International Equities Monthly
- The U.S. dollar has traded sideways for six months, held in place by opposing forces. It has been caught between cyclical pressures pointing to weaker labor market conditions and structural safe haven demand supporting it. It will likely take a clear Fed pivot in either direction or a strong global growth surprise to break the dollar out of this range.
- We need to talk about Japan. The Bank of Japan (BoJ) has begun exiting decades of ultra easy policy, lifting rates as inflation proves more resilient and above trend wage growth continues. Even small hikes matter because they mark a structural shift away from Japan’s longstanding deflationary regime.
- Yet the yen has weakened despite rising rates. The main driver is relative policy expectations: markets expect the Fed to remain at a much higher terminal rate than the BoJ and see Japan maintaining its role as a low yield funding currency. Ongoing purchases of foreign bonds also apply structural downward pressure on the yen.
- This brings the carry trade into focus. The carry trade involves borrowing in a low yielding currency, historically the yen, to invest in higher yielding assets elsewhere. It provides global liquidity, supports risk taking, and can amplify asset price trends. When funding costs rise or the funding currency appreciates sharply, the trade can unwind quickly, tightening financial conditions. The estimated size of the yen carry trade is between $1-$4 trillion, so substantial.
- How long can current dynamics hold? Japan’s rate path is likely to remain gradual; absent a decisive BoJ tightening cycle, the rate gap with the U.S. should stay wide enough to limit yen strength. A sharp reversal would require either faster-than-expected BoJ hikes or deeper-than-expected Fed cuts.
- A disorderly carry-trade unwind is not our base case. Funding stresses typically emerge when volatility spikes or when Japan surprises with aggressive policy changes. As long as the BoJ moves slowly and communication remains clear, conditions for a disruptive unwind appear limited, but the risk rises if inflation proves sticky and forces the BoJ to tighten more quickly than markets expect.
- We maintain a neutral strategic allocation to developed international equities. Traditional headwinds such as currency volatility and expanding valuation discounts are easing and may even become tailwinds. As these pressures subside, developed international markets are better positioned to compete with U.S. equities, with earnings and dividends expected to be the primary drivers of returns.
- Europe’s economy is expected to rebound modestly in 2026, with earnings projected to grow in the high single digits after three years of stagnation. Promisingly, strong price and earnings performance from European banks signals improving economic health, and Germany’s suspension of its debt brake opens the door to fiscal stimulus. A cessation of the war in Ukraine would further strengthen the outlook.
- European banks have staged a substantial rally, surpassing even the Mag 7 over the last three years. This was primarily driven by earnings growth from rising rates. European interest rates dropped below zero in 2014 and stayed there until 2022. Despite higher interest rates and balance sheet strength, valuations remain compressed. European bank P/E multiples are lower than any industry other than autos.
- Japan recently passed its largest fiscal stimulus package since COVID, aimed at easing consumer price pressures. It is estimated to lift GDP by 1.4 percentage points annually over the next three years. With inflation above target and this stimulus package, the BOJ is expected to raise rates to 0.75% on December 18. The BoJ is expected to continue to slowly raise rates in 2026.
- Performance for the MSCI EAFE index has diverged significantly from that of the S&P 500. EAFE returns have been driven by Value exposure, with the MSCI EAFE Value index outperforming the S&P 500 over the past one, three, and five years. Meanwhile, U.S. returns have been dominated by Growth. From a portfolio construction standpoint, differentiated return streams are a meaningful positive.
- Looking ahead, we believe developed international equities offer long-term advantages – including lower valuations, higher dividend yields, potential currency tailwinds, and less reliance on a narrow set of U.S. mega cap stocks.
- We have a slight tactical overweight in emerging market (EM) equities, reflecting an attractive risk/reward profile relative to developed equities.
- Like developed international markets, EMs face easing currency and valuation pressures. As these headwinds diminish, earnings and dividends should play a larger role in driving returns, putting EM fundamentals on more even footing with U.S. stock return drivers.
- A weaker dollar and Fed rate cuts should support EM assets by giving local policymakers more room to stimulate growth and attract capital flows. Historically, EM equities have outperformed U.S. and developed international stocks during Fed easing cycles that did not coincide with recessions.
- EMs also provide significant exposure to Technology and AI. The tech sector is now the largest weight in the MSCI EM index and includes key players in the global AI semiconductor supply chain. Investors also gain exposure to China’s differentiated approach to AI (open source), which may accelerate adoption and broaden investment opportunities.
- China remains a study in contrasts. Manufacturing PMIs continue to contract, domestic demand is soft, and the housing market remains under pressure. Yet China leads in many advanced technologies. In the last year, it installed 9x as many industrial robots as the U.S. and more than the rest of the world combined. Its biotech industry has rapidly shifted from developing “me-too” drugs to developing innovative compounds increasingly licensed globally. There are tremendous investment opportunities within China despite many structural issues.
- Looking forward, EM earnings growth appears poised to rival U.S. earnings growth over the next decade, supported by favorable relative demographics, improving profitability, and a more growth-oriented index composition. Despite this backdrop, the index trades at just 13x expected 2026 earnings, a 41% discount to the S&P 500. Lower labor costs and less saturated technology and service sectors create room for operating leverage.
- In summary, EM equities offer diversification and long-term growth potential, despite ongoing risks that come with this more volatile asset category.
Equity Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
Glossary of Investment Terms and Index Definitions
*Local currency earnings estimates are not available for broad indexes with a mix of currencies.
Source: Bloomberg. Percent ranks are based on 30 years of monthly data as of the end of November; EPS growth estimates based on consensus bottom-up analyst estimates.
The Touchstone Asset Allocation Committee
The Touchstone Asset Allocation Committee (TAAC) consisting of Crit Thomas, CFA, CAIA – Global Market Strategist, Erik M. Aarts, CIMA – Vice President and Senior Fixed Income Strategist, and Tim Paulin, CFA – Senior Vice President, Investment Research and Product Management, develops in-depth asset allocation guidance using established and evolving methodologies, inputs and analysis and communicates its methods, findings and guidance to stakeholders. TAAC uses different approaches in its development of Strategic Allocation and Tactical Allocation that are designed to add value for financial professionals and their clients. TAAC meets regularly to assess market conditions and conducts deep dive analyses on specific asset classes which are delivered via the Asset Allocation Summary document. Please contact your Touchstone representative or call 800.638.8194 for more information.
A Word About Risk
Investing in equities is subject to market volatility and loss. Investing in foreign and emerging markets securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. The risks associated with investing in foreign markets are magnified in emerging markets due to their smaller economies. Events in the U.S. and global financial markets, including actions taken to stimulate or stabilize economic growth may at times result in unusually high market volatility, which could negatively impact asset class performance. Banks and financial services companies could suffer losses if interest rates rise or economic conditions deteriorate.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.
Touchstone is a member of Western & Southern Financial Group
Not FDIC Insured | No Bank Guarantee | May Lose Value
