Global Convergence Arrives To Spoil the ‘America First’ Party


Tuesday, August 07, 2018 7:00PM / FDC

The Trump Administration may be looking to put “America First” in global markets, but the rest of the world appears poised to catch up in the second half. The U.S. economy and financial assets pulled away from the pack at the start 2018, which culminated with the fastest growth since 2014 in the second quarter. But an easing of trade tensions and a concerted pro-growth shift by Beijing are set to amplify the underlying convergence in economic activity and help catalyze a new phase of market leadership.

Equities gained following re-ports that China and the U.S. are making renewed efforts to reach a détente on trade, with the MSCI World Index getting a bigger initial pop on the news than the S&P 500 Index. “The Q2 GDP numbers could mark the peak in the divergence trade, especially as the move by Chinese policy makers could mitigate the tail risks to global growth from trade wars,” Mark McCormick, North American head of FX strategy at TD Securities, wrote in a note to clients, adding that “the reflation story is on the mend.” The strategist recommends selling the U.S. Dollar Index around 95, anticipating that the euro will break to the upside against the U.S. currency into the fall.

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The greenback has traded sideways the past six weeks as the rest of the world finds its economic footing, with the gaps narrowing between economic surprise indexes in the U.S. versus the euro zone and emerging markets. Meanwhile, analysts at Morgan Stanley, State Street Corp. and Wells Fargo & Co. say the dollar has just about peaked, and currency strategist Richard Franlovich of Westpac warned that it could see a “correction” if the index breaks below 93.

EM Comeback

Expectations have now been “right-sized,” according to Erin Browne, head of asset allocation at UBS Asset Management, whose active equities division is bullish on developing-market stocks, particularly in Asia. Stability in the dollar means the “groundings in place for convergence with the rest of the world are starting to pick up,” she said. Emerging market stocks trailed the Russell 2000 Index of domestically oriented U.S. equities by nearly 15 percentage points in the first six months of the year. But they are on track to best U.S. small-cap gauge this month for the first time since January. “A shakeout in emerging market equities has created value in a world where good quality value is scarce,” Richard Turnhill, global chief investment strategist at BlackRock Inc., wrote in a note to clients. “The EM equity selloff is set against a backdrop of strong fundamentals: Attractive valuations, robust earnings growth and the highest return on equity in four years.’’ Forecasts for earnings growth in 2018 and 2019 have been on the rise, he added.

Small-Cap Swoon

U.S. small caps were popular in the first half because they offered insulation from escalating clashes over commerce, as well as exposure to a robust domestic economy. But their appeal has waned as investors rotate out of the “trade war trade’ in equities. Peak divergence means the Rus-sell “will underperform and be a great risk-off hedge vehicle,” said Michael Purves, chief global strategist at Weeden & Co. Of course, convergence might not be a straight-line story, as seen in China’s underwhelming July factory gauge report, which reinforced the timeliness of the government’s economic easing plan. Still, since June 18, when the U.S. and China traded tariff threats, the Russell 2000 is trailing the Shanghai Composite amid a cooling of cross-border commerce rhetoric. And during earnings season, these small U.S.-focused firms have failed to post upside surprises as often as their larger peers.

Caution on Europe

In some pockets of the market, traders remain wary of pricing in too much convergence. Take the difference be-tween yields on two-year U.S. and German notes, which lingers near a record high. “This spread trades pretty much on policy differential between the ECB and the Fed,” said Antoine Bouvet, a strategist at Mizuho International Plc. “For the ECB, the market is not pricing enough tightening in 2020 after the end of Draghi’s tenure.”

In the euro area, traders are redoubling bets that bund prices will re-main well anchored by a dovish monetary stance, with the two-year note stuck around -0.6 percent. The swelling two-year Treasury yield reflects expectations that the Federal Re-serve will press on with rate hikes in the near term, even as federal funds futures contracts show creeping doubts about the longevity of the tightening cycle. The gap between yields on December 2019 and 2020 contracts turned negative, a signal that easing is viewed as more likely than further tightening.

A similar reluctance to accept the case for convergence holds in European stocks. Even as earnings growth perks up on the continent, it’s still dwarfed by the pace of profit gains in the U.S. -- even after tax benefits are stripped out, according to Jonathan Golub, Credit Suisse Group AG’s chief U.S. equity strategist. “We remain underweight Europe versus U.S. equities, as our tactical models for both markets imply around 5 percent relative downside over the coming months,” Sebastian Raedler, head of European equity strategy at Deutsche Bank AG, wrote in a note.


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