American Exceptionalism Revisited

Good day. It’s almost more than a financial writer can handle: there’s a CPI inflation report and a Federal Reserve press conference today! I’m all agitated. Send calming thoughts: robert.armstrong@ft.com.

American exceptionalism versus emerging markets

In January without coverage wrote about what we call “American exceptionalism”: the fact that for more than a decade, virtually the optimal geographic mix for a stock portfolio has been to be 100 percent in the United States. Why have American comebacks been so beautiful for so long, and how long can they continue that way?

The case for continued outperformance of the United States is based on the country’s unique strengths. It is rich and has a huge domestic market. It has the best demographic profile of any developed economy. Its unique combination of deep, open capital markets and rule of law make it a magnet for global capital. It has immense resources, both natural (oil and gas) and human (education and research).

The argument against sustained exceptionalism – and therefore in favor of more diversified stock portfolios – is that even if everything in the previous paragraph has been and remains true, it must be factored into the price. has been driven primarily by rising valuations, not superior earnings growth. That type of tree does not grow to the sky.

Emerging market stocks are, in some ways, the opposite of U.S. stocks. While many emerging economies offer strong economic growth, they lack many (and in some cases all) of the structural advantages of the United States. They therefore constitute an ideal test case for the exceptionalism thesis.

Is it time to take advantage of some US progress and rebalance towards the emerging world? The question may provoke laughter, given that since 2011 U.S. stocks (the S&P 500) have outperformed emerging market stocks (the MSCI EM index) by more than 400 percentage points. But it wasn’t always this way: between 1999 and 2007, emerging markets outperformed the United States by almost 200 percentage points. America’s superior performance is not an eternal truth.

One reason to think is that emerging market stocks could perform better in the coming years: economic fundamentals appear to be improving. Businesses in many emerging markets were severely affected by the pandemic and Russia’s war in Ukraine. Last year, the world Bank and IMF were sounding the alarm about imminent waves of sovereign debt defaults. But the situation in most emerging markets has improved dramatically since the end of 2023. Global growth is improving, inflation is falling and several struggling countries, such as Côte d’Ivoire, have been able to access bond markets after having been blocked. for two years.

The improving macroeconomic context is visible in the solid performance of dollar-denominated emerging market sovereign bonds. Sovereign bond spreads have narrowed across the board, and belt-tightening in countries such as Argentina, Turkey and Nigeria has been effective in improving their creditworthiness. This is despite rising US yields and a strong dollar in recent months, which typically trigger capital outflows and economic stress:

Fundamentals are important, but for emerging market investing, flows are still key. Fixed income investors are looking for yield and are willing to go all the way to local currency bonds in frontier markets to get it, as Joseph Cotterill recently said. wrote in the Financial Times:

The local currency debts of Egypt, Pakistan, Nigeria, Kenya and other countries have been some of the least appreciated assets – except for openly unpaid debt – in emerging markets in recent years, as currency crises have devastated their economies.

But those bonds are now returning, helped by a series of interest rate increases and measures to liberalize currency markets, as these countries try to repair their damaged economies. With interest rates falling in some of the more mature emerging markets, such as Brazil, investors find the double-digit yields on offer in frontier markets too attractive to ignore.

How much of the fundamental improvement/capital flows transfers from bond markets to equity markets? To date, none at all. Leaving aside China and its unique problems, emerging market indices have performed reasonably well this year, returning 10 percent in dollar terms. But this still trails the United States by a huge margin, and the valuation gap, which narrowed last year, has widened again. Here’s the difference between US and emerging market price/earnings ratios:

Unhedged is just an emerging markets aficionado. But sustained American exceptionalism – at least in stock valuations – is difficult for us to understand.

Low volatility is not caused by zero-day options

After last week Newsletter As to why U.S. stock market volatility has been so low, readers responded with several theories of their own. More than one suggested that zero-day to expiration (0DTE) options, options contracts that expire on the same day they are purchased, are to blame.

This was a fairly popular narrative in 2022, when 0DTEs first emerged. Proponents of the theory usually cite two reasons:

1. 0DTE trading undermines demand for the 23- to 37-day options that form the basis of the Vix index, which is the standard volatility measure.

2. The high volume of 0DTE is causing increased coverage and trading of the S&P 500 by market makers, suppressing the Vix.

No explanation holds up. While 0DTEs are incredibly popular, they haven’t cannibalized interest in other options. Bank of America chart:

0DTEs represent approximately 50 percent of all options traded, but they are additive. All other tenors have remained at the same volume or increased since 2022.

According to Kris Sidial of the Ambrus Group:

0DTEs are primarily used by sophisticated volume stores, which use them as a performance enhancer rather than a hedge against long-term risk. They will cover some daily fluctuations with 0DTE, but in the current low volatility environment it would make no sense to protect against a catastrophic event with a 0DTE. They will continue to take longer-term positions to protect their portfolios.

The second reason also doesn’t fit with the way 0DTEs are being implemented. 0DTE are traded in a new electronic market, which Bank of America’s Nitin Saksena calls “peculiarly balanced” between buyers and sellers. That balance means that large market makers do not have to hedge or buy/sell the SPX to reduce their risk or achieve their objectives.

Perhaps the clearest way to demonstrate that 0DTEs are not the cause of suppressed volatility is to look for their absence. They were introduced to the US market in May 2022 and were not released in Europe until August 2023.

But Vix and VStoxx, its European equivalent, performed similarly in that period. Case closed.

a good read

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