Global markets continued to perform well in the second quarter, resulting in solid gains for most broad asset classes during the first half of the year. Foreign stocks outpaced their U.S. counterparts, helped by a weaker dollar and improving corporate fundamentals, while bonds benefited modestly from falling interest rates. Commodities continued their recent struggle, as oil markets were again impacted by increased production and oversupply.
As we review the factors that inform our investing, the starting place is evaluating global economic growth. In that evaluation, manufacturing data can be a very useful indicator. The table below shows a heatmap of global manufacturing data for the past 12 months: green=economic expansion, yellow=neutral, and red=economic contraction. Over the past year, the data has become “greener” across the board, especially for developed economies. Moreover, even troubled emerging market countries such as Brazil have markedly increased manufacturing. The IMF currently estimates that global GDP growth will accelerate to 3.5% in 2017 and 3.6% in 2018. This compares to 3.1% growth in 2016.
Purchasing Manager Index for Manufacturing
Source: Markit, JP Morgan Asset Management. Heatmap colors based on PMI relative to the 50 level, which indicates acceleration or deceleration for the time period shown. Data as of May 31, 2017.
In addition to improved manufacturing data, global corporate earnings trends have also shown improvement. Earnings growth is the biggest driver of stock prices over time, and the U.S. has had the strongest earnings growth and the best stock market performance among major economic regions since the global recession. U.S. earnings recently improved to new highs, overcoming 18 months of weakness in the energy sector and a strong dollar.
Earnings levels for European and emerging market stocks have also turned positive over the past 18 months, reversing a multi-year downtrend that started in 2011. We see potential upside in these markets for two reasons. Earnings levels and price levels for Europe and emerging markets are still well below previous highs, in contrast to the U.S. In addition, valuations of foreign stocks are more attractive than U.S. stocks at the margin.
Finally, the global political environment has stabilized over the past year, with closely contested major elections in the United States and Europe, along with the United Kingdom’s “Brexit” referendum now behind us. While political headlines in the U.S. and foreign nations may continue to frustrate voters and create short term bouts of volatility, the markets have largely brushed off these events in favor of fundamentals.
So how does this data inform our investing? In this environment, we continue to find U.S. stocks attractive as earnings rise, but are cognizant of strong price increases and above-average valuations. We therefore plan to take some profit from the U.S. side of the ledger and marginally increase our allocation to foreign stocks. This change does not represent an overweight to foreign stocks versus domestic stocks, but rather a return to baseline levels of approximately 70% U.S. and 30% foreign.
While it’s true that over the last 7 years, investors would have been better off owning only U.S. stocks and no foreign stocks, over longer periods of time the argument for including foreign equities is compelling. Referring to the graph below, an investor owning a 70/30 mix of U.S. and foreign stocks since 1970 would have earned 4 times the amount earned by an investor owning only U.S. stocks.
Source: Dimensional Fund Advisers. Global Stock Portfolio composed of 70% US stocks and 30% foreign stocks. Foreign stocks include developed and emerging markets securities. Data as of December 31, 2016.
Finally, many investors are asking a simple question— should we lower the risk in our portfolios? Is a correction coming? This is the emotional trap we don’t want to entertain. We need to keep in mind that exposure to stocks is absolutely needed to achieve long term goals. Core bonds provide ongoing protection during equity market declines, and hedged equity is designed to achieve greater returns than bonds with lower volatility than stocks. We emphasize the importance of staying invested. As recent examples, investors that tried to time Brexit or the U.S. election likely missed out on significant positive returns subsequent to those events.
* Information provided should not be construed as investment advice and is not meant to be taken as a recommendation to buy or sell. The financial situation and investment objectives of each individual must be considered for suitability prior to any recommendations being made.