Perspective. Economic and Market. Stock investors should look a yonder

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1 Wells Capital Management Economic and Market Perspective August 8, 2016 Bringing you national and global economic trends for more than 30 years Stock investors should look a yonder James W. Paulsen, Ph.D Chief Investment Strategist, Wells Capital Management, Inc. We think the global economic recovery may be in the early stages of a synchronized bounce. While we suspect the overall pace of economic growth will likely remain subpar by historic standards, the global recovery appears poised to broaden. That is, for one of the rare times in this recovery, perhaps most economies about the globe will bounce northward together. Recently, somewhat better economic reports have already helped elevate stock prices about the globe including pushing the U.S. stock market to new record highs. However, if evidence of a global economic bounce broadens, it is likely to help international stocks much more compared to domestic stocks. For several reasons, we think investors should consider a near maximal overweight toward both ex-u.s. developed and emerging stock markets. International stock markets have underperformed for some time and consequently most are now significantly under-owned and represent better values relative to U.S. stocks. Additionally, only the more mature U.S. economic recovery now faces the challenges associated with returning close to full employment. Consequently, most international stock markets will continue to be supported by hospitable policy actions whereas U.S. officials are beginning to turn hostile for the stock market. Moreover, the U.S. dollar has peaked in the last year and appears likely to weaken in the coming year. Finally, and perhaps most importantly, compared to an aging earnings cycle in the U.S., most international companies still have the potential to achieve considerable earnings gains. A global economic bounce? After seven years of chronically disappointing economic growth about the globe, in the immediate aftermath of the current crisis de jour Brexit and in a world which now boasts negative sovereign bond yields as commonplace, few anticipate that the world economy may be on the brink of an economic bounce. However, for the first time in this recovery, all policy officials are simultaneously pushing upward on the global economy. Although the U.S. has persistently employed stimulus, other developed and emerging economic policies have often been in conflict. Today, though, Japanese policy officials are no longer hesitant but rather are implementing full out Bernanke stimulus. Likewise, the eurozone, which earlier adopted fiscal tightening, has now also fully embraced central bank balance sheet expansion. Moreover, the oil crisis has forced energybased economies like Canada and Australia to also become accommodative. Finally, China (similar to other emerging economies) is no longer attempting to moderate its recovery as it was until 2015 but rather is using all weapons (a collapse in its sovereign bond yield, a surge in the growth of its money supply and a more aggressive yuan devaluation) to quicken growth. Economic policies around the world are finally attuned suggesting the odds of a synchronized global economic bounce may be higher than ever before in this recovery. Indeed, a global economic upturn may already be underway? As illustrated in Chart 1, the Westpac Positive Surprise Global Index has surged by its quickest and largest amount of the entire recovery since March and now stands at its best level in more than five years! An improvement in economic momentum is also strongly suggested by rising stock markets. Developed world stock markets are up by about 15% to 20% and emerging stock markets have risen by almost 30% from early-year lows. Finally, commodity prices also imply rebounding economic momentum with U.S. industrial commodity prices up by about 20% from first quarter lows.

2 Chart 1 Westpac Positive Surprise Global Index Four-week moving average Chart 2 U.S. S&P 500 Composite Stock Price Index, natural log scale Trailing 12-month earnings per share vs. trendline average Chart 3 MSCI World Ex-U.S. Stock Price Index, natural log scale Trailing 12-month earnings per share vs. trendline average A significant earnings rebound abroad? As shown in Charts 2 and 3, corporate earnings have been declining in the U.S. for the last couple of years and throughout much of this recovery abroad. The trailing 12-month earnings per share for the S&P 500 stock price index and the MSCI world ex-u.s. stock price index are shown relative to their respective trendlines since Interestingly, in the last 45 years, both domestic and international corporate earnings growth has been about the same. Foreign earnings growth has averaged about 6.5% per year compared to only slightly faster 6.8% U.S. earnings growth. However, since early in this recovery, U.S. earnings performance has far outpaced a worsening trend in foreign profitability. While corporate performance about the globe has struggled in the last couple of years, U.S. earnings have only declined modestly to about 13% below trend and still reside almost 20% above the peak during the last recovery in By comparison, foreign earnings have declined almost 40% below trend and are almost 45% lower than the record peak in

