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Investors’ Global Turn Depends on Shaky Policy Hopes

Mohamed A. El-Erian

(Bloomberg Opinion) -- Long eager to exploit international equity markets that have underperformed the S&P 500 Index for years, some investors are finally being rewarded for shifting into emerging markets and European stocks. Their good fortune is likely to attract others, opening a window for continued short-term outperformance. For this to turn into sustainable longer-term returns, however, policy and economic hopes will need to turn into durable realities — a prospect that is far from assured.

The multiyear underperformance of international investing in recent years has been nothing short of remarkable. Since the end of 2010, for example, the S&P has returned a total of 196% compared with 55% for Europe and 10% for emerging markets, as measured in dollar terms by the Euro Stoxx 50 Index and the iShares MSCI Emerging Markets ETF, respectively. This sharp divergence has led some investors to switch away from U.S. stocks to gain larger international exposure — a strategy that has not worked in general but has succeeded more over the last month.

In the 30 days ended last Friday, the measures for emerging markets and Europe returned in dollar terms just more than 8% while the S&P gained 6.9%. This also stands in contrast to what had taken place up to Oct. 8 this year, when the S&P returned 17% compared with the Euro Stoxx’s 13% and the emerging-market ETF’s 4%.

The explanation for this shift lies in policy and economic hopes whose impact on asset market valuations has been turbocharged by investor positioning.

The de-escalation of trade tensions between China and the U. S. has given rise to hopes that a period of “de-globalization” —  or, at least, a globalization pause — is coming to an end. The impact on markets has been amplified by hopes that Germany will adopt meaningful fiscal stimulus, which, combined with the strength of the U.S. consumer, could set the stage for a rebound in global growth.

This changed outlook is particularly favorable for Europe and many emerging markets that are more open to trade than the United States and whose economic performance has lagged more. The resulting outperformance of international stocks is likely to attract more money into the trade, helping to sustain technically what has so far been a rally fueled by hopes of continued better fundamentals. It also helps that the dollar has weakened over the last month and that a few of the idiosyncratic issues holding back international markets — particularly Brexit, but also EU-U.S. trade issues — appear less problematic.

The question for global investors is not whether international investing can outperform in the short term — it can, given the previous wide divergence — but whether this can be sustained over the medium and long term. For that, policy and economic hopes need to turn into lasting realities.

Judging from a recent trip to Germany, there are few indicators that significant fiscal stimulus is imminent. And it’s not just because the current political setup is unlikely to undertake sweeping policy change. Many Germans I met believe that, given the weakness in global manufacturing and structural challenges facing the auto sector, the economic impact of fiscal stimulus would be limited. This is more so given that the service sector (and non-tradables in general) continue to do well. As such, they believe that fiscal stimulus would be at best ineffective and could even cause more harm than good.

The hesitancy to go large on fiscal stimulus is amplified by those who believe it’s better to wait to give time for the economy to adjust by itself. After all, Germany has a history of adaptation, and its large stock of wealth provides an ample buffer for this adjustment period.

Questions also arise when it comes to the durability of the recent easing of China-U.S. trade tensions. It is far from obvious that this will prove anything more lasting than a short-term truce. After all, many of America’s genuine grievances about certain Chinese trade practices remain unaddressed. As such, it wouldn’t surprise me if the “mini-deal” eventually gives way to renewed tensions as opposed to providing a stepping stone to a still-free and fairer trade system.

All of which would make the recent partial rebound in global economic growth rather fragile. Meanwhile, the U.S. would continue to benefit from a strong labor market and a relatively more closed economy. Moreover, greater relative European easing of monetary policy would support the dollar, adding to the longer-term edge for the U.S.

To reduce the risk of short-term gains giving way to renewed disappointment, investors who are increasing their international exposure would be well advised to stress quality in selecting their investment vehicles. The emphasis should be on companies with solid balance sheets, strong management teams, considerable cash-flow generation and a domestic tilt in their operations. This would allow these investors to keep a claim on the short-term upside while limiting some of the possible longer-term downside risks.

To contact the author of this story: Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens' College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include "The Only Game in Town" and "When Markets Collide."

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