U.S. and non-U.S. markets are facing increasingly different fiscal and monetary policies.
Although the difference in monetary policy rates isn’t new, it is becoming more significant this year as the gap widens and U.S. fiscal stimulus is now being felt.
The investment consequences of the policy divergence may help investors identify areas of relative out-performance by different sectors and asset classes.
If the European Central Bank (ECB) hadn’t remembered to change the date on the statement issued following last week’s meeting, there would be little way of telling if a meeting had taken place based on the widely-watched document alone. Yet, the message was clear: no change to QE or the zero interest rate policy. Also this month, expectations rose for further rate hikes by the Federal Reserve (Fed) as economic data exceeded expectations. The minutes to the last Fed meeting showed a rare display of unanimity, with all member of the Federal Open Market Committee agreeing that the economic outlook had strengthened in recent months and that inflation would move back up over the coming year.
This raises two important questions for investors:
- How much further can the gap between U.S. and ECB policy rates widen?
- What does the increasingly different policy environments in U.S. and non-U.S. economies mean for stock market investors?
Mind the gap
The gap between U.S. and ECB policy rates seems wide, but actually isn’t yet stretched to the level at which it began to narrow in the past. Over the past 20 years, the spread has typically been in the 2-3% range before narrowing, as you can see in the chart below. That has been true in both directions: when the ECB policy rate exceeded those in the U.S. and when U.S. rates exceeded those of the ECB, as they do now.
Source: Charles Schwab, Factset data as of 4/27/2018.
The gap between U.S. and ECB policy rates may again reach that 2-3% range before it begins to narrow. The ECB is widely expected to maintain zero rates this year, but is expected to begin to raise the policy rate next year as it nears its long-term target inflation rate. At the current pace of Fed rate hikes, this means the gap could continue to grow for another year.
Recent economic data supports the divergence in monetary policy rates. There is evidence that this year, Europe is starting to slow from a period of exceptionally strong growth which exceeded U.S. GDP growth. At the same time, U.S. economic data has been exceeding expectations and may lift GDP growth above the pace of Europe after the first quarter.
Another support for the gap in policy rates is the U.S. fiscal policy stimulus, in the form of the tax cuts, resulting in a widening deficit. The U.S. is unique when it comes to fiscal stimulus, in that it is the only advanced economy in the world expected to see a rise in the percentage of debt-to-GDP over the next 5 years.
U.S. is unique
Source: Charles Schwab, International Monetary Fund projections as of 4/23/2018.
Different policies, different performers
Over the next year, the widening policy gap between the U.S. and Europe (and also Japan) is likely to continue. The U.S. stands to benefit from fiscal policy stimulus despite modestly reining in monetary policy stimulus. The opposite is true in Europe and Japan. How does this impact investors? Although both are net stimulative and supportive for stocks, they do so in different ways.
Fiscal stimulus typically takes the form of government borrowing, pushing money into the economy through consumers by way of tax cuts to stimulate their spending, or by spending directly. Alternatively, monetary stimulus works indirectly by lowering borrowing costs which encourages consumers and businesses to borrow and spend.
The emphasis on monetary policy stimulus in Europe and Japan may support stocks in the financial sector with the anticipation of higher short-term interest rates next year and the benefit of easy financing conditions influencing solid loan demand. It may also support consumer spending on financing-driven items like housing and autos, benefiting the companies in those industries. The lingering drag on interest rates may also help the performance of yield-sensitive sectors like telecommunications services, utilities, and real estate relative to their U.S. counterparts. The emphasis of monetary policy stimulus on easy financing conditions outside the U.S. generally benefits value and small cap stocks whose companies tend to have more debt than growth and large cap companies do (although this may be largely mitigated by the valuation premium reflected in small cap stocks relative to large caps in the MSCI EAFE and MSCI EAFE Small Cap Indexes).
Policy favored areas for non-U.S. markets relative to U.S. markets:
- Financials sector
- Housing and auto industries
- Value stocks
- Small cap stocks
We are not suggesting these sectors will outperform the overall MSCI EAFE Index, just that these areas of the market may outperform the same areas of the U.S. stock market.
The emphasis on fiscal policy over monetary policy in the U.S. compared to Europe may support sales of consumer products given the boost to after-tax disposable incomes. This favors U.S.-focused consumer discretionary stocks over their non-U.S. peers. The boost to capital spending by businesses seeking a higher after-tax return on investment may help U.S. technology companies. Additionally, the government is spending more on defense which may benefit companies in the defense industry. The consumer discretionary sector, information technology sector and defense industry are classic growth stock areas of the overall market. The potential for tighter financial conditions could weigh on small cap stocks relative to large caps (for more reasons small caps may underperform large caps see Don’t Fear the Yield Curve Reaper).
Policy favored areas for U.S. markets relative to non-U.S. markets:
- Consumer discretionary and information technology sectors
- Defense industry
- Growth stocks
- Large cap stocks
We are not suggesting these sectors will outperform the overall U.S. market, just that these areas of the U.S. market may outperform the same areas in Europe (and Japan).
The divergences in both monetary and fiscal policies may ultimately revert, but are likely to continue over the next year. Although the difference in policy rates isn’t new, it is becoming more significant this year as the gap widens and U.S. fiscal stimulus is now being felt. The investment consequences of the policy divergence may help identify areas of relative out-performance of different sectors and asset classes.
In general, the policy stimulus seen around the world continues to support stock markets. Therefore, continuing to invest globally make sense, but consider emphasizing different sectors and asset classes in regions based on the different types of policy stimulus in those regions. It is important to remember that the differing policy backdrop is just one factor of global investing; there are many other factors that could magnify or mitigate its effects on investing outcomes.