At Fathom, one question that has occupied our minds for quite some time is whether US equities can continue their record outperformance against other developed markets (DMs). While we have been expecting a turbulent equity market since Q1 and turned more broadly risk off in our asset allocation in Q2 of this year, the continued resilience and large outperformance of the US equity market in the face of emerging market meltdowns and the escalating trade war rhetoric has been one aspect that has puzzled us throughout the year. We think this is a trend that has potentially stretched too far and now poses an ongoing risk to market calmness.
Until last week, the US equity market outperformance had been a clear outlier relative to how closely correlated other developed markets have been to each other this year. In other words, US equity returns had a life of their own reaching over 1.7 standard deviations above the cross section of other individual DM markets returns. We flagged to clients how such occurrences have been inherently unstable and have been short-lived, reverting over 90% of the time over the course of the next year. This started happening this week with the US market underperforming other developed markets by 5% since Monday.
The strong outperformance of the US market has also pushed US relative valuations to near-record levels not seen since the dot-com bubble.
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To assess the resilience in this trend and assess its future prospects, we turned to our new value and momentum geographical equity allocation model. While each factor on its shown has been shown to offer excess returns in the long run, the two factors are often complimentary in the short run. Looking at each factor individually, it is noticeable that momentum-driven markets, such as the US, have been performing better than their cheaper, value counterparts in recent years. Not only has this been observed across countries, with the momentum-driven US market outperforming high value markets such as Canada, but this was also the case for value and momentum stocks within the US market for much of the post-crisis bull market.
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However, as the chart above shows, change is on the horizon. The US-DM performance gap has stabilised, and within the US, value stocks have started to outperform. In our latest strategy brief to clients, we link this shift in factor regime to changes in the global macroeconomic and liquidity environment by using our proprietary asset allocation indicators. The chart below shows how a tighter than expected monetary cycle from the Fed has been one of the main contributors to the weakening market liquidity, with the unexpected Chinese renminbi devaluation being the other systemically important liquidity event. Overall, we argue that a ‘perfect storm’ of tighter global liquidity, trade war uncertainties and a peaking global growth cycle have created an environment where value should outperform momentum. As a result, we also believe that the momentum-driven US equity market might be primed for a continued and long overdue underperformance over the next months. We would see such a trend as an important step towards a market less vulnerable to reversals in crowded positions, a necessary condition if the bulls are to live to fight for another year in 2019.
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