Chapter 1  What is it about ?

When we think about the challenges facing an investor today, the big problems, the things we worry about that could cause a lot more harm than some interest rate hikes, are mostly outside the United States. China is prominent this weekend because of demonstrations against their zero-COVID policies. The Chinese people appear to be pretty well fed up with the endless lockdowns and have finally decided to try and do something about it. Unfortunately, I’m not sure there’s really any win to be had for the Chinese people.

Zero COVID has “worked” in the sense that it has limited the number of infections and deaths so far but it has also limited immunity since fewer have been infected. Opening up completely, even if they decide to import mass quantities of western vaccines, likely means a lot of infections and deaths. Their healthcare system would, unlike in most developed countries, be overwhelmed. I think we forget sometimes how poor and undeveloped most of China actually is.

There are some obvious implications for the rest of the world if China continues its rolling lockdowns. Supply chains for many US and European multinationals are dependent on Chinese production. Shutdowns in Zhengzhou mean no iPhones for consumers. Unless China opens up, we could have a return of the supply chain issues that so many have blamed for the current bout of global inflation (which is ridiculous and not inflation by the way). It may seem a bit petty to worry about iPhone supply considering the conditions the Chinese people have been laboring under, but investors often have to be cold-blooded that way.

Apple, to continue that example, has been moving production out of China but estimates are that it would take a decade or more to significantly reduce Apple’s reliance on China. There are, no doubt, many other western companies facing similar problems. What I think is less often considered is that China is as reliant on Apple as Apple is on China. Their response to the demonstrations about zero COVID are limited by that fact. If they react too strongly, they risk further alienating every western country manufacturing in China. If they do nothing, they risk a full-scale uprising. They will have to do something to quell the demonstrations and get people back to work. I’m not sure how they’ll do that but do it they must. The limited reaction in US markets so far seems to indicate that investors believe Xi will find a way.

The other big international problem is, obviously, the Ukraine/Russia conflict. The impact from that has mostly fallen on Europe in the form of higher energy prices but the US has been impacted too. Exporting LNG to Europe to close their energy supply gap has pushed up prices domestically. There were also costs for US companies who pulled out of Russia wholesale and there will be ongoing costs in shortages of some natural resources from both Ukraine and Russia. But the direct impact on the US has been and probably will continue to be more political than economic.

These external problems, along with an aggressive Federal Reserve, have pushed up the value of the dollar this year. And in truth, the rise in the dollar really started in 2021 when a consensus developed that the best place to invest in a post-COVID world was right here in the US of A. The emergence of the Ukraine war and its impact on energy prices and the plethora of potential issues in China (real estate implosion, zero-COVID policies, response to aggressive US tech policies, and the ever-simmering issue of Taiwan) merely reinforced the narrative that the US was the safe haven, the most insulated from the world’s problems.

That narrative has proven to be largely true since the onset of COVID if measured by stock market performance. In dollar terms, the S&P 500 has outperformed the EAFE international stock index 30.6% to 6.9% since February 1, 2020. What is interesting though is that over the last year it is EAFE that has outperformed even in the face of a strong dollar. Over the last 12 months, EAFE is down 9.94% and the S&P 500 is down 11.0%. Not exactly what you would expect is it?

Considering that Russia’s invasion of Ukraine only started in February and that the impact on Europe’s energy supply has been so dramatic, one would expect that European stocks would be doing terribly in comparison to the US. But that is not the case. The Eurozone stock ETF (EZU) has underperformed the S&P 500 but only by 1.7% (-16.04% to -14.31%). Germany has underperformed by the most (-20.6%) but France, Spain, and Italy have outperformed by a pretty good margin (-11.5%, -5.5%, and -13.01% respectively). The UK isn’t really Europe anymore but I’m sure you’ve heard how terrible things are there. And yet, the UK ETF is down a mere 4.3% this year.

When we look at some of these countries in their home currencies they look even better. In Euros, the German DAX is down only 8.5%, the French CAC40 -6.2%, and Spain’s IBEX -3.4%. In Pounds, the FTSE 100 is up 1.4% YTD. There are other countries whose stock markets have also beaten the US in their home currencies. The Nikkei is down just 1.8% YTD, Canada down 4%, Australia down 4.3%, Singapore up 3.9%, Brazil up 4% (and the Real is up against the dollar this year), Mexico up 4.3% (and the Peso is up against the dollar too), Indonesia up 8.7%, and finally Chile up 22%.

Some of this outperformance has been obscured by the rise of the dollar but with the dollar now in a short-term (for now) downtrend, investors need to pay attention to what is actually going on rather than just relying on the simple narratives one hears about the rest of the world. Europe has been negatively impacted by the Ukraine war, no doubt. But what I hear from my contacts there is that they know they have to change their energy policies and they are getting on with it. They don’t really see much impact on everyday life – at least not yet – other than the rise in their home energy bills. But the scare stories you’ve been hearing about Europe are just that – stories.

Home country bias is real and especially for US investors. A big part of that bias is built on the US dollar’s global dominance. We see everything through the prism of a US dollar that dominates world trade and provides us with enormous advantages. Over the last 10 years, the S&P 500 is up 245%. In dollars, none of the other markets I mentioned above have even cracked triple digits, the closest being France at 96.7%. And a big part of that is the dollar, up over 50% during that time and adding directly to the bottom line of US-based investors.

Whether the recent outperformance of non-US shares continues likely depends on the dollar. If its recent drop is merely a correction in an ongoing uptrend then the US will remain the place to be. But if the dollar has peaked, international markets are likely to continue to outperform, in dollars as well as Euros or Yen or Pesos. The US stock market, as a whole, is still not cheap but non-US markets are. Europe trades for 1.3 times book value and less than 1 times sales. Japanese stocks are 1.1 times book and 0.9 times sales. EM ex-China is 1.5 times book and 1.1 times sales. And that’s after they’ve rallied off their lows.

Non-US stocks are cheap and they are performing well this year even with the strong dollar. Imagine what they could do if the dollar really does pull back substantially.

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