Research Notes: Looking Overseas
Will foreign turmoil hurt U.S. equities — or rescue them? Plus, a look at impacted multinationals
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Investors in the U.S. are doing what we Americans do: focusing on our country pretty much to the exclusion of all of the other ones. And so the discussion around the Fed, the possibility of a recession, and the sentiment of other investors (they seem too bearish, it’s time to buy!) seems to be driving attitudes toward the short- and mid-term direction of the U.S. equity market.
We argued in this space just last week that this discussion misses a pretty key point: that valuations remain stretched:
Shiller PE, source: multpl.com
This chart of the Shiller PE — also known as CAPE (Cyclically-Adjusted Price-to-Earnings) — shows we’re still in rarefied air. And it seems a more valuable starting point for this macro guessing game (which, admittedly, some investors are happy to opt out of, taking a more Buffett-like approach) than the folly of trying to play the Fed/interest rates/recession circle. (And it is a circle, as witnessed by how many pundits and investors disagree about the actual direction of mechanism: will the Fed slow the economy, or will a cooling economy slow the Fed? Or both?)
At the risk of turning this space into a consistent source of doom-and-gloom macro analysis, let’s look at another point US investors might be missing. The rest of the world is on fire, in some cases literally.
Let’s go down the GDP rankings:
China (#2, 15% of world GDP): Thousands of homebuyers are refusing to pay their mortgages. Covid remains severe in cities like Shanghai. Per S&P (not exactly Chicken Little on the real estate front), at least one in five developers in the country could be functionally insolvent.
Japan (#3, 6% of world GDP): The yen continues to weaken, threatening the Bank of Japan peg and risking an all-out implosion in a currency that’s already touched a 24-year low. The company’s former prime minister — and most famous politician — was just assassinated. Tokyo is facing an energy crunch.
Germany (#4, 4.6%): The head of the country’s largest producer of ammonia told the Financial Times that production will go from “100 to zero” if Russia cuts off natural gas supplies. The article adds that “Berlin fears a winter gas crisis that could paralyze industry and leave millions freezing in their homes.” Similar fears haunt the rest of the EU, an incremental 12% or so of GDP.
United Kingdom (#6, 3.3%): No leadership (literally and figuratively), a cost of living crisis, energy worries, impact from Brexit, and now a record and no doubt fatal heatwave.
Russia (#11, 2%): A potentially ruinous war, foreign sanctions, likely political unrest, etc. etc.
Include all of the EU in this brief analysis and we’re up to countries that combined account for ~43% of global GDP and that seem to have pretty significant problems at the moment, even disregarding lingering (or potentially returning!) pandemic/supply chain problems.
That creates an intriguing thesis: that the scale of those overseas issues, in terms of both their effects and their reach, is far more important than domestic concerns about (for example) whether the Fed hikes 75 bps or 100 bps at its next meeting.
Two questions follow. First, is the thesis correct? There’s always something going on somewhere, and usually multiple somethings in multiple somewheres. This analysis focuses almost exclusively on Europe and China, and in both cases it’s not as if the concerns are new. Fears of a real estate-driven crash in China have been around for literally decades; the country had its own version of the late 2000s housing bubble. Worries about European economic growth have persisted for just as long.
Indeed, probably the most bullish analogue for where the US market sits now is the 2011 sell-off, which seems a bit forgotten at this point. (It’s much more difficult to argue similarities to 2002 or 2009; as we’ve argued since our first post, not enough dead wood has been cleared to suggest that kind of bottom.) That year, similar fears were front and center, with investors fretting about a “hard landing” in China and a sovereign debt crisis surrounding the “PIIGS” (Portugal, Italy, Ireland, Greece, and Spain) of Europe. Italy in particular was seen as a source of contagion; though aid packages had been created for Greece and Ireland, Italy’s economy (the third-largest in the Eurozone) was too large for a bailout.
On Oct. 3, 2011, the S&P 500 closed below 1100. Including dividends, and even with the sell-off so far this year, investors in that index since have more than quadrupled their money, generating annualized returns over 14%.
This time around, however, does seem different. There’s a quantitative difference between Spain and Italy being at risk and Germany and the U.K. being under fire, not least because the combined GDP of the latter two countries is almost double that of the first two. Social unrest in China does seem to add a new wrinkle, and it may be that China’s problems, which have been mostly unaddressed, have grown in the intervening 10-plus years since the “hard landing/soft landing” debate dominated conversation about that economy.
The second question is: if the thesis is true, what is the play? So far, there’s been one obvious winning trade:
The U.S. Dollar Index (DXY) is at a 19-year high. The corollary is that the weakness elsewhere might actually be good news for U.S. stocks. There’s still plenty of money in these suddenly volatile markets — again, they combine for 40%-plus of global output — and it has to go somewhere. A turbulent U.S. equity market might look like the best option, even if only the best of bad options.
In essence, it’s a new version of the TINA (There Is No Alternative) market. Previously, there was no alternative to equities, because bonds provided no yield. Now, there’s no alternative to US equities, because global equities provide too much risk.
To some extent, this thesis probably already is playing out. Dollar strength is one piece of evidence. Another comes from an exceptionally intelligent friend of mine who works on the institutional side of the industry. He told me that appetite for international stocks from US investors is as low as it’s been in some time — and that’s saying something, given returns outside the US over the past decade. (The iShares Core MSCI Total International Stock ETF (IXUS), for instance, has gained 17% total over the past ten years. Those returns are less than one-tenth those of the S&P 500 over the same period.)
It’s also possible to take the opposite view: that the U.S. is not, and can not, be permanently immune to these issues overseas. It’s an interconnected world, of course, and at some point, if the problems in Europe and Asia are persistent and structural, they’re going to wind up on our shores as well.