3 Although a synchronized global economic bounce would boost earnings performance across the globe, there is much more potential for a dramatic earnings rebound outside of the U.S. The divergence between U.S. and foreign earnings performance in this recovery has been unique. At least since 1970, during global economic recoveries, the earnings performance in the rest of the world has never been this poor relative to profit results in the U.S. Therefore, should the current global economy finally broaden for the first time in this recovery, foreign profits will likely improve significantly more compared to U.S. company results. As shown in Charts 4 and 5, foreign companies appear to have greater potential to boost sales and to expand profit margins relative to U.S. companies. While sales have flattened for U.S. companies in the last couple of years, they have collapsed among foreign companies. A bounce in global economic activity would most likely boost sales trends more abroad than within the U.S. Similarly, while U.S. profit margins remain near all-time record highs, foreign profit margins have considerable room for improvement. Indeed, because the U.S. has returned close to full employment, any boost in sales among U.S. companies may be mostly offset by margin erosion since wages and other costs are poised to accelerate. Chart 6 is a simple reminder that what falls the most, often rebounds the most. It overlays the percent by which earnings among U.S. and foreign companies are above or below their respective trendlines. Since 1970, this chart has provided a good indication of who may experience the strongest earnings recovery U.S. or foreign companies after an earnings decline. In the early 1970s, both U.S. and foreign earnings declined by similar amounts and subsequently recovered by nearly equal amounts in the ensuring recovery. In the late 1970s however, foreign earnings bounced back much more aggressively after underperforming U.S. profitability during the previous recession. This happened again in the 1980s. Foreign earnings contracted more severely and recovered more strongly compared to U.S. results. In the 1990s, just the opposite occurred. U.S. earnings initially declined more dramatically and then posted a more robust recovery compared to foreign earnings. In the early 2000s, foreign earnings similarly declined more and recovered more relative to U.S. earnings. In the contemporary recovery, both U.S. and foreign earnings declined by about 45% below trend and both initially recovered in a similar fashion. However, in the last few years, foreign earnings have been much more dissapointing compared to U.S. earnings. Chart 4 S&P 500 Index vs. MSCI World Ex-U.S.A. Index Trailing 12-month sales per share, natural log scale Solid S&P 500 sales per share Dotted MSCI World Ex-U.S.A. sales per share Chart 5 S&P 500 Index vs. MSCI World Ex-U.S.A. Index Trailing 12-month profit margin Solid MSCI World Ex-U.S.A. profit Margin Dotted S&P 500 profit margin 3

4 Consequently, investors should expect a more robust foreign earnings recovery should the economic cycle soon broaden and improve. Chart 6 S&P 500 Index vs. MSCI World Ex-U.S. A. Index Earnings per share as a percent above / below trendline Solid S&P 500 EPS percent above / below trendline Dotted MSCI World Ex-U.S.A. EPS pecent above / below trendline Although U.S. stocks are highly priced today, valuations could still rise further. At about 17.5 times trendline earnings, they are still priced lower than they were in the last recovery and significantly below the peaks reached during the tech bubble. However, U.S. stocks are also more expensive today than almost any time prior to 1995 and excluding the 90 s tech run, they are near the top end of the historic valuation range. Probably the best investors can reasonably hope for U.S. stocks is that they maintain the current PE multiple and simply follow earnings gains higher. Foreign stock valuations suggest a very different opportunity. Currently, ex-u.s. stocks have a PE multiple nearly as low as any since Moreover, the PE today is among the cheapest of the entire recovery. Should the global economic recovery bounce and broaden, foreign stocks should benefit both from a superior earnings recovery and from much more valuation improvement potential. Chart 7 Relative stock price performance MSCI World Ex-U.S.A. Index vs. S&P 500 Composite Index Under-owned and a better relative value? As shown in Chart 7, international stocks have underperformed the U.S. stock market throughout most of this recovery. Because foreign stocks have underperformed so persistently, they are likely significantly under-owned by most investors. More importantly, they have become an increasingly good value. As shown, on a relative price basis, ex-u.s. stocks are lower today than at any time since at least Charts 8 and 9 examine the current relative values of domestic and foreign stocks based on trendline earnings. In Chart 8, a price-earnings (PE) multiple is constructed by dividing the price of the S&P 500 stock price index by trendline earnings (i.e., the dotted line in Chart 2). Chart 9 calculates a similar PE multiple for the MSCI world ex-u.s. stock index. 4

