This Quarter Represented the Most Attractive Allocation Opportunity in Two Decades

Part II of Volume I Issue X

November has given a glimpse of the outperformance that emerging markets can deliver in the post-stimulus world as the maturing phase of Federal Reserve tightening focuses investors’ minds on the opportunities beyond.

Stocks, currencies and local bonds in developing nations rallied this month by the most since March 2016, a period that heralded the biggest gains since the commodity boom of the early 2000s. That helped the benchmark gauge for emerging-market equities to surpass the S&P 500 Index by the most since the global financial crisis, while dollar-denominated bonds advanced the most since then.

~ Bloomberg, November 29, 2022

Investors are turning more positive on Europe, spurring a recovery in the region’s beaten-down stocks.  As of Tuesday, the benchmark Euro Stoxx 50 index had gained nearly 19% this quarter, putting it on track for the best quarterly performance since 2009. The mood has brightened after a period of extreme pessimism about Europe, brought on by the invasion of Ukraine, a subsequent jump in energy prices and the highest inflation in decades…

Foreign investors have snapped up European assets. In a marker of that international appetite, flows into exchange-traded funds holding eurozone-based stocks, but which are denominated in other currencies, rose to the highest monthly level since early 2021 last month…

~ The Wall Street Journal, December 7, 2022

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Editor’s Note: This is Part II of Volume I, Issue X of The Macro Value Monitor. Part I, A Punch Bowl Removed, and the Deceptively Innocuous First Year of a Long-Term Bear, can be found here. A full PDF of this issue is available here.

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One of the central, painful dilemmas facing investment advisors and managers in recent years has been the absence of attractive opportunities beyond overvalued U.S. stocks. 

In the decade following the financial crisis, yields on U.S. bonds remained low leading up to the Covid pandemic, and then reached historic lows never before seen in 2020 and 2021.  As the Federal Reserve expanded its balance sheet in successive quantitative easing programs after 2008, and then doubled down on its monetary expansion in 2020, the underlying risks for bond holders receiving one or two percent was immense. 

Throughout those years, it would have only taken a modest decline in bond prices to trigger large losses, and even if such a decline did not occur, it would take only a modest uptick in inflation above 2% to turn bonds into negative-yielding investments, on an inflation-adjusted basis. These risks compounded after the Federal Reserve offered a revised interpretation of its dual mandate in 2020, emphasizing a new flexible approach to achieving 2% inflation over time.

To invest in U.S. bonds over the last decade, and especially in 2020 and 2021, required an investor (or investment manager) to accept interest rate and inflation risks that loomed over the paltry yields like a Sword of Damocles.  This year, the single strand of hair holding the Sword aloft finally broke, and in the unwinding that followed, a decade’s worth of yield was clawed back from investors in less than 9 months.

Outside of U.S. stocks and bonds, there was a high return/risk bar to meet as the U.S. dollar trended higher after 2012.  The dollar’s bullish trend after 2012 cemented the bear market in commodities that had begun in 2008, with the price of oil, copper and the broad CRB Index all falling by more than half as the dollar rose higher.  The dollar’s rise also dampened gold and precious metals. Gold fell 45% between 2011 and its lowest price in 2015, while silver and other precious metals continued to set new lows throughout the latter half of the decade.  When the pandemic hit in 2020, most commodities (except gold) fell to new post-2012 lows.

It was a similar story in equity markets outside the U.S.: for dollar-denominated investors, equity markets outside the U.S. have been moribund since the financial crisis.  The powerful combination of declining local currencies and contracting equity market valuations proved to be a recipe for high volatility and negative returns after 2012 – a depleting combination.  The dollar-denominated MSCI World (ex-USA) Index, shown below, traded as low as half its 2008 peak at the end of the third quarter of this year, and remains at the same level it was 22 years ago.  Relative the S&P 500, global equity markets sank to the lowest level in decades in 2022.

Alongside global equity markets, global bond markets were no more attractive than U.S. bonds, and suffered the added risk of being denominated in currencies that began suffering relentless downtrends versus the dollar. 

An example serves to illustrate the risk in global bonds.  One of the largest global sovereign bond funds, the SPDR Bloomberg International Treasury Bond ETF, suffered a very difficult year in 2022: the fund’s total return during the first three quarters of 2022 was negative 24.9%.  This return was the result of tightening monetary policy across the globe, but it was exacerbated by the dollar’s rise.  Over the last 3, 5 and 10 years, as the dollar rallied, the fund delivered the following annualized returns to investors: -9.2%, -4.8%, and -2.9%, respectively.

Including higher-yielding global corporate bonds to sovereign bonds improved the results over the past decade, but only modestly.  The Vanguard Total International Bond Index has annualized returns over the past 1, 3, and 5 years of -13.2%, -3.6, and 0.0%, respectively, but a positive 1.5% annualized return over the past decade.  It remains to be seen whether corporate bonds around the world will retain their positive 10-year return while central banks around the world induce an economic slowdown over the next year to rein in inflation. 

With bonds in the U.S. and around the world offering very little incremental return for the interest rate and inflation risks, with global equity markets mired in a cycle of devaluation, and with commodities struggling under the weight of private sector deleveraging and a 60% rise in the U.S. dollar over the course of a decade, there were few attractive alternatives to U.S. stocks leading up to this year.  It was an unpalatable choice between asset classes with either acute underlying risks (bonds) or ongoing negative returns (global equities & commodities), and an equity market that, by a number of valuation measures, had reached its highest valuation on record (the U.S.). 

However, in a most welcome turn of events for value-minded, risk-conscious investors, that entire set of unpleasant alternatives has flipped this past quarter into one of the most attractive allocation opportunities in two decades.