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A defensive market that is looking increasingly risky

A defensive market that is looking increasingly risky

09-11-2018 | Visión

Historically, switching to the US is an obvious choice at a late stage of the bull market when a shift towards more defensive equity allocation is desired. However, this time may be different.

  • Peter van der Welle
    Peter
    van der Welle
    Strategist

Source: Thomson Reuters Datastream, Robeco

America first! It's hard to deny that the US stock markets have set the tone of President Trump's first term in office. The US also finds itself in the exceptional situation that the economy is doing so well that monetary policy normalization is well underway, in contrast to what is happening in Europe and Japan. The US economy is now running at full throttle, spurred by a president who claims to be an expert in the rules of the economic game. Investors are pricing in uncertainty and seem to believe Trump's vow to put “America first”. 

Since he was elected in November 2016, it's remarkable how much the risk premium that investors demand for investing in equities in the US has fallen compared to the rest of the world.  Large corporate tax cuts and a market with a sector bias towards growth and tech stocks which have so far performed well, also play a role. 

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Mind the gap

The risk premium* investors demand for investing in stocks in the US is now at a low compared to what they demand in other countries. This reflects the relatively high level of confidence of US investors. The rules of the economic ‘game’ in Trump's America seem more transparent than elsewhere in the world. Take Europe, for instance, where politicians quarrel about Italy and the future of the euro project still seems uncertain. However, this negative perception of risk about Europe is nothing new. Since the Eurozone crisis erupted in 2011, the gap between the equity risk premium investors demanded in Europe compared to the US has continued to widen.

However, the current, exceptionally large difference with the average risk premium in the US indicates that European investors may overestimate the risks, while US investors could be underestimating them. 

First, the thorny Brexit situation must take a decisive turn before March 2019; regardless of the outcome, this will reduce uncertainty for European equity investors. Second, there are ‘market forces’ at work, i.e. yields on Italian government bonds are rising, which will eventually force Italian populists to compromise and submit a budget more in line with the EU's rules, thus providing temporary respite from the risks associated with Italy. Third, Trump's economic policy is losing clout. 

The US versus the rest of the world

In other words, by now, the lingering, well-known European risks have been amply priced in, as the political playing field in the US grows increasingly complex. Although a higher risk premium on European equities is therefore still justifiable, looking ahead, the downside risk of European equities compared to their US counterparts is, in fact, more limited.  This observation also applies more broadly, because in Japan, too, the political risks seem more limited, since Abe’s re-election and the continuation of ‘Abenomics’. 

Our analysis demonstrates that with equity risk premiums in the US at their current, astonishingly low levels relative to the rest of the world, the returns on US equities have historically lagged. In other words: based on current valuations, the rest of the world has an edge on the United States when it comes to return potential. 

Historically speaking, switching to the US, which has traditionally been a defensive market for equities, is an obvious choice at a late stage of the bull market. However, in this case, there are actually reasons to prepare for an increasing share of equities from other countries, so that one can gradually reduce the weight of US equities. Take, for example, the sustained global economic growth, the attractively priced European and Japanese markets and the expected decrease in political/geopolitical risks in Europe compared to the US. 

*Determination of the Z-score
We define the regional equity risk premium (ERP) as the earnings/price ratio of the regional equity index (the inverse of the price/earnings ratio, i.e. (1/K/W)) minus the return on the corresponding 10-year government bond. We calculate the US ERP as the S&P 500 earnings/price ratio minus the 10-year Treasury yield. For the global ERP, we subtract the yield on the Merrill Lynch global government bond (which has a comparable duration to the 10-year Treasury) from the MSCI World earnings/price ratio. Both data sets are denominated in dollars. Then monthly data from 1985 onwards was used to calculate a Z-score using the absolute difference between the US ERP and the global ERP. 

This article is part of our investment outlook 2019: ‘Turbulence ahead’.

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