Month: April 2025

A New Cycle for International Markets

American stocks have experienced a stratospheric rise since the Great Financial Crisis, while foreign stocks have languished. This long period of “American Exceptionalism” was marked by enormous inflows of foreign capital into the U.S., which boosted the value of the dollar and U.S. assets to altitudinous levels. However, recent political shifts and new market trends point to a tidal change that could lead to a sustained reversion in U.S. asset prices and a relative outperformance of international assets.

In recent American financial history, periods of “American Exceptionalism” have been followed by bouts of “American Malaise.” These cycles—from euphoria to despair and back—are typically marked by the relative GDP growth of the United States compared to the global economy. During periods of American Exceptionalism, strong U.S. GDP growth relative to the global economy is usually driven by political and technological trends. Conversely, during periods of American Malaise, relatively weak U.S. growth is typically driven by a reversion of previous trends and by the rise of foreign economic powers, such as Germany in the 1970s, Japan in the 1980s, and China and emerging markets in the 2000s. Importantly, these cycles have significant effects on monetary flows, currency valuations, and asset prices. During periods of American Exceptionalism, capital is attracted to the United States, driving up the value of the dollar and U.S. asset prices. During periods of American Malaise, capital flows out of the U.S. into foreign markets, driving their currencies and markets higher.

Since the mid-1960s—a period that includes the turbulence of the final years of the Bretton Woods dollar/gold fixed exchange rate system and over five decades of a U.S. dollar-centric fiat currency global monetary system—the U.S. has experienced three full cycles of sentiment, moving from pessimism to exuberance and back. Conveniently, these cycles can be marked by the rise and fall of the dollar in a fiat currency system such as the one we’ve had since 1971. The chart below highlights these four phases:

Cycle 1

American Malaise (1966–1980)
By the mid-1960s, both Europe and Japan had recovered from World War II, and the U.S. began to run current account deficits, leading some countries—such as France—to decry the “exorbitant privilege” enjoyed by the U.S. and to repatriate gold. This led President Nixon to end the convertibility of the dollar to gold in 1971, breaking the Bretton Woods system established in 1944. The collapse of the dollar and the stagflation of the 1970s ensued. This period of American Malaise was marked by the rise of Germany as an economic power and the embrace of the Deutsche Mark and gold as alternative “safe haven” assets. In 1979, President Carter’s famous “Malaise Speech” expressed a general feeling of national frustration and pessimism following Vietnam, Watergate, and the Iranian Revolution. He warned that “the erosion of our confidence in the future is threatening to destroy the social and political fabric of America.”

American Exceptionalism (1979–1986)
President Reagan (1981–89) embodied American Exceptionalism with his “Morning in America” rhetoric and his vision of America as a “shining city on a hill,” a moral lighthouse to inspire the world. An extremely hawkish monetary policy, executed by Fed Chairman Paul Volcker, triggered debt crises in Latin America and Eastern Europe, collapsed commodity prices, and set off huge capital inflows into U.S. assets, driving the dollar upward. The Plaza Accord in 1985 aimed to weaken the dollar through coordinated market intervention. Reagan also restrained Japanese car exports (1981), requiring automakers to build factories in the U.S. to maintain market share.

Cycle 2

American Malaise (1986–1992)
During the second half of the 1980s, Japan was heralded by magazines and best-selling books as the new economic power threatening U.S. hegemony. Japanese companies—such as Toyota, Sony, Panasonic, and Honda—were believed to be outperforming U.S. competition by being more efficient, more innovative, and offering better quality. This aura of Japanese dominance was punctuated by a wave of Japanese acquisitions of Western trophy assets, such as Rockefeller Center, Pebble Beach, and iconic Western artworks. Moreover, this was a period of strong recovery for emerging market economies, which once again attracted significant speculative capital. America’s despondency was further punctuated by the First Gulf War and a rise in oil prices, which drove the U.S. economy into recession and led to the election of President Clinton.

American Exceptionalism (1992–2001)
President Clinton (1993–2001) presided over a remarkable period of American Exceptionalism. The Cold War ended in 1991 with the collapse of the Soviet Union. Francis Fukuyama’s book The End of History (1992) expressed the widely held belief that Western liberal democracy and capitalism had permanently won the battle of ideas. The “peace dividend” allowed Clinton to cut defense spending from 6% of GDP to 3% and, along with tax increases, run fiscal surpluses from 1998 to 2001. The 1990s saw a productivity boom driven by the Information and Communication Technology (ICT) revolution—computers, software, and networking technology—and a stock market boom, particularly in tech and internet companies. Concurrently, emerging markets suffered a long series of financial meltdowns, beginning with Mexico in 1994, Asia in 1997, and Russia in 1998.

Cycle 3

American Malaise (2002–2012)
Clinton’s deregulation of the financial sector (the repeal of Glass-Steagall and deregulation of derivatives) laid the groundwork for the dot-com and housing bubbles, which burst in 2000 and 2007, respectively. The stock market crash and the Great Financial Crisis brought forth unorthodox monetary policies, which undermined the dollar and revived interest in gold. The accession of China to the WTO (2001) and the launch of the euro (2002) also sparked dollar outflows. China’s economic miracle (2000–2012) caused a commodity super-cycle and enormous inflows into emerging market assets, which created massive stock market and credit bubbles.

