Given current market conditions, we think international stocks could be poised to outperform. In this piece, we examine five factors we think suggest why international markets may be beneficial. Additionally, in our view, some international exposure is a good practice generally considering that nearly 45% of the world's market capitalization lies outside the U.S.1
Five Factors that May Favor International Stocks in 2021-22
1) Earnings Are Expected to Rebound
Corporate earnings plummeted in 2020 as many sectors of the global economy were forced to shut down2. With the economy now opening up, we believe corporate earnings may rebound, driven by the prospect of above-trend economic growth. The International Monetary Fund’s (IMF) January 2021 World Economic Outlook forecasts that global gross domestic product will rise by 5.5% in 2021, led by emerging markets, especially in Asia, where growth could surge by 8.3%. In contrast, growth in the U.S. is expected to amount to 5.1%.
Chart 1. Emerging Markets May Lead Global Recovery
2) Central Banks Will Remain Accommodative
The Federal Reserve (Fed), the European Central Bank, the Bank of England, and the Bank of Japan dramatically stepped up their bond-buying programs in 2020, flooding the global economy with cash and helping to keep interest rates low3. Major central banks are likely to remain accommodative over the near term, according to the IMF, and the Fed has indicated that it won’t raise short-term interest rates until the end of 2023.4 Low interest rates are considered a benefit to equities markets because they boost valuations, keep borrowing costs low, and may encourage fixed-income investors to seek better returns in the stock market.
3) The U.S. Dollar Could Remain Weak
At the peak of the pandemic in 2020, the U.S. dollar’s status as a safe haven resulted in heightened demand for dollars. But since then, the dollar has weakened (Chart 2). Dovish monetary policy from the Fed has kept interest rates low. Recently, the dollar has rebounded as long-term interest rates have risen. But the Fed has said it is willing to tolerate a higher level of inflation until the economy recovers fully. Higher inflation could cause demand for the dollar to weaken, resulting in a loss of value versus other currencies.5
Chart 2. The U.S. Dollar Index Has Plummeted Since March 2020
Historically, a weak dollar has benefited the performance of international stocks versus U.S. stocks. A weak dollar often coincides with rising commodity prices, which tend to benefit economies that depend on the production of oil and other commodities. Economies such as those in the Middle East, for example, depend on oil and gas production, while many other developing countries depend on exports of metals and agricultural products.6 In addition, for U.S. investors the outperformance of international stocks can also result from the added returns that come from the translation of non-dollar-denominated returns into a relatively weak U.S. dollar.
Chart 3. Historically, a Drop in the Dollar Has Benefited Non-U.S. Equities
4) Valuations in Non-U.S. Markets Are Relatively Attractive Compared to the U.S.
As the U.S. economy has recovered, the forward price-earnings (PE) ratio on U.S. equities has risen dramatically (Chart 4). As of early March 2021, the forward PE on U.S. stocks was 21.9. In contrast, valuations in non-U.S. markets, as measured by the MSCI All-Country World Index (ex U.S.), was 16.3.
Lower valuations on non-U.S. equities may attract investors who consider U.S. stocks overvalued. Increased demand for non-U.S. equities could contribute to international stock market performance.
Chart 4. Valuations in Non-U.S. Markets Are Relatively Attractive
5) Cyclical Stocks Are Likely to Outperform
Another reason that non-U.S. equities could outperform is that they are less concentrated in technology and growth sectors. The large exposure of non-U.S. equities to cyclical sectors, including industrials, materials, and energy means that they may outperform as the global economy accelerates. If long-term bond yields rise in international markets in response to rising economic growth and inflation expectations, as they have in the U.S., we think this may also benefit non-U.S. banks and other financial companies.
Capitalizing on the Current Environment: A Focus on Geographic Diversity and Quality
To take advantage of the current environment, investors may want to consider adding non-U.S. equities to their portfolios. Well-diversified, actively managed strategies that measure themselves against the MSCI EAFE Index, which tracks the performance of non-U.S. developed market stocks, may be an appropriate way to capitalize on the current opportunity.
In addition, non-U.S. equities are less exposed to the U.S. market, potentially providing diversification benefits. As Chart 5 indicates, the revenues of companies in the MSCI EAFE Index are more geographically diversified than companies in the MSCI North America Index, which tracks U.S. and Canadian stocks. In the graphic on the left, the inner circle shows that 35.6% of companies in the MSCI EAFE Index are based in Japan. A somewhat larger percentage of companies are based in “Other” countries. But more importantly, the outer circle shows that the largest percentage of the revenues of companies in the index comes from “Other” countries, and only 18.4% come from the U.S. market.
In contrast, in the graphic on the right, the inner circle shows that 88.0% of companies in the MSCI North America Index are based in the U.S. Moreover, as the outer circle shows, nearly 60.0% of the revenues of the companies in this index come from just one market, the United States.
So, the geographic dispersion of the revenues of companies in the MSCI EAFE Index is much greater than it is for those in the MSCI North America Index. This can be beneficial because a more diverse revenue profile potentially provides greater diversification benefits.
Chart 5. Revenues of Internationally Domiciled Companies Are More Geographically Diversified
Of course, exposure to international markets can also bring greater risk. But active managers can take steps to try to mitigate this risk. In addition to revenue diversity, another way to try to address this risk is to focus on high-quality companies.
Walter Scott, a manager of international equities that has been owned by BNY Mellon since 2007, concentrates on companies that historically have had stronger earnings and more consistent cash flows. Walter Scott’s bottom-up, fundamental approach is robust and defines quality in terms of seven key elements (Chart 6). These include such features as valuation, management experience, competitive advantages and longer-term business factors, among others.
Chart 6. Seven Key Elements in Our Selection of Quality Companies
2 “Global corporate profits tanked 33% through 2nd quarter and won't rebound 'anytime soon,' JPMorgan says,” https://markets.businessinsider.com/news/stocks/economic-outlook-global-corporate-earnings-tumble-no-rebound-anytime-soon-2020-9-1029574497.
3 Yardeni Research, https://www.yardeni.com/pub/peacockfedecbassets.pdf
4 International Monetary Fund January 2021 World Economic Outlook, MarketWatch, Fed Commits to Keeping Interest Rates Low Despite Some Inflation Overshoot, March 17, 2021, www.marketwatch.com.
5 “Inflation Might Hold Back Dollar’s Rebound,” The Wall Street Journal, March 19, 2021.
6 The United Nations Conference on Trade and Development (UNCTAD) defines a country as commodities-dependent when commodities make up more than 60% of its merchandise exports. More than 65% of developing countries are dependent on commodities.
The MSCI All Country World Index tracks the performance of large- and mid-cap non-U.S. stocks in 23 developed and 27 emerging markets. It captures approximately 85% of the free float-adjusted market capitalization in each market.
The MSCI EAFE Index tracks the equity performance of large and mid cap companies across 21 developed markets, excluding the U.S. and Canada. The index captures approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI North America Index tracks the equity performance of the large and mid cap segments of the U.S. and Canada markets. The index captures approximately 85% of the free float-adjusted market capitalization in the U.S. and Canada.
The MSCI USA Index tracks the performance of the large and mid cap segments of the U.S. stock market. The index covers about 85% of the free float-adjusted market capitalization in the U.S. market.
The MSCI Emerging Markets Index tracks the equity performance of large and mid cap companies across 27 emerging markets. The index captures approximately 85% of the free float-adjusted market capitalization in each country.
The Standard & Poor’s 500 Index tracks the performance of 500 leading companies and covers approximately 80% of available U.S. market capitalization.
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