J.P. Morgan's Gabriela Santos Likes International Stocks for 2024 | #513

Episode Summary

Executive Summary: Gabriella Santos, Chief Market Strategist for the Americas at JPMorgan Asset Management, discusses the macro outlook for 2024, emphasizing a shift towards international equities. She argues that after 15 years of US outperformance, conditions now favor international markets due to inflation, higher rates, and improved shareholder returns abroad. She is bullish on Japan, India, and Mexico, sees China as a tactical trading market, and recommends reducing cash exposure in favor of bonds and equities as peak rates approach.

Main Topics: 2023 Macro Review and Surprises (Priority: 5/5): The year saw above-trend growth (~2.5%), supply-side improvements boosting productivity, and inflation falling without demand weakness. Fixed income underperformed due to rate volatility, and equity gains were highly concentrated in the 'Magnificent Seven' tech stocks, not broad-based. Outlook for U.S. Monetary Policy and Bonds (Priority: 5/5): Santos argues we are at peak rates and that holding cash (T-bills) carries significant reinvestment risk. She recommends locking in yields in fixed income and believes bonds will provide positive returns, especially if recession or crisis emerges. Inflation Outlook and Structural Drivers (Priority: 4/5): Inflation is expected to decline to ~2% by end of 2024, but average 2.5% over the next 10-15 years. Structural upward pressure from reshoring, energy transition, and geopolitical tensions suggests a moderately higher inflation regime than the post-2008 era. International Equity Opportunity Set (Priority: 5/5): Santos is bullish on international developed and emerging markets, citing a regime change (inflation, higher rates, shareholder focus) that could lead to outperformance versus US equities. Japan, India, and Mexico are highlighted as especially compelling. China as a Tactical Market (Priority: 4/5): China is seen as a high-beta, trading-oriented market rather than a strategic allocation. Pessimism is extreme, valuations are low (9.8x P/E), and a policy-induced rebound is possible, but structural risks (geopolitical, regulatory) make it unreliable for long-term buy-and-hold. Small Cap Valuation but Caution (Priority: 3/5): Small caps are at their cheapest relative to large caps since the dot-com era. However, higher interest rates, floating rate debt exposure, and cyclical sensitivity to recession fears mean it is not yet time to overweight them. Risks to the Base Case (Priority: 4/5): Key risks include credit risk from an upcoming refinancing wall in high-yield debt, a potential shift to business caution leading to recession, and geopolitical escalation (Middle East) impacting energy prices.

Key Arguments: Cash (T-bills) is attractive today but carries reinvestment risk; investors should lock in yields in fixed income and allocate to equities at discounted valuations. International markets, after 15 years of underperformance, are entering a favorable regime with inflation, higher rates (boosting bank profits), and improved shareholder returns (buybacks in Japan and Europe). The dollar is overvalued and likely to weaken, providing a tailwind for unhedged international equity investors. Mexico benefits from nearshoring trends (USMCA, cheap wages, proximity to US), which are already visibly boosting construction and consumption. India offers high-quality companies with US-like return on equity and benefits from a 'China plus one' diversification strategy. China should be approached tactically; while valuations are cheap, the market is driven by policy pendulum swings and geopolitical risks, making a strategic overweight unwise. Europe has discovered corporate buybacks, matching the US in buyback yield, a significant cultural shift. Small caps are strategically cheap but tactically risky due to floating rate debt and cyclical headwinds.

Data Points: US GDP growth in 2023: ~2.5% - Above-trend growth, contrary to hard landing fears. 30-year bond performance: Three consecutive down years - Only seen once before (late 1970s/early 1980s). Bloomberg Barclays US Aggregate return YTD 2023: +2.8% - Mildly positive after two negative years. Expected inflation end-2024: ~2% - Declining from current levels. Expected average inflation next 10-15 years: 2.5% - Structural upward pressure from reshoring, energy transition, underinvestment. Fed funds rate peak: Current - Santos believes we are at peak rate, cuts expected ahead of other central banks. Japan stock market return 2023 (local currency): +28% - Despite yen weakness, delivered strong local returns. Japan stock market return 2023 (USD): +15% - Slightly underperformed US in dollar terms. China equity valuation (P/E): 9.8x - 15% below long-term average; same level as October 2022 low. China rebound after October 2022 low: +60% - Historical precedent for rallies from extreme pessimism. China equity performance 2023: ~ -15% - Negative year for Chinese equities. Emerging markets ex-China performance 2023: +12% - Decoupling from China performance. India equity performance 2023: +17% - Strong absolute and relative returns. Taiwan equity performance 2023: +23% - AI boom benefited Taiwan, driven by semiconductors. 10-year yield decline in November 2023: 70 basis points (to ~3.5%) - Rapid drop suggesting rate sensitivity. High-yield company refinancing rate: ~9.5% - Current refinancing cost high; need rate cuts to avoid stress. Small cap discount to large caps: Highest since dot-com - Valuation opportunity but not yet time to overweight.

Pivotal Quotes: "I think in the long run, when we model out currencies, it's all about inflation differentials, GDP per capita, purchasing power parity. And that's all fine and good, but you need a catalyst. By those measures, the dollar is expensive. What was missing was a shorter-term catalyst. And I do think we have that now." — Gabriella Santos: Explaining dollar weakening thesis and the timing catalyst from falling interest rate differentials. "Finally, after a decade, European companies, Japanese companies have started paying attention to shareholders again. I don't know that everyone knows that Europe and the U.S. have the same buyback yield. Europe has discovered kind of the magic of returning capital to shareholders, not just via dividends, but via buybacks. Japan, record high number of buyback announcements." — Gabriella Santos: Highlighting a structural change in corporate behavior that supports her international bull case. "If 12 months from now the strategy is still T-bill and chill, then they're going to wish they had done something different today. And that's because we really think we're at peak rate." — Gabriella Santos: Warning against complacency with cash and making the case for locking in bond yields and equity exposure.

Implications: Investors should reduce cash positions, extend fixed income duration, and increase international equity exposure, especially in Japan, India, and Mexico. The dollar is expected to weaken, benefiting unhedged positions. China offers tactical opportunity from extreme pessimism but carries structural geopolitical risk. A soft landing is base case, but credit risk and business caution require monitoring.