer-focused one paced by rising wages. During a tour of a department store, for example, one manager observed that sales are up 30% this year, partly because increasing consumer affluence is boosting demand for high-end products such as vacuum cleaners and cell phones. A similar trend was reported at auto dealerships. As wages and spending power rise, the team noticed that many consumer products are being outfitted with upscale features, such as refrigerators that remind consumers of the expiration dates for various foods.

Bond yields have stabilized since their run-up late last year.

One of the biggest worries heading into 2017 was the outlook for long-term interest rates following their post-election surge. However, yields have moderated as investors wait for clearer signs about President Trump’s legislative strategy for enacting tax cuts and boosting infrastructure spending following the aborted effort to repeal the Affordable Care Act. The benchmark 10-year Treasury note finished the first quarter at 2.39%, in line with its 2.45% level at the end of 2016. Our fixed-income team believes that global economic and political undercurrents make it likely that rates will remain low by historical standards even if global growth picks up.

Slight adjustments have been made to client portfolios based on financial or market conditions. For example, we have maintained an overweight position in health care but lightened exposure because ongoing uncertainty in the sector could lead to increased volatility.

Our municipal bond managers have been drawn to tax allocation and tax assessment bonds, which fund construction projects such as single-family housing developments. These securities offer attractive risk-adjusted returns, and many are insured to safeguard creditors if a planned project doesn’t materialize. These are complex securities, so Capital Group’s extensive research capabilities, including visits to many of these sites, provide an advantage in identifying attractive opportunities.

As for taxable portfolios, we have reduced holdings of Treasury Inflation-Protected Securities, or TIPS, following the sector’s robust gains in recent months.  We continue to favor asset-backed securities because of their ability to add incremental yield without adding undue volatility.  One area where we have found value is auto loans. The credit worthiness of these securities tends to be strong in an economy marked by rising job growth and wage gains.

The above article originally appeared in the Spring 2017 issue of Quarterly Insights magazine.