Marco Pirondini is Head of Equities, US and Portfolio Manager of global equity strategies.
Since 2009, US equities have been on a roll compared to international equities. We think this is about to change. The primary reason US equities have outperformed is that earnings growth for US companies has been higher than for international companies. We believe international earnings growth may begin to accelerate, benefitting international stocks.
Why has earnings growth been higher in the US in recent years? In our opinion, more favorable demographics, a greater focus on economic efficiency and returns, a higher level of innovation and well-developed financial markets have all contributed to higher US earnings growth. We believe these factors will continue to drive earnings growth in the US going forward.
Source: Bloomberg. Last data point 8/31/16. International equities represented by the MSCI EAFE Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
Source: Bloomberg earnings estimates, rebased. Last data point 8/31/16. International equities represented by the MSCI EAFE Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
Over the next few years, however, we believe international equities should outperform due to:
- An acceleration in earnings growth for international companies due to greater exposure to value-oriented sectors such as financials, industrials and materials, which we believe will benefit from increased fiscal stimulus over the next few years.
- Low international equity valuations relative to US equity valuations. We believe the gap in valuations will begin to close as international earnings growth accelerates.
Having exhausted monetary policy options for stimulating the global economy, we believe policy makers will turn to fiscal stimulus. Japan, for example, recently launched a stimulus package, as did the UK. In addition, Mario Draghi, President of the European Central Bank, has indicated that one of the reasons aggressive monetary policy has not been more successful in stimulating economic growth in Europe is because of restrictive fiscal policies. We believe fiscal stimulus should increase globally next year as political leaders attempt to increase growth. International equities should benefit disproportionately from this stimulus due to their higher exposure to cyclical/value-oriented sectors such as the ones referenced above.
International Equities Have Lower Valuations than US Equities
On a price-to-earnings (P/E) basis, the MSCI EAFE Index trades 15.6x forward 1-year earnings, which is meaningfully lower than the 17.9x P/E ratio of the S&P 500 Index (as of August 31, 2016), based on Bloomberg data. While it is true that part of the difference in valuation can be attributed to the fact that international indices have less exposure to high-growth, high-P/E companies, this does not completely explain the gap. In our opinion, international indices are undervalued relative to US stocks due to concerns about economic growth that will dissipate as international growth recovers. If growth does accelerate next year, as we expect it will due to fiscal stimulus, international equities should outperform.
There are a number of risks to our forecast, including the potential negative impact of Brexit, the possibility that the Italian Referendum will lead to a further weakening of the European Union and the instability of the European banking system. In addition, fiscal stimulus may not occur or may not be significant enough to drive economic growth meaningfully higher. US economic growth could also surprise on the upside.
Despite these risks, we believe international equities should do well for the reasons mentioned above.
While we see opportunities in international equities, we also see selected opportunities in the US. We continue to favor US large-cap stocks over US small-cap stocks. Within large caps, we prefer companies with superior sales and cash flow growth, above average returns on capital and justifiable valuations. We also favor certain companies that generate dividends due in part to the long-term, secular trend towards investors seeking dividend income from equities. Within the cyclical area of the economy, the technology sector, which has underperformed year-to-date, may do well due to earnings growth, driven by the shift to mobile and cloud computing. Health care, meanwhile, is likely to be volatile due to political rhetoric related to pricing, but may perform well overall due to continued innovation and consolidation.
In our experience, market trends can be slow to form, but usually persist for some time once they begin. If we are correct in our forecast, international stocks (especially, we believe, Japanese and UK stocks, which have lagged but should benefit from immediate fiscal stimulus) should outperform over the next few years. Investors who have under-allocated to, or given up entirely on international equities, may be slow to readjust their portfolios, providing a good entry point for those who invest now.