For US financial markets, an inflection point is looming. In coming months, the Federal Reserve’s multi-year quantitative easing program will end – and with it, a profound source of support for stocks over the past six years.
How exactly US markets will behave as “QE” fades from the scene for good is, of course, unknowable. But from our vantage point as managers of BlackRock’s Global Allocation Fund, there seems little question that, when it comes to identifying the next opportunity for generating portfolio return, forward-thinking advisors and investors need to redouble their focus on markets beyond the U.S.
Today, there is ample reason to be looking to both Japan and Europe for such return -- with a discerning eye, however, since the macroeconomic fundamentals of both areas remain challenged and require investor patience. Each investment case has its own idiosyncrasies. But -- just as has been the case in the U.S. -- we believe that proactive monetary policy will be a key driver of the opportunities likely to emerge in both parts of the world.
Since 2009, US stocks have enjoyed an enviable run. But acquainting clients with the straightforward fundamentals likely to shape returns across markets going forward can help them understand why it might be time to rebalance toward stocks abroad.
We believe that Japan and Europe also can offer a useful counter-narrative to potential investor fears about investing far from home. Non-US companies today make up 54% of the world's market cap, but they collectively represent just 27% of U.S. investor assets. Indeed, in a recent BlackRock survey of 1,004 investors, about six in 10 agreed that “investing outside of the U.S. is too risky.”
By offering clients a look at the landscapes of both Japan and Europe today, an advisor can add powerful color to the time-tested and still valid benefits of maintaining an intelligently diversified, truly global investment stance.
Trimming US Exposure
Since 2014's start, we have systematically trimmed our U.S. stock allocation, to 24 percent of the portfolio at the end of August from 33 percent in January. It's not that we're "bearish" on the U.S. -- indeed, our U.S. stock allocation remains our portfolio's largest. Rather, what we see is that on a relative basis, certain overseas markets offer more attractive valuations.
Currently the S&P 500 trades at about 15 times forward earnings and about 26 times cyclically adjusted earnings - well above the historical average of 16.5 times. Lower capitalization US stocks are even more pricey: Mid-caps now trade at about 17 times forward earnings, and small caps at about 20.
QE is now in its late innings, but that is not the only factor muddying the U.S. case. Though U.S. corporate profitability has been excellent, we believe that it might now be near a cyclical peak. Furthermore, in recent decades, U.S. corporate managers have focused on squeezing higher ROE from balance sheets through aggressive financial management and now the potential for additional returns from this activity might be diminishing.
Today, we believe that all these drivers of equity return -- monetary policy, rising profitability, and focus on shareholder value -- have further to run in other parts of the world than in the U.S.
Europe: Stimulus on the Way
Continent-wide, Europe remains troubled. But from the bottom up, we are finding some individual sectors and companies across portions of the region which are attractive. Today, we are closely examining large cap situations particularly in France and Germany. The German market trades at just 12 times forward earnings, considerably less expensive than the US, and opportunities in the industrial, health care and materials sectors look promising.
In a development with potentially far-reaching implications, the European Central Bank announced in early September that it would launch a QE-like program of economic stimulus and interest rate cuts designed to strengthen the region's faltering recovery from the global recession.
The program's impact remains to be seen. But the stubborn reality is that Europe's recovery remains several years behind that of the U.S. -- creating the opportunity to invest today with an eye toward improving asset values in months and years to come.
Japan: In the Midst of a Bull Market
The Japanese story is perhaps even more provocative. In fact, we believe that we could be early in a long-running Japanese bull market.
Plagued by low growth, Japan has been out of favor for two decades, and many attractive companies are now trading at below book value. On a total market basis, the Nikkei is now trading at just 1.4 times book value, compared with 2.4 times book value for the S&P {500}.
As was the case in the U.S. -- and is now in Europe -- Japan is deploying monetary tools to move its economy forward, with the Bank of Japan conducting a massive asset buying program to increase the money supply, depreciate the Japanese yen and stimulate growth. The government is also progressing on other structural reforms, including improving corporate governance and reducing corporate taxation.
Ultimately, Japanese investors’ willingness to invest in their own stock market could be the biggest mover. Overall, individual Japanese investors maintain just a 6 percent allocation to equities. That will not be enough, given the mismatch between the financial needs of an aging population and ongoing low bond yields. We believe that the Japanese investing marketplace is on the verge of a fundamental and broad-scale shift toward stock investing and away from cash and bonds, particularly as the Japanese government continues to pursue policies designed to stimulate inflation. We want to position our investors ahead of the shift, because the impact on Japanese stock valuations could be profound.
Support for "Thinking Globally"
The case for a smartly constructed, long-term global allocation portfolio is firmly established. Yet, the Japan and Europe stories -- and the contrast with an aging U.S. bull market -- represent fresh support for investors to think about owning a well-diversified global portfolio.
If the global market crisis taught investors anything, it is surely that the relative appeal of asset classes, industry and business sectors, and nations and regions changes all the time -- often suddenly and precipitously. Investors also need to recognize that, a home market's comforts notwithstanding, investment beyond the U.S. -- far from being inherently risky -- will typically be a valuable counterbalance to the arguably more serious risk of over-concentration at home.
Helping investors stay properly positioned globally will remain a long term exercise. But showing an investor that tapping a new market beyond home is not about taking on incremental risk -- but rather seeking a new source of value that can restore their portfolio risk/return balance to a comfortable posture -- can go a long way toward "thinking globally" in the most positive and rewarding way.
Dennis Stattman is managing director and portfolio manager at BlackRock Global Allocation Fund.