International Developed (EAFE) vs. U.S.
Investing in developed international stocks has historically provided investors with:
- Diversification: portfolios that included international stocks have historically produced higher risk-adjusted returns (Flavin and Panopoulou).
- Opportunity: 76% of publicly traded companies are not U.S.-based (Source: MSCI) and 43% of the global market cap resides outside of the U.S. (Source: Bloomberg). Why limit equity exposure to just a fraction of the total market opportunity set?
But why now...
Conclusion: We moved to an EAFE underweight at the start of Russia’s invasion of Ukraine. While relative valuation remains attractive, we see near-term risk to relative earnings prospects as well as a stronger dollar. We also think that the sanctions against Russia will remain in place for an extended period. We believe that the U.S. economy and markets are more insulated from reduced trade with Russia and higher commodity prices. A quick resolution to the war and sanctions, something we don’t anticipate, would likely lead to an upgrade.
Relative valuation in a historical perspective clearly favors EAFE, and versus its own history EAFE looks fairly valued. For the active manager, we believe there may still be opportunities to uncover, but we also recognize that the risk profile has also increased, partly offsetting the valuation differential.
Through May, the MSCI EAFE® Index has performed in line with the S&P 500®, which is somewhat remarkable given the headwinds of a strong dollar, the war in Ukraine, and a relatively weaker earnings season. This may partly be a reflection of relative valuation, but also the Fed moving to a more hawkish stance.
Relative Earnings Prospects
- Relative price performance and relative earnings growth have historically followed a similar path. Relative earnings growth since mid-2008 has favored the S&P 500® Index versus the MSCI EAFE® Index.
- MSCI EAFE® Index earnings saw a small uptick relative to the S&P 500® earlier in the pandemic, but has begun to give that back. Year-to-date, we are seeing downward estimate revisions for EAFE (namely for European stocks). The supply shock of higher energy prices is likely to slow real economic growth in Europe.
- Historically the U.S. dollar typically moves directionally with U.S. stock relative performance. A sustained period of U.S. dollar weakness would provide a tailwind for international stocks.
- The dollar has been strengthening over the last 12 months. This rally may continue as monetary policy is moving out of sync between the U.S. and developed international countries. The Fed needs to address demand-driven inflation due to substantial stimulus efforts. Other developed central banks are likely to take a slower approach to policy tightening or normalization as their inflation is more supply driven, where monetary policy has little influence. Still, we may be near the end of the rally and the dollar could quickly reverse course once the Fed slows its rate increases.
Thomas J. Flavin, Ekaterinin Panopoulou, “On the robustness of international portfolio diversification benefits to regime-switching volatility,” Journal of International Financial Markets, Institutions and Money, 2009.
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