Planning matters

The World is Still Flat

 

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Thirteen years ago, New York Times journalist Thomas Friedman wrote the international best-selling book “The World is Flat.” The title suggests the world is an integrated global landscape in which we are all interconnected, with businesses and individuals having an equal opportunity to compete, consume, trade, or access information. He was right.

Apple’s iPhone, for example, may be designed in California, but nearly every component is manufactured outside the U.S. As individuals, for instance, we can go online and buy a carpet from a vendor in Turkey, sell a pair of boots to a consumer in Hong Kong, or even check out someone’s apartment in Vietnam before renting it for a holiday stay. The world is at our fingertips, yet the average U.S. advisors’ allocation to international equities is just 22%. [1] In other words, within a 60/40 portfolio (60% equity / 40% bond), just over 13% of the portfolio is invested globally.

To put this number into context, let’s use a valuation metric made popular by famed investor Warren Buffet, Market Cap to GDP.

 

Data: MSCI, IMF, Capital Group, World Bank

 

The U.S. generates about 25% of global GDP, yet its share of world stock market capitalization represents over half the entire globe, a twenty-year high, suggesting not only a massive over-allocation into U.S. stocks but a home bias among U.S. investors. Home bias is defined as a preference for the familiar. According to The Vanguard Group, “investors generally feel more comfortable with their home market and allocate investments accordingly, even if it results in a poorer risk-return trade-off for their portfolio.” [2]

The graphic above also highlights that Emerging Market (EM) stocks are severely under-owned and under-valued relative to its share of global output. According to BlackRock Group, U.S. advisor allocations to EM equities is a slight 3.5%. [3] As I wrote in January 2017 (“In 20 Years”), the emerging world, specifically emerging Asian economies, have some of the highest growth rates in the world being driven by highly favorable demographics and a rising middle class, also known as the emerging consumer.

According to the IMF (International Monetary Fund), emerging & developing Asia is forecast to grow at 6.5% over 2018-2019, while the U.S. and Eurozone are forecast to grow at 2.7% and 2.2%, respectively.[4]

Some readers of my November 2016 memo “Cambio, Change, Wechsel”, will recall that currency risk for a U.S. dollar-based investor, is a critical factor that helps drive foreign stock and bond returns. Therefore, it’s important to identify both cheap currencies along with being on the right side of the U.S. dollar’s trend.

This excellent graphic below shows that emerging market equities and currencies, tend to move in multi-year patterns and that even after a 2-year rally, a period of outperformance in emerging market assets may still be in the early innings.

 

 

Keep in mind, the Trump Administration’s policies (and rhetoric) are widely viewed as protectionist, which has contributed toward an 11% decline in the U.S. dollar, just since the election fifteen months ago. According to Pimco, the U.S. administration is engaged in a “cold currency war” that supports a period of sustained dollar weakness.[5]  Assuming November 2016 was the start of a new bear trend in the dollar, and historical patterns hold true (as illustrated above), then investors can anticipate a multi-year period of further dollar weakness, and strengthening currencies in emerging markets.

From a valuation standpoint, using a P/E ratio based on trailing 12-month earnings, emerging markets are still very attractive relative to developed markets in the U.S., Europe, and Japan.

 

Index P/E
S&P 500 22.9
MSCI EAFE 17.6
MSCI Emerging Markets 14.7

 

Sources: Standard & Poor’s; Europe & Japan is measured by the MSCI EAFE Index. U.S. is measured by the S&P 500 Index. Emerging Markets are represented by the MSCI EM Index.

After the most recent ballistic move in most risk assets since the 2016 election, I expect a period of consolidation in global equities as interest rates move higher and assets get re-priced to reflect a higher absolute level of rates worldwide. However, I believe there’s a secular shift into emerging market assets from U.S. equities where EM’s share of world stock valuation will catch up with its 35% (and rising) share of global GDP, while the reverse holds true for the U.S.

 

[1] Source: Barron’s – 9.2017

[2] The Vanguard Group “The role of home bias in global asset allocation decisions” – 6.2012

[3] BlackRock Investment Institute – 11.2017

[4] IMF.org – 1.2018

[5] Source: Pimco – “Winning the Cold Currency War”, Joachim Fels – 1.31.2018

 

Disclosures:

The information presented herein has been obtained or derived by sources believed to be accurate and reliable. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchases any securities or other financial instruments, and may not be construed as such.

The investment strategy, views, and themes described herein may not be suitable for all investors.

All opinions expressed are those of the author and are current only as of the date appearing on this material.

There is risk of substantial loss associated with trading equity, currency, interest rate and commodity-related futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their whole financial position and tolerance for risk, and determine if the proposed trading style and investment strategy is appropriate.

Advisory services offered through KMS Financial Services, Inc.

The performance results contained herein do not reflect the deduction of transaction costs and other fees that may be associated with investing, such as brokerage or advisory fees. Past performance is not an indication of future results, and should not be construed as such.

Copyright © 2018 by Robert Okada

 

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