Stocks in developed markets outside the United States have underperformed those in the United States almost without interruption for the last decade. While the long-lasting U.S. stock market dominance is understandably a cause for caution, there are reasons to look at international equities. There are some explanations why international equities’ performance could be poised to improve.
Economic growth in developed international economies continued to slow at the end of 2019 and remained tepid into 2020. Efforts to boost growth through fiscal policy and structural reforms saw little success. The benefits of aggressive monetary policy appear to be exhausted. Trade tensions, the exit of the United Kingdom (UK) from the European Union (EU), known as Brexit, and rising populism have created uncertainty. But there is some good news. There is some evidence that economic growth has stabilized or bottomed in developed economies. This overall positive development has garnered attention, even as the coronavirus outbreak has temporarily reduced economic activity in China. It may be too soon to move some U.S. equity allocations over to developed international markets. However, here are four reasons to think about upgrading the outlook for developed international equities.
Expanding valuation discount. The developed international equity benchmark, the MSCI EAFE Index, has been trading at a forward price-to-earnings (P/E) ratio slightly below 15, which is about 20% below the United States. Right now, stocks in developed international markets are more expensive in absolute terms than they have been over the past decade, but they currently are valued much more attractively relative to U.S. stocks than they have been historically.
Stabilizing global growth. EU gross domestic product (GDP) growth has slowed from near 2% to barely over 1% in the past year. Consensus expectations call for growth of only about 1% in 2020 (Source: Bloomberg). Japanese GDP grew north of 1% through the first three quarters of 2019, but slumped 6.3% on an annualized basis in the 4th quarter. A sales tax hike in October, typhoons and the Sino-U.S. trade war hurt consumption and factory output. Weakness will likely continue through the 1st quarter. Hopefully, the coronavirus will die out well before the Tokyo Olympics.
Although growth in Europe and Japan may remain lackluster, we have seen some encouraging signs. The latest Leading Indicators Index from the Organization for Economic Co-operation and Development (OECD), which tracks leading data from several regions around the world, rose for a third straight month in the latest release, which covered the period ending November 30, 2019. This included an upgraded outlook for the key German economy. More recently, forward-looking purchasing managers’ surveys in Europe and Japan have improved, pointing to the potential for stable, if not better, growth in these areas.
The developed markets outside the United States that make up the MSCI EAFE Index (Europe, Australasia, and Far East) are more value-oriented markets. That means when growth stocks in the United States have led a global rally, as they have in recent years, developed international equities have tended to lag. We expect the U.S. growth rally to at least slow this year, or possibly reverse, given its duration and magnitude, which could provide a better environment for international stocks.
U.S. dollar rally due for a pause. The U.S. Dollar Index has been rising since early 2018, even as the Federal Reserve cut interest rates three times last year. In just the first seven weeks of 2020, the dollar has been up more than 2%. Looking ahead, we expect the combination of stabilizing growth in international economies, less aggressive (more normalized) policies from the European Central Bank and the Bank of Japan, and the twin deficits (trade and budget) in the United States to put increasing downward pressure on the dollar.
In addition to developed international markets, suitable investors should consider carving out a small piece of their equity allocation for exposure to emerging markets. The pace and trajectory of economic and earnings growth appears superior to international developed markets. The coronavirus outbreak will hurt economic growth in China, but there is cause for hope that China’s aggressive containment efforts will soon be successful and limit future drag on its economy. China’s central bank has provided fresh stimulus to help offset the impact. We never want to minimize the loss of human lives, but the history of prior outbreaks such as SARS, bird flu, and swine flu suggests we could see a manageable near-term impact on global economic output.
Looking around the world, there are better economic fundamentals and opportunities for earnings growth in the United States and emerging markets than in developed international markets, primarily Europe and Japan. Current valuations, however, support international investments. Diversification has its benefits over the long term in appropriate strategies.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial, Bloomberg and Reuters.
- All investing involves risk including loss of principal.
- All indices are unmanaged and cannot be invested into directly.