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In my August 2022 commentary, I discussed the S&P 500’s recent dominance over its foreign counterparts and whether this trend was likely to reverse course.
Given it has been roughly half a year, I thought it would be a good time to revisit this topic. While you should never overreact to short-term moves (higher or lower), foreign markets have significantly outperformed the S&P 500 over the past five months.
Here are the returns from 10/23/2022 to 3/23/2023 (as of this writing):
S&P 500: +5.24%
EEM (Emerging Markets): +16.99%
EFA (Developed Foreign Markets): +20.77%
Seeing all three markets with a positive return is a welcomed picture, given how shaky things were in October. The natural question is whether this outperformance will continue. While no one can say with any high degree of certainty, I believe it will, and my belief is even stronger after the recent U.S. banking saga.
U.S. Bank Failures
By now, we are all familiar with the recent U.S. bank failures and the initial panic that ensued. The FDIC and Federal Reserve took immediate action to calm markets, an action that investors embraced. These banks failed for many reasons, with the rapid rise in interest rates being one of the main culprits.
Given the aggressive stance of the Federal Reserve in raising interest rates last year, the bond market struggled mightily, with long-term bonds enduring the most pain. U.S. bank balance sheets hold hundreds of billions of dollars of U.S. treasuries, with a sizable amount in intermediate- and long-term treasuries.
As bond prices decreased, so did the unrealized losses on the bank balance sheet, which was the start of their demise. The Federal Reserve knew their actions weren’t without risk. While hyper-focused on bringing down inflation, they failed to realize how much of a ripple effect it could have on the banking sector. They need to proceed with extreme caution to avoid further banking failures.
Ironically, markets have since rallied sharply as investors now assume the Federal Reserve will reduce or stop raising rates this year and likely start cutting rates in 2024. While I do not expect the Federal Reserve to abandon their interest rate policy and to begin aggressively cutting rates this year or next since certain inflation components are still too elevated, I see them taking a softer stance and acting much more cautiously moving forward.
You are likely asking yourself: Why does this matter for foreign markets? Well, if the Fed slows or pauses interest rate increases, that likely means a weaker U.S. dollar, which is a tailwind for foreign equities. A weaker U.S. dollar means foreign stocks are worth more once converted to our currency. A weak dollar increases the cost of U.S. imports, which can impact the bottom line for many U.S.-based companies.
With that said, U.S. multinational companies and foreign companies that import goods stand to benefit, as a strong currency increases purchasing power.
Foreign markets have lagged in recent years partly due to the strong U.S. dollar. Given that most of the heavy lifting of interest rates appears to be over and the likelihood of the Fed pausing or cutting rates is increasing, this could help propel these markets even higher.
Now, you could be asking yourself whether it’s too late, given the recent outperformance. The answer is no, and the reason is valuations. Both developed and emerging market valuations remain far below the U.S. While the gap has slightly decreased, I maintain that foreign investments remain an attractive risk/reward opportunity.
Of course, no one was rooting for the banking system to collapse, but if there is a silver lining, it is that this occurred before it was too late. Had this not taken place and the Federal Reserve continued their normal course, we could have been met with a much bigger problem.
While far too soon to claim victory, it does appear that steps have been taken to help shore things up and restore customers’ confidence in the banking system. If the Fed continues taking a softer stance, foreign markets could continue their recent run of outperformance.
Let’s hope for brighter and smoother days ahead.
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