5 Chart 8 S&P 500 Composite Stock Price Index Price to trendline earnings (PE) multiple Chart 10 U.S. Dollar Index vs. Fed funds interest rate Solid (left) Trade-weighted U.S. Dollar Index Dotted (right) Fed funds target interest rate Chart 9 MSCI World Ex-U.S.A. Stock Price Index Price to trendline earnings (PE) multiple Will U.S. dollar surprise on the downside? Finally, we believe international investment returns may also be boosted by a surprising decline in the U.S. dollar. For some time, consensus has expected the U.S. dollar to rise. However, despite more aggressive easing by foreign policy officials, negative sovereign bond yields in several international economies and less aggressive monetary policy actions in the U.S., the U.S. dollar has been essentially flat against most currencies in the last year. We think the U.S. dollar has peaked and is more likely to decline in the coming year. Probably the biggest reason most expect a stronger U.S. dollar is because the U.S. Federal Reserve is likely to soon begin regularly raising the federal funds rate while foreign officials continue to keep interest rates low. However, as shown in Chart 10, a rise in the federal funds rate has not typically been associated with a strong dollar as most seem to believe. The chart highlights (by bolding) six times since 1970 when the federal funds rate rose significantly. In every instance, the U.S. dollar index either weakened or was essentially flat. As illustrated, both times in the 1970s when the Fed boosted the funds rate, the dollar declined. This also occurred again during the late 1980s, the mid 1990s and in the mid 2000s. Most recently, the U.S. dollar has also weakened since the Fed lifted the funds rate last year. 5

6 Just because the Fed is likely to raise the funds rate in the next year does not necessarily imply that foreign investing will be hurt by a strong dollar. Indeed, at least since 1970, periods of Fed tightening have more typically weakened the U.S. dollar to the benefit of offshore investments. Summary Most have long given up expecting any significant economic traction from policy officials. However, for the first time in this recovery, economic stimulus has been aligned across the globe and evidence suggesting a synchronized economic bounce is expanding. We suspect this change in the global recovery will benefit foreign stock markets much more than the U.S. stock market. For several reasons, we think investors should consider a near maximal overweight toward both ex-u.s. developed and emerging stock markets. International stock markets have underperformed for some time and consequently most are now significantly under-owned and represent better values relative to U.S. stocks. Additionally, only the more mature U.S. economic recovery now faces the challenges associated with returning close to full employment. Consequently, most international stock markets will continue to be supported by hospitable policy actions, whereas U.S. officials are beginning to turn hostile for the stock market. Moreover, the U.S. dollar has been peaking in the last year and appears likely to weaken in the coming year. Finally, and perhaps most importantly, compared to an aging earnings cycle in the U.S., most international companies still have the potential to achieve considerable earnings gains. Written by James W. Paulsen, Ph.D. An investment management industry professional since 1983, Jim is nationally recognized for his views on the economy and frequently appears on several CNBC and Bloomberg Television programs, including regular appearances as a guest host on CNBC. BusinessWeek named him Top Economic Forecaster, and BondWeek twice named him Interest Rate Forecaster of the Year. For more than 30 years, Jim has published his own commentary assessing economic and market trends through his newsletter, Economic and Market Perspective, which was named one of 101 Things Every Investor Should Know by Money magazine. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital Management, LLC; and The Rock Creek Group); Wells Capital Management, Inc. (also includes First International Advisors, LLC and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at or refer to our Form ADV Part II, which is available upon request by calling