International Stocks Present a Compelling Opportunity

Since the Great Recession, U.S. equities have been the place to be, especially over the last few years, as the U.S. economy moved upward while European and emerging markets economies struggled for a toehold, reeling from slowing growth and the end of the commodities boom.

But now?

U.S. stock performance falls behind the pack

U.S. markets have been solid since the end of 2016, but perhaps the better opportunity may be elsewhere. Since the beginning of 2017, markets overseas are outperforming the U.S. Through June 27, the S&P 500 is up 9.1%, whereas foreign developed markets are up 14.3% and emerging markets are up a scorching 17.9% in dollar terms. The question is: Is this just a short-term phenomenon or the beginning of a longer-term rotation?

Recent strategy reports from major banks, including Morgan Stanley, Goldman Sachs and J.P. Morgan, all advocate that investors begin to reposition more outside the U.S., and articles are appearing in mainstream business media suggesting that the rotation is underway.

Watch where the money goes

Investors are definitely listening. Thomson Reuters Lipper’s fund flows year to date through April 26 show that investor flows are strongly heading this direction. Mutual fund flows for domestic equities are in net redemption to the tune of -$18.6 billion. Contrast that to net foreign equity mutual fund inflows of $7.9 billion. Even more interesting is what is happening with ETFs. Year to date through April 26, domestic equity ETF net inflows are $38.5 billion, but they were outpaced foreign equity ETF net inflows of $49.1 billion. The trend is obvious. You can hear the almost automatic march of the passive investors and the robo-advisers in the U.S., but it looks like advance units are scouting out better opportunities elsewhere.

What do they know that maybe you don’t?

What’s behind the trend: A mismatch

At the most basic, overseas markets are cheaper and may have greater growth potential. Investors are taking notice of the historically high valuations in U.S. equities, whose forward P/E ratio is now approaching 19 times earnings per share, compared with emerging markets and foreign developed markets at 12 and 15, respectively, according to Thomson Reuters IBES. And that is after the recent run-up. In addition, the U.S. has enjoyed, in general, stronger economic growth vs. other mature economies over the last few years, but that, too, may be changing. Gasps could be heard when first-quarter GDP growth clocked in at only 0.7% annualized, lower than Britain or even France. Leaving aside the “old world,” eyes are mostly now watching China, in particular, and the rest of Asia as engines of growth.

The wheel may be turning. It is always interesting to compare the importance of the U.S. equity markets vs. the importance of the U.S. economy in the world. The U.S. comprises 53% of the MSCI All Country World Index (although closer to 40% by other more inclusive measures), but only about 20% of the world’s GDP, depending on how you count it. A favorite analogy is Japan, whose 17% contribution to global GDP was overshadowed by its 44% contribution to global indices in 1989, and we all know how that worked out. Oversimplification is always dangerous, but the message is clear: There is a mismatch.

Currency issues contribute

Another headwind for the U.S. market is that the dollar has strengthened over the last five to six years against a basket of other major currencies. This has the double whammy of making foreign investments look cheaper from a U.S. perspective and making U.S. exports less attractive, presenting a drag on the U.S. economy.

The U.S. dollar has begun to weaken in 2017, and further dollar weakening could improve the potential for foreign equity returns for U.S. investors.

Relative valuations between U.S. and foreign markets, faster economic growth abroad, and fund flows into foreign stocks all are the hallmarks of a rotation. So, what are you waiting for?