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: 77% 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: Much like the Value versus Growth picture we see supportive valuation for international stocks and a stronger cyclical earnings rebound versus U.S. stocks, but we see longer term structural fundamental issues that may preclude longer term outperformance. Once this pandemic fully abates, we do see the potential for a weaker U.S. dollar. If this were to occur, it may benefit international performance as the local currency returns get repriced into cheaper dollars.
Relative valuation in a historical perspective clearly favors EAFE, though versus its own history EAFE is not terribly cheap. Still, for the active manager, we believe there are many opportunities to uncover. As developed economies re-open, we expect the more cyclical EAFE index to outperform U.S. stocks. Japanese stocks have been holding back EPS growth and returns for the EAFE index, but an easing in Delta variant cases should help remove this headwind.
Relative Valuation Measures
Based on the MSCI EAFE Index/S&P 500® Index as of August 2021
|Price/Trailing 10 Year EPS||1|
|Summary Signal (Average)||1|
*Average of the five relative valuation measures
Sources: Bloomberg, MSCI
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 until mid-2016.
- MSCI EAFE® Index earnings have been outperforming in 2021 due to the anticipated economic rebound from the COVID crisis, despite continued weakness seen in Japan. Unfortunately, structural issues such as demographics, a weak banking system, and seemingly permanent negative interest rates may disadvantage MSCI EAFE® earnings relative to the S&P 500® beyond this near-term cyclical bounce.
Sources: Bloomberg, MSCI
- The Fed and U.S. government has been much more aggressive than other developed nations initially, creating a more positive backdrop for the relative performance of U.S. stocks. In a recovery, a portion of the aggressive stimulus could be given back through a weaker currency. We are watching the relative trend in U.S. interest rates versus Europe and Japan, and whether there is progress on future stimulus (infrastructure and American Families Plan).
- Historically the U.S. dollar typically moves directionally with U.S. stock relative performance. This has not been the case over the last couple of years. A sustained period of U.S. dollar weakness would provide a tailwind for international stocks.
Sources: Bloomberg, Intercontinental Exchange
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
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