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 60% 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 remain at an equal weighted stance. While the valuations for the MSCI EAFE Index are attractive, the fundamentals have begun to fade. We had anticipated that continued monetary policy stimulus would help drive underlying economic growth. Unfortunately we are seeing more signs of economic slowing. We also see numerous geopolitical tail risks that could drive the markets lower (i.e., a no-deal Brexit and further tariff war escalation).
Our views on Developed Markets are based on historical relative valuations, relative earnings prospects vs. the S&P 500 Index, and monetary policy.
Historical Relative Valuations
- Relative valuation in a historical perspective favors EAFE, with both relative Price/Book and Price/Sales at historically low levels.
- At the end of August 2019, the S&P 500® Index closed at a price that was more than 89% above the 2007 peak, while the MSCI EAFE Index would need to rise 30% to get back to its 2007 peak. As of August 2019, on a forward P/E basis, the MSCI EAFE Index was selling for 13.2x and had a dividend yield of 3.6%. For the active manager, we believe there are many opportunities to uncover.
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 began to outpace the S&P 500® Index in 2017. But since then, S&P 500® earnings have done better due to the tax cut in 2018 and due to relative economic performance to date in 2019.
- What looked like a temporary deceleration in economic growth in Europe and Japan in 2018 continued into the 2019 as global trade volumes decelerated and uncertainties have increased regarding Brexit. Downward earnings revisions suggest the underperformance will likely continue into 2020.
Sources: Bloomberg, MSCI
- While monetary conditions outside of the U.S. continue to be more market friendly, the impact on their economies (namely Japan and Europe) has been limited. As such, the perspective here has changed from what central banks are doing currently to what they can do in the future to stimulate growth. While the European Central Bank (ECB) and the Bank of Japan (BOJ) are pursuing a more accommodative policy, they are limited in what more they can do. On the other hand the Federal Reserve has room to both lower rates and resume quantitative easing.
- While not directly tied to monetary policy we also need to consider numerous geopolitical risks including Brexit negotiations, populist election wins in Germany, Italy, and Spain, Italy’s budget deficit, a planned October 25% consumption tax increase in Japan, and potentially disruptive bilateral trade talks with the U.S. in the near future.
Bank assets represent the sum of banking balance sheet assets within an economy (including private or commercial banks, central banks or both). The year/year growth in these assets is representative of money creation and contraction within the economy. The picture is not fully representative of the economy as it excludes non-bank financial institutions (i.e., shadow banks).
Sources: Bloomberg, Federal Reserve, Bank of Japan, European Central Bank
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