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 40% 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, though the headwinds from the stronger dollar appear to have dissipated. 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.
Relative Valuation
Relative valuation in a historical perspective clearly favors EAFE, and versus its own history, our combined valuation measures rank the MSCI EAFE Index in the bottom third. For the active manager, we believe there may be opportunities to uncover, but we also recognize that the risk profile has also increased, partly offsetting the valuation differential.
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.
- In local currency terms, earnings for MSCI UK and Europe have been revised up sharply for 2022. This may seem odd given the backdrop of slowing economic growth and onerous energy prices. The composition of the indexes holds the key where there is significant energy exposure as well as large global companies that source more income outside of their currency footprint than inside. Their weak currencies became a competitive weapon.
Monetary Policy/Currency
- 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 had been strengthening versus developed currencies over the last 12 months. The dollar’s strength has mainly been a function of monetary policy, changes in current account balances due to the war in Ukraine, and a flight to safety in a time of uncertainty. The dollar does look extended and due for a pullback as it is trading well above fair value. While higher short term rates could still support the dollar, historically, the dollar peaked before the Fed stopped increasing rates.
Glossary of Investment Terms and Index Definitions
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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