American exceptionalism revisited

Good morning. It’s almost more than a finance writer can stand: today there is both a CPI inflation report and a Federal Reserve press conference! I’m all aflutter. Send calming thoughts: robert.armstrong@ft.com.

American exceptionalism vs emerging markets 

Back in January Unhedged wrote about what we called “American exceptionalism”: the fact that for well over a decade, pretty much the optimal geographic mix for a stock portfolio has been having 100 per cent in the US. Why have American returns been so beautiful for so long, and how long can it continue?

The case for continued US outperformance rests on the country’s unique strengths. It is rich and has a huge internal 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 case against sustained exceptionalism — and therefore in favour of more diversified equity portfolios — is that even if all the stuff in the previous paragraph has been and remains true, it must be priced in. The outperformance of US stocks versus the rest of the world has been driven mostly by rising valuations, not superior earnings growth. That kind of tree does not grow to the sky.

Emerging markets stocks are, in a sense, the opposite of US stocks. While many emerging economies offer strong economic growth, they lack many (and in some cases all) of America’s structural advantages. So they make an ideal test case for the exceptionalism thesis.

Is it time to take some US gains and rebalance into the emerging world? The question may provoke laughter, given that since 2011 US stocks (the S&P 500) have outperformed EM stocks (the MSCI EM index) by more than 400 percentage points. But it was not always so: between 1999 and 2007, emerging markets outperformed the US by almost 200 percentage points. American outperformance is not an eternal verity.

One reason to think is that EM equities might do better in the next few years: economic fundamentals appear to be improving. Companies in many emerging markets were hit hard by the pandemic and Russia’s war in Ukraine. Last year, the World Bank and IMF were raising the alarm about impending waves of sovereign debt defaults. But the situation for most emerging markets has drastically improved since the end of 2023. Global growth is improving, inflation is coming down, and a number of distressed countries, such as the Ivory Coast, have been able to access bond markets after being locked out for two years.

The improving macro backdrop is visible in the solid performance of dollar-denominated EM sovereign bonds. Sovereign bond spreads have tightened across the board, and belt tightening in countries such as Argentina, Turkey, and Nigeria have been effective at improving their credit worthiness. This despite rising US yields and a strong dollar in recent months, which usually trigger capital outflows and economic stress:

Fundamentals are important, but for EM investments, the key is still flows. Fixed-income investors are looking for yield and are willing to go as far as local-currency bonds in frontier markets to get it, as Joseph Cotterill recently wrote in the Financial Times:

Egyptian, Pakistani, Nigerian, Kenyan and other countries’ local currency debts have been some of the most unloved assets — short of outright defaulted debt — in emerging markets in recent years, as currency crises have ravaged their economies.

But such bonds are now making a comeback, helped by a series of interest rate rises and moves to liberalise currency markets, as these countries bid to repair their damaged economies. With interest rates on the way down in some of the more mature emerging markets such as Brazil, investors are finding the double-digit yields on offer in frontier markets too attractive to ignore.

How much of the fundamental improvement/capital flows story transfers from bond to equity markets? To date, none at all. Setting aside China and its unique problems, EM indices have performed reasonably well this year, returning 10 per cent in dollar terms. But this still lags the US by a huge margin, and the valuation gap, which shrank last year, has widened again. Here is the difference in US and EM price/earnings ratios:

Unhedged is just a dabbler in emerging markets. But sustained American exceptionalism — at least in equity valuations — is hard for us to understand. 

Low volatility is not caused by zero-day options

After last week’s newsletter about why US equity market volatility has been so low, readers replied with several theories of their own. More than one suggested that zero day to expiration options (0DTEs) — options contracts that expire the same day they are bought — are the culprit. 

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

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

2. The high volume of 0DTEs is prompting more hedging and trading of the S&P 500 by market makers, suppressing the Vix.

Neither explanation holds up. While 0DTEs are incredibly popular, they have not cannibalised interest in other option tenors. Chart from Bank of America:

0DTEs make up about 50 per cent of all options traded, but they are additive. All other tenors have stayed at the same volume or increased since 2022.

According to Kris Sidial of The Ambrus Group:

0DTEs are mostly used by sophisticated vol shops, who are using them as a yield enhancer rather than as a hedge to long-term risk. They will hedge some daily fluctuations with 0DTEs, but in the current low vol environment it would not make sense to hedge against a catastrophe event with a 0DTE. They will still take longer tenor positions to protect their portfolios.

Reason two doesn’t fit with how 0DTEs are being deployed, either. 0DTEs are being traded on a new electronic marketplace, which Nitin Saksena of Bank of America calls “peculiarly well-balanced” between buyers and sellers. That balance means that large market makers are not having to hedge or buy/sell the SPX to reduce their risk or hit targets.

Perhaps the clearest way to show that 0DTEs are not the cause of suppressed volatility is looking for their absence. They were introduced in the US market in May 2022, and only rolled out in Europe in August 2023.

But the Vix and the VStoxx, its European equivalent, behaved similarly in that time period. Case closed.

One good read

“Why do rich men and rich women want to own baseball teams?”

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