It has become something of a beauty contest.
As US equity funds suffered their eighth consecutive week of outflows last week, money was still pouring into European and emerging market stock funds in one of the most dramatic shifts in global investors’ asset allocation strategies in recent years.
While US equity funds enjoyed a surge in inflows just after Donald Trump’s election in November, as investors bet on the speedy enactment of pro-growth policies of tax cuts and infrastructure spending, waning confidence in Trump’s presidency and mounting concerns about lofty equity valuations have led to a sharp rotation from US to European and emerging market stocks.
Since the middle of June, US equity funds suffered over US$20 billion in outflows, according to EPFR Global, a data provider. European stock funds attracted more than US$10 billion of inflows, bringing the cumulative inflows since the start of this year to more than US$30 billion.
Yet Europe is facing stiff competition from faster growing developing economies, where stock valuations are cheaper.
According to JPMorgan Chase & Co., cumulative inflows into emerging market equity funds since the beginning of this year have reached over US$52 billion, with the pace of inflows increasing sharply since April, just when investors began to pile into European stocks.
Make no mistake, over the past four months, the Eurozone has been vying with emerging markets as the preferred region for equity investors.
According to last month’s Global Fund Manager Survey published by Bank of America-Merrill Lynch, the Eurozone and developing economies are the two regions where investors have the most “overweight” positions, in stark contrast to the US and the UK where fund managers are “underweight” relative to their exposure in the past.
Over half the respondents in the survey have an overweight position in European stocks compared with a net 37 per cent in emerging market equities.
In the US, a net 20 per cent of investors have an underweight position in shares, the highest underweight level since 2008.
As I explained in an earlier column, Europe is benefiting from a confluence of economic and political factors. Trump’s woes intensified just when the reform-minded and pro-European Emmanuel Macron won the French presidency, causing the pendulum of political risk to swing away from Europe and towards the US.
Just as importantly, the Eurozone economy is currently expanding at its fastest pace in six years, while the region’s equities are more attractively priced, with a price-to-earnings ratio of just over 14, compared with more than 18 in the US, according to MSCI.
Emerging markets, for their part, are benefiting from the “reach for yield” as investors seek to generate higher returns amid ultra-low (and in some cases negative) interest rates in developed economies.
The Trump-driven plunge in the dollar this year and expectations that the Federal Reserve will tighten policy gradually are fuelling demand for emerging market assets. The equity markets of developing economies, moreover, are trading at only 12.5 times their forward-looking earnings, according to MSCI.
Yet both regions face challenges. The surging euro, which hurts the region’s export competitiveness, is starting to take its toll on Eurozone stocks.
The equity markets of Europe’s single currency area are down 0.4 per cent since mid-April, the period during which the euro shot up 11.3 per cent against the greenback to its highest level since January 2015. Exports account for roughly half the sales from the Eurozone’s largest companies.
Emerging markets, meanwhile, are still vulnerable to a sharp rise in bond yields in advanced economies stemming from the withdrawal of monetary stimulus by the Fed and the European Central Bank. Developing nations even suffered a brief spell of outflows from bond funds at the end of June in a sign of how sensitive the asset class is to central bank policy action.
Yet it is the recent escalation in tensions on the Korean peninsula that poses the biggest risk in the near-term.
European shares fell 2.7 per cent last week – their sharpest slide since Trump’s election as president – while emerging market stocks dropped 3.5 per cent. Even the Vix index, Wall Street’s so-called “fear gauge” which has barely moved over the past month, shot up 55 per cent to its highest level since the US election.
Still, if tensions between Washington and Pyongyang take a dramatic turn for the worse, the state of financial markets will be the least of the world’s problems.
For the time being, however, the beauty contest between Europe and emerging markets carries on.
Nicholas Spiro is a partner at Lauressa Advisory