Like everything else right now, reasonable investors can see this very differently. Personally, I’d take the view that we’re still in mid-term trouble, largely due to valuation, but we may get a bigger short-term bounce than bears might think, with some support perhaps coming from overseas.
Longer-term, however, the doomsday scenario we cited last month seems firmly in play. It increasingly looks like things are simply breaking, at home and overseas. From a global perspective, mankind is not healthy economically, politically, or socially. The Fed alone can’t fix that problem.
A Brief Look at Biotech
We did not plan for this platform, and particularly the Research Notes feature, to contain so much in the way of macro commentary — and we will dial it back substantially from this point onward. We’ve made our case for a bearish perspective and some cautious trading, and we’ll ride that horse until she bucks.
Before that, however, an intriguing chart:
On June 13, the SPDR S&P Biotech ETF (XBI) just about set a five-year low. (The ETF had closed pennies lower on May 11.) Since then, XBI has rallied 32% in just over five weeks.
Particularly over a one-month period, XBI (which focuses on smaller biotechs) is a pretty good proxy for risk appetite. As far as 2021 trading goes, XBI was perfect for the simplistic narratives that dominated a lot of that bull market: optimism toward “gene editing” and cancer platforms trumped the long-running concerns that had kept a lid on the space even during the pre-pandemic bull market. (Incredibly, as of this writing, XBI still has declined 8% over the last seven years.)
Jin Daikoku pointed out on Twitter that the Merck (MRK) / Seagen (SGEN) deal could have been a catalyst; indeed, the Wall Street Journal report on deal talks came just a few days after XBI bottomed (the deal was made official earlier this month).
So investors can tell whatever kind of story they want with the XBI chart: that investors got too far in the “risk-off” direction earlier this year; that risk appetites remain healthy; that the argument that investors should be bullish because “everyone is bearish” doesn’t really hold up. At this point, readers likely know about where we stand.
Returning to the discussion about overseas economies, macro aside, there are some companies at potential risk here. A look at a few:
I covered IBM earnings for Investing.com this week: short version is, I’m not impressed. I’ve long argued that IBM is a value trap, and I’m not sure if it’s any different now: as discussed in detail here, the seemingly accelerating revenue growth is coming in large part from the Kyndryl (KD) spin-off that took place late last year.
But for our purposes, let’s focus on a single number from the Q2 report: $3.5 billion. That’s the headwind to full-year IBM revenue being driven by the stronger dollar — about 6% of 2021 sales.
We are going to see a lot more of this as earnings reports roll in; Johnson & Johnson (JNJ) also highlighted FX during its report Tuesday morning. I don’t think forex is why IBM dropped 5% post-earnings on a dark green day for the market as a whole, but it surely didn’t help. A lot of low-growth multinationals may be posting some weak guidance after Q2, and some weak-looking Q3 and Q4 releases, given where the dollar is right now.
Procter & Gamble (PG)
On P&G’s Q3 conference call, CFO Andre Schutten bragged that his company had kept its full-year guidance range intact. And with good reason: just from the start of the calendar year (the beginning of Q3), between input costs and FX P&G had seen an incremental 56 cents per share in cost, about 10% of adjusted EPS for all of fiscal 2021.
Those pressures no doubt continued through fiscal Q4 — and there’s a scenario where they continue to get worse. The strong dollar doesn’t only hurt P&G through the translation of international sales (nearly half the total), but by giving a competitive advantage to rivals who report in local currency.
Commodity inflation may ease, but it’s still elevated. Macro concerns can lead to trading down to private label and/or cheaper alternatives.
We’ve been here before with P&G. When the dollar spiked in 2015, it obscured the progress the company in retrospect was making with its turnaround, and PG stock wa dead money for a few years. The difference now is that PG is trading at ~24x this year’s earnings.
Coming out of that Q3 report, we wondered whether the stock might be a short (though unfortunately we didn’t put on that trade). 10% lower, there’s still a short case at this point, but at the very least investors need to be very careful here, and look past the yield or an easy “flight to quality” argument.
Along those lines…is it completely insane to think about an AAPL short here? Any investor short the S&P is short Apple anyway. The strong dollar seems a big issue here: in FY21, 58% of Apple revenue came from outside the Americas, so ~60% is ex-US. A good chunk of cost, however, is either denominated in dollars or in yuan, the latter of which hasn’t weakened as much as the dollar index.
There’s probably some post-pandemic/post-stimulus/recessionary impact on Mac revenues (almost 10% of the FY21 total) after that category returned to roaring growth. Android models have dominant market share overseas and now have incremental competitiveness on price as well; it’s going to be even tougher sledding for any Apple product amid macro weakness in Europe or even China.
This is mostly a thought exercise, certainly. (~$170 million in Apple stock is sold short at the moment, however.) There seem better shorts out there, particularly after the bounce of late. But, as with PG, valuation does not look cheap — at all — given some of the potential pressures out there.
Now, there no doubt are some winners, though they’re perhaps a bit more difficult to find. In theory, Alcoa (AA) should be a beneficiary, as it mines and smelts mostly overseas while selling in dollars. But there are macro issues to worry about there, and aluminum prices are at a 12-month low.
Ostensibly, retailers should be winners, sourcing from Asia and selling in the U.S. But retailers have their own issues. Utilities and healthcare stocks often have U.S.-only revenue — but also U.S.-only costs.
It’s worth trying to thread the needle here, perhaps, with the caveat that factor-based strategies may already have sniffed this upside out. We’ll aim to have more thoughts on this front in the coming weeks — and hopefully a bit more optimism.
As of this writing, Vince Martin has no positions in any securities mentioned.
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