With the S&P 500 up 20% this year, outperforming markets worldwide, investors are asking why I continue to advise staying globally diversified. Over the last decade, US stocks have outperformed non-US stocks by an average of five percentage points per year. That’s a lot of information.
However, we may have reached a tipping point in that dynamic for various reasons. Indeed, in local currency terms, European stocks have outperformed the US over the last year. However, for many US investors, the near-record-high dollar has obscured the recovery.
More broadly, here are some reasons why stocks will outperform foreign equities.
- Still Looks Like a Value trap.
Valuations have been among the most popular arguments favoring investing in developed international equities.
According to forward price-to-earnings ratios (PE), the MSCI EAFE Index is trading at a 27% discount to the S&P 500, the largest in the last 20 years and significantly higher than the long-term average discount of 9%.
- However, stocks in Europe and Japan have been cheap for a long time, which has hurt relative performance.
- Moreover, valuations don’t tell us much about the next year or two, so we’d need more reasons to switch from U.S. to international equities than just low PE ratios.
On the other hand, lower valuations have historically been well correlated with long-term returns, suggesting that strategic investors who are in it for the long haul may benefit from international equity allocations.
- Weak economic growth
In many parts of the world, economic growth may have peaked. However, even as data in China, Europe, and Korea has deteriorated, the rate of deterioration has slowed, and stock prices have generally remained stable, indicating room for improvement. In contrast, the United States’ economic fundamentals are weaker.
- Waiting For Value Stocks To Have Their Day
The leadership of growth-style equities is the biggest problem for international equities in their decade-long struggle to keep up with the US.
- Over the last decade, the Russell 1000 Growth Index has outpaced the Russell 1000 Value Index by approximately 6.5 percentage points per year, while the MSCI EAFE has lagged the S&P 500 Index by approximately 8 percentage points per year.
- In a growth-led market, the MSCI EAFE Index for non-US developed market equities has only a 10% weighting in the technology sector, compared to 28% in the S&P 500, making it extremely difficult for developed international equities to keep up with the US.
We believe that a pickup in global economic growth over the next quarter or two will help value stocks at least match growth-style returns, with cyclically oriented value stocks potentially doing even better—a critical component for developed international equities’ prospects. However, as long as US growth stocks lead, developed nations will struggle to keep up over any meaningful period.
- International Earnings Look Good, But So Does The U.S.
Earnings in Europe and Japan are recovering nicely, similar to the economic growth picture, but they need to stand out compared to the United States. According to FactSet’s latest consensus estimates, as major global economies recover from the pandemic, MSCI EAFE Index earnings are poised to grow nearly 50% in 2021.
However, this is only a few percentage points higher than the US.
Estimate revisions have been more positive in the United States than elsewhere, indicating stronger earnings momentum and offsetting the allure of the extra bit of earnings growth potential. So, earnings are a toss-up at this point. However, the United States may have a slight advantage given its track record of exceeding expectations and heavy exposure to technology, e-commerce, and digital media.
Conclusion
If developed international market equities outperform, we’re nearing the point where we’ll see it. As global growth accelerates, markets may be on the verge of another rotation to value. Economic growth in Europe, which accounts for most of the MSCI EAFE Index, may outpace the United States next year.
However, as we enter 2022, we continue to favor the United States over developed international markets, owing to technical factors such as the weak momentum for major stock indexes outside the United States, the strong US dollar, and continued strength in U.S. growth stocks, which makes it difficult for more value-oriented markets in Europe and Japan to keep up.
Finally, our emerging market equity recommendation remains negative due to ongoing regulatory risks in China, which could slow Chinese economic and earnings growth while increasing uncertainty.
