The great decoupling may be entering its final phase.
U.S. financial assets surged through the summer while much of the rest of the world floundered. The trend entered a fourth month in August and brought the biggest divergence since U.S. President Donald Trump’s election win in November 2016. That’s left the S&P 500 Index just below all-time highs as Europe’s benchmark equity gauge sits is near a two-month low and developing-nation shares are on the verge of a bear market.
The chasm is dividing Wall Street into two camps: those betting the U.S. will continue to break away from the pack, and others who caution that American financial assets have to fall back to the pack.
John Higgins, a senior markets economist at Capital Economics, is a pessimist on U.S. markets. He expects equities to fall between now and year-end and decline in 2019 as well, due to a slowing domestic economy and retaliatory trade measures by other countries, particularly China, that weigh on multinationals.
“The only other notable occasion in the past quarter of a century when a similar pattern of divergence in the stock markets was seen for any length of time was also during a period of Fed tightening,” according to Capital Economics. “Although we expect interest rates in the U.S. in this cycle to climb until the middle of 2019, we don’t think that the divergence in stock markets will last until then or end with equities elsewhere recovering ground.”Higgins isn’t alone in the bear camp. The lackluster rebound in U.S. investment-grade credit -- which has interest-rate spreads far from the lows reached earlier this year -- even as equities rally portends downside for stocks, according to Morgan Stanley.
“This is quite a divergence and typical at the end of an economic cycle or before a meaningful equity market correction,” writes chief U.S. equity strategist Michael Wilson.
Seasonality may also be a factor, the strategist adds, as U.S. stocks kick off the weakest month of the year by trading to the downside in the early days of September.
“Correlations can outlast reality for a while as machines chase momentum factors in a quiet summer news cycle” but it won’t last forever, warns Matthew Sigel, a portfolio strategist at CLSA.
Others map out a route for a rosier resolution of the yawning gap between assets in the U.S. and the rest of the world.
“Crowding into U.S. assets doesn’t entail a massive correction, but a window for U.S. underperformance,” said Jared Woodard, a global investment strategist at Bank of America Merrill Lynch. “If the easing we’ve had out of China shows up in South Korean exports and the Kospi, it shows there’s room to run -- and it’s much easier to make a case for recovery in the rest of the world than a catastrophe in the U.S.”