Is It Finally Time to Look Beyond US Large Caps?

The last eight years have been a great run for investors, with valuations climbing higher and the major indexes tripping over themselves to set new records. As of this month, the second longest bull market in history is only 10 months shy of the all-time record, which is starting to make some investors nervous. Over the last few years just tracking a major benchmark with a low-cost, plain vanilla ETF has yielded respectable returns. But when the market correction arrives, a more tactical approach can deliver considerably more value.

The start of the fourth quarter is a good time to identify some of the opportunities investors might consider pursuing, both domestically and internationally — starting with Europe.

Strong Fundamentals and Solid Growth in Europe

Right now many portfolios are overweighted with large-cap U.S. equities, which is understandable, since that’s where some of the best returns have been found. But for those investors who believe the bull may be on its last legs, the eurozone may be a good place to look for new opportunity. For example, the region’s top financial names have solid fundamentals and have been demonstrating global growth resulting in great price appreciation in the first three quarters of this year.

Europe has had 17 consecutive quarters of positive growth and is enjoying year-over-year GDP growth of 2.3%, driven by strong exports and consumer confidence. Manufacturing numbers throughout the region have been high, particularly in Germany, the largest economy in the eurozone.

Fiscally, the region is also attractive as gradual quantitative easing by the European Central Bank has been beneficial to the euro regional currency and will continue to be a tailwind to the eurozone.

The manufacturing Purchasing Managers Index, used to gauge economies’ productivity, continues to trend higher in the eurozone, hitting multi-year highs.

Eurozone PMI. Source: Direxion

MSCI Europe Financials Fund Flow. Source: Direxion

China’s a Mixed Bag

Investors have expressed concerns over the near- and midterm performance of the CSI 300 China A Shares Index, but this index is up over 23% year to date. There have been numerous indicators of the region’s positive performance this year, including an influx of capital from money managers and other investors. At the same time, there has been considerable chatter about the lack of hedging or inverse tools available in that marketplace should a pullback occur.

This is reminiscent of the situation several years ago, when there seemed to be never-ending rallies in the CSI 300, followed by a very sharp pullback and short squeeze in the various underlying products that investors look to short.

China economic indicators are showing signs of a slowdown in recent months.

China Export Trade YoY Change. Source: Direxion

Caution of course is required when making investment decisions, and it’s always a question of which way the market will turn.  China has failed to hit analysts’ estimates on exports, industrial output and retail sales. And last month the S&P downgraded China’s sovereign credit rating for the first time this century, explaining that credit growth is still too fast while risk growth is lagging.

The Chinese counter is that this analysis ignores certain fundamentals. GDP growth, at 6.8%, is exceeding expectations. Whether the country will stay on that kind of growth track is the big unknown, but so far investors seem to be maintaining their long positions, although that could change if the 19th Communist Party Congress later this month addresses reform as part of its agenda.  

Shrinking Supply/Increasing Demand Pushing Up Oil Prices

After watching energy prices sink to their lowest levels in years, investors have some cause to return to a bullish posture on the sector. With U.S. drilling data showing further reduction in rig counts, and a drop in the global oil supply, which fell by 720,000 barrels per day in August due to unplanned outages and scheduled maintenance from non-OPEC countries, the price of crude oil is up over 12% since the end of June.

The drop in U.S. drilling continues to support signs of a global decline in crude surplus, with current signs of a reduction in supply boding well for investors in the oil market. The price of crude has risen from around $44 a barrel at the end of June to over $50 at the start of October, and the International Energy Agency reported an upward revision to global demand on the latest data. The devastation caused by this season’s hurricanes around the Caribbean and southern U.S. also had a negative impact on the short term supply.

Current crude demand above the one-year average demonstrates a pickup in demand.

Crude Oil Product Demand. Source: Direxion

Billions More for Defense

The November elections fostered a buoyant sense of optimism toward the aerospace and defense sectors for many investors, but even the most starry-eyed didn’t anticipate the magnitude of the $700 billion defense policy bill that came out of Congress in September. The National Defense Authorization Act will boast the performance of leading government defense contractors such as Boeing, Lockheed Martin and Northrop Grumman. 

This sector is attracting investor interest for a couple of fundamental reasons. The first is that this president, who loves to surround himself with generals, is a staunch advocate for a stronger and better equipped military. The war in Afghanistan continues with a new troop surge, the Mideast remains a tinderbox and terror attacks in Europe appear on the upswing. And then there’s the antagonistic rhetoric exchanges with North Korea in 140 characters or less.

The constant media attention to these trouble spots is likely to raise the profile of companies in this sector. As always, the future remains uncertain, but given recent inflows into the universe of aerospace and defense ETFs — and promises of increased spending as fears of international tensions rise — this may be a sector to watch.

The increase in geopolitical risk has resulted in price appreciation in defense and aerospace.

Top Defense Stocks vs. S&P 500. Source: Direxion

What About Reflation?

Finally, in the fourth quarter investors will be watching what the Federal Reserve does as well as changes to tax policy for signs of reflation. So far this year, the reflation trade has struggled due to the lack of any fiscal policy progress, a weakened dollar and a range bound 10-year U.S. Treasury. When the Fed clarified its intention to continue with the next planned rate hike and to commence balance sheet rebalancing, the market immediately reacted by moving both the dollar and the 10-year Treasury upward.

The U.S. dollar has also recovered based on the Bloomberg dollar index. The 1,150 level breakdown in August has been reverted as the dollar trades at 1,157 currently. A continuation and stabilized uptrend will be a tail wind for small-cap equities. 

And now that dealing with the debt ceiling has been pushed off until December, we may see some real momentum toward reforming tax policy. Any positive progress in that area should bode well for small-cap stocks.

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