American Exceptionalism (2012–2024)
The GFC left most of the global economy in a semi-depressed state, including China, which was burdened with excess debt, a housing bubble, and diminishing returns on infrastructure investment. However, starting in 2012, the U.S. experienced a relative resurgence based on four pillars: (1) a rising dollar, (2) the shale oil revolution, (3) the remarkable success of its winner-take-all global tech titans, and (4) a cycle of fiscal expansion and debt accumulation. These factors led to massive inflows of capital into American financial assets and a singular “wealth effect” for  America’s moneyed classes.

Cycle 4

American Malaise (2025–?)
President Trump has articulated a darkly negative vision of a country mutilated by elites—both domestic and foreign—who have “sold out the country” and caused “an American carnage” of crime, poverty, and decaying infrastructure. He aims to dismantle both domestic institutions (public programs, the courts, universities) and the American-led world economic order—its liberal foundations and its system of alliances—which has long buttressed American leadership and soft power. Unsurprisingly, Trump’s wrecking-ball tactics are unsettling investors and raising questions about the reliability of the U.S. as a partner in military, financial, business, and educational matters.

Initial reactions to Trump’s second-term agenda point to the start of a new phase of American Malaise. A weakening dollar, rising long-term interest rates, declining U.S. stock prices, and a surge in the price of gold indicate significant capital outflows from U.S. assets. Moreover, the drivers of the past decade of American Exceptionalism appear tired. First, the administration is ambivalent about the dollar’s reserve status and is considering measures (e.g., a new Plaza Accord) to bring it down from its  high level. Second, the shale revolution appears to have peaked, with output now expected to stabilize. Third, high valuations, saturated markets, deglobalization costs, regulatory hurdles, and increasingly capital-intensive business models for the tech titans point to more moderate return prospects. Fourth, bond markets are showing low tolerance for further fiscal largesse.

A phase of American Malaise can be expected to last 5–10 years. Outflows from U.S. markets into foreign markets drive the dollar lower, raise commodity prices, and unleash credit, boosting GDP growth and asset prices outside the U.S. These flows create a virtuous cycle of rising confidence, growing liquidity, and higher asset prices abroad.

Expected Returns in Emerging Markets Q1 2025

Emerging markets stocks outperformed the S&P 500 in the first quarter of 2025 in a rare show of strength. China and Latin America led the way, while India sputtered.

Foreign markets are buoyed by hopes that a shift is occurring in the relative strength of growth away from the U.S. and in favor of China and Europe. This has led to some dollar weakness and triggered capital flows out of U.S. assets.

The strength of the S&P 500 0ver the past decade can be attributed to two factors: first, a remarkable decade-long expansion in profit margins, of which about 60% was driven by lower interest rates and globalization—two trends that are now clearly in reverse; and second, an expansion of earnings multiples, which has brought valuations to extremely high levels on most measures.

The valuation premium of the S&P 500 over the MSCI EM Index closed the quarter at historically elevated levels, surpassed only by the 2016–2018 and 1998–1999 periods. The rising valuation premium over the past three decades may reflect the U.S. market’s transition from one dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits. Unfortunately, this transition has not taken place in emerging markets, except briefly in China—until Chairman Xi curtailed the tech sector to “safeguard social harmony.” However, the valuation premium may have peaked and started to trend downward, as America’s tech titans have reached very high valuations and may face lower profitability in the future as they invest heavily in developing the highly capital-intensive and competitive AI business.

The extraordinary profitability of America’s tech giants over the past decade drove profit margins and earnings to record levels. Meanwhile, many other companies in the U.S. and abroad have experienced a prolonged downturn. For example, as shown below, MSCI EM earnings in nominal dollar terms have not risen for about 15 years.

The chart below estimates the current expected returns for emerging markets and the S&P 500 based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio, which calculates the average of inflation-adjusted earnings over the past ten years, helps smooth out earnings cyclicality. This tool is especially useful for highly cyclical assets like emerging market stocks and has a long history of use among investors, gaining popularity more recently through the work of Professor Robert Shiller at Yale University. We use dollarized data to account for currency trends, and the seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average over time. Earnings are adjusted based on each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (October 2024).

As logic dictates, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns are based on two key assumptions: first, that the current CAPE levels relative to historical averages are unjustified; and second, that over time, market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not in the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its current growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios. The same may be true for the Philippines.

The following chart shows actual MSCI EM country returns for the past 12 months in the context of which markets had the highest seven-year expected returns at year-end 2023.  The chart shows that the CAPE ratio was not predictive of performance over this one-year period, as is frequently the case. Over one- to three-year time frames, momentum, narrative, liquidity, and cyclical conditions have a much greater impact on performance than long-term valuation parameters. Nonetheless, when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling.

Looking ahead, Chile and Colombia may be well-positioned to perform over the next year, as they offer both cheap valuations and momentum and are in the early to middle phases of their business cycles. Chile has the added attraction of an upcoming election, which may bring in a more business-friendly administration. However, rising geopolitical tensions and sluggish global growth create an unfavorable investment environment. Only a continued weakening of the U.S. dollar could result in sustained capital outflows from U.S. assets, which would be beneficial for EM stocks.