For several years, US stocks have outperformed equities overseas. But evolving conditions in global capital markets could change that. US investors who have avoided non-US stocks may want to take a fresh look at their allocations.
Stocks have posted solid gains since they started to recover from last year’s painful crash. The MSCI EAFE Index of developed-world stocks outside the US surged by 26.8% from October 2022 through the end of January 2023 in US-dollar terms, outperforming the S&P 500’s 14.3% gain. Four months doesn’t necessarily signal a durable trend. However, since US stocks outperformed international stocks for eight of the past 10 years, many investors are rightly asking whether return patterns may shift this year.
Several developments are challenging the US equity market’s supremacy. In particular, a weaker US dollar and the global implications of China’s reopening are supporting equities outside the US, while several central banks are farther along than the Fed in their monetary policy tightening phases. Market valuation dynamics could add another impetus for international stocks.
US Dollar Depreciation May Favor Non-US Stocks
For most of 2022, the US dollar strengthened sharply against major currencies. The dollar’s appreciation was driven by the US Federal Reserve’s aggressive interest-rate hikes, aimed at curbing a spike in inflation. But since the end of September, the dollar has weakened. While it’s still too soon to declare that the dollar’s downward trajectory will be sustained, the recent weakening is widely seen as a response to softer inflation readings. The market anticipates that a more meaningful decline in inflation will lead the Fed to ease its rate-hiking policy and, eventually, may lead it to begin taking rates down.
That matters for international stocks. Our research shows that when the dollar was weaker over the last 20 years, non-US stocks tended to outperform US stocks (Display). The weaker dollar creates beneficial effects for some countries and select stocks in global markets. And currency fluctuations will factor into returns for US investors who own international stocks, which are worth more after they’re converted back to a relatively weak US dollar.
China’s Reopening Could Offset Recessionary Pressures
Policy trends that drive currency moves and macroeconomic growth differ around the world. In China, for example, inflation remains relatively low, which should enable authorities to continue with stimulus policies that could help revive growth. The recent accelerated reopening following COVID lockdowns should help boost the economy and risk assets; this has helped Chinese stocks surge back to life in recent months. Similarly, emerging-market stocks may benefit from Chinese growth and improved conditions driven by the world’s adjustment to higher inflation and interest rates.
The release of pent-up demand in China could help support the global economy at a sensitive moment. China is the European Union’s biggest trading partner. And China’s biggest trading partner is the 10-member Association of Southeast Asian Nations (ASEAN), while four Asian countries that are not ASEAN members are among China’s top 13 trading partners. The reopening could ease supply chain pressures across the region. Asian economies could also benefit from a wave of Chinese tourism. While these trends may complicate efforts to bring global inflation down, they would also help offset some of the recessionary pressures at play.
Gauging Regional Return Potential
Companies that may benefit from these trends can be found in different parts of the world. Equity investors will want to make sure that their valuations are attractive, considering P/E multiples have expanded from year-end 2022 levels because of market gains early this year. In international developed markets and emerging markets, stocks have been relatively cheap versus US stocks for some time. But that generally didn’t translate into better returns during an era when US markets were driven by a persistent demand for mega-cap, high-growth stocks, with low inflation and interest rates a material tailwind for many of those years.
Now, as the market environment evolves, the landscape of potential opportunity warrants a closer look.
The earnings risk premium (ERP) is an important gauge at a time when interest rates are rapidly adjusting to the inflationary environment. This metric captures a market’s earnings yield minus the 10-year regional government bond yield to evaluate the attractivity of risk assets such as stocks versus lower-risk assets such as government bonds—a higher ERP indicates a more attractive potential investment opportunity. Our research suggests that the ERP looks especially attractive for non-US stocks (Display). In several European countries and Japan and Canada, the ERP is currently substantially higher than in the US and higher than each country’s long-term average.
How can investors position themselves to capture this return potential? Don’t be tempted to seek regional exposures that reflect global macroeconomic conditions, which are notoriously hard to predict. And the domicile of a company isn’t necessarily a reflection of its home-country’s macroeconomic circumstances. European companies generate 58% of their revenue from outside the region (Display above). Japanese and US companies also sell significant volumes to customers abroad. As a result, revenue and earnings growth potential will often be determined more by global industry dynamics than by inflation and GDP at home. So portfolios based on non-US companies should use fundamental research to evaluate the sources of a company’s revenue and the forces driving its business.
Disciplined stock selection can help investors achieve effective global diversification in different types of international equity portfolios suited for individual investor risk tolerances. To be sure, US stocks still offer solid long-term return potential and remain an integral component of a US investor’s strategic allocation to risk assets. But for US investors seeking to dip a toe into international markets or expand global allocations, the time may be right to revisit regional diversification.
- Walt Czaicki
- SVP & Senior Investment Strategist—Equities
- Jillian Geliebter