Global stocks had a strong October, climbing above the record high hit in late July. The MSCI All Country World Index returned 2.8% from the start of the month, and 5.2% since the rally really gathered steam after 8 October. The gains were propelled largely by optimism that the US and China will reach a trade deal, a relatively positive start to the third-quarter earnings season, and some signs of stabilizing business activity.
But, while most assets have rallied since the start of the month, we think over the coming months it makes sense to seek relative value rather than overall price gains:
* Cyclicals have been the driving force, with defensives lagging. Globally, cyclicals have outperformed defensives by 2%. In Europe, this margin has been much larger at 6%. The extent of this rotation looks overdone, in our view. While purchasing managers' index readings have shown some signs of stabilization, surveys continue to point to a contraction in industrial activity and further deterioration remains possible. There is also potential for the scope of a US-China trade agreement to disappoint.
* Eurozone underperformance is set to continue. The MSCI EMU index returned 4.9% versus 5.1% for US stocks since 8 October, when the rally picked up momentum. We expect the US market to outperform over the next six months. While both markets are trading at a premium to their 10-year average valuations based on consensus 12-month-forward price-to-earnings ratios, we expect zero earnings growth from the Eurozone in 2020 versus 5.5% growth in the US. We also see the US economy growing faster, at 1.2% versus 0.7% in the euro area.
* Japan's catch-up hasn't gone far enough, in our view. Year-to-date Japan has lagged global equities by 5 percentage points. Since 8 October, Japan has kept pace with the global rally, returning 5.1% compared with the AC World's 5.2% and the Eurozone’s 4.9%. While Japan has started to outpace the Eurozone in the last two weeks, we see room for this to go further. Like the Eurozone, the Japanese market stands to gain disproportionately if global economic conditions improve and trade tensions abate. Unlike the Eurozone, however, we see the market as attractively valued, and it currently trades at a 12% discount to global equities, compared with a 10-year average of 2%.
We are modestly underweight stocks, though we see relative value in the US and Japanese markets versus the Eurozone. In this environment, we also like carry strategies.It is certainly possible that a positive surprise sends equities higher, such as an interim trade deal that includes an indefinite suspension of the December tariff increase, or a better-than-expected recovery in manufacturing. On balance we currently believe investors should continue to avoid increasing equity exposure significantly until we see more evidence of stabilizing growth and an improvement in trade relations.