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Written by: Todd Asset Management
Although international market indexes have underperformed the S&P 500 year to date (1/1/23-6/30/23) as the rebound in the growth style favored U.S. stocks, we think this underperformance masked an important change — since China re-opened, growth in international economies has been estimated to be better than growth in the U.S. As seen in the chart below, this pivot in growth expectations first occurred in the 3rd quarter 2022 — nearly a year ago.
Despite concerns early in 2023 of a hard landing, as well as several prominent bank failures in March and fears of a U.S. debt default, many global economies held together as inflationary pressures appeared to ease. In addition, the U.S. dollar weakened as the expected recession was deferred and it is likely the Federal Reserve (Fed) may be nearly finished with their tightening cycle. Rates are on the rise worldwide and it appears that Japan is considering ending their yield curve control policies. In many European markets, we have seen inflation rates decline (albeit still higher than central bank targets). Investors seem to be embracing the idea that the Fed can achieve a soft landing, which has lifted growth expectations.
As investors feel better about the outlook, we have seen many developed market indexes challenge new multi-year or even all-time highs. Germany, France and Japan are examples of this, as rates have been normalizing higher. Although China has been making halting steps toward stimulus, it appears that the process is going to take longer than many investors expected. We expect more positive developments from the Chinese authorities over the coming quarters. Other emerging markets have been under more pressure, but most of them raised rates earlier than other markets. We anticipate they could become more stimulative sooner than many advanced economies.
Furthermore, a new capital investment cycle is aimed at spending in the “old” economy. Governments have become more proactive in promoting investment in semiconductor manufacturing and “green” investments. Governments have also been pursuing industrial policy that seeks to re-shore supply chains and limit exports of advanced manufacturing machinery. Against this backdrop, employment has remained strong in Europe, China, Japan, and the U.S. It would be hard to forecast a recession without a decline in employment. Re-shoring implies that companies (and politicians) are emphasizing security of supply over higher costs. This could lead to margin pressures; however, we believe the pros should outweigh this over time. Re-shoring typically leads to employment gains and a larger wage base. The average age of European plant and equipment is the oldest since the 1940s, so a period of reinvestment is needed and welcome. New facilities could be more productive too, something to which developments in artificial intelligence can probably provide a tailwind. We expect spending on development of new energy resources to see continued growth, both in green and traditional hydrocarbons, especially if recession fears get pushed out further. Lastly, the world is a more dangerous place than it has been since before the fall of the Iron Curtain. Governments worldwide are spending more on defense.
No scenario is perfect; there are signs of weaker consumer sales, purchasing managers indexes are weaker and commercial real estate is a concern. Still, economies are holding up. Another recession will happen someday, but markets have pushed that expectation out much further, and until a recession becomes a much nearer-term worry, we believe international equity markets are well positioned. Furthermore, as the year progresses and economies likely avoid recession, we believe value factors may once again take the lead, as they did in 2022.