International equities have lagged U.S. stocks over the past decade, but Portfolio Manager and Managing Director Emily Leveille thinks the tide is about to turn.
It may be tempting for U.S. investors to turn their backs on the rest of the world in 2023. After all, in our view global inflation will remain elevated and keep central banks on their toes, even as it continues to moderate, and international and emerging markets will remain vexed by the unresolved Russia-Ukraine war and the rivalry between China and other major countries. But ignoring foreign markets could mean overlooking attractive buying opportunities. In fact, we think 2023 could provide a setup for high-quality foreign companies with durable growth prospects to outperform. In this article, we highlight the five key reasons we think international investments may be better positioned than those offered by U.S. markets.
#1. International Valuations Are Significantly Lower than in the U.S.
As seen in the chart below, over the past 10 years, foreign markets have traded at a discount to the U.S. that has widened since COVID. We think the discount right now is even wider if we consider that consensus estimates for Europe appear to be closer to pricing in a recession than bottom-up earnings estimates for U.S. companies. If the U.S. market indeed falls into recession this year (which we believe is a likely event) and equity prices contract further, the ex-post valuation disparity will have shown itself to be even wider. We believe European stocks are already more accurately calibrated toward an economic slowdown and that foreign markets offer a better entry point for buyers looking to pick up high-quality names at a discount.
Historical Valuations of S&P 500 vs. MSCI ACWI ex US Index
Source: Bloomberg
#2. U.S. Dollar Strength May Be Peaking
2022 was a notable year across many dimensions, including in the Federal Reserve’s aggressive shift towards monetary tightening as they sought to combat historically high inflation. Consequently, the U.S. dollar rallied against nearly every other major currency to levels not seen in decades, advancing by roughly 20% from the beginning of last year to September. Since that point, however, we have observed some signs that the dollar’s strength may be soon coming to an end.
First, inflation has started to moderate, and the growing view is that the Fed will slow the pace of rate hikes this year. Secondly, China’s sudden and rapid reversal of its draconian COVID restrictions came earlier than most expected and may provide the additional boost needed to soften the impact of a global recession, thus reducing the need for the dollar to act as a safe-haven currency. These factors will likely put downward pressure on the dollar, a trend we believe will persist throughout the rest of the year — which, in turn, ultimately benefits international companies.
#3. Lower Energy Prices
Oil and natural gas prices soared in 2021 and through much of last year after Russia invaded Ukraine, but they have now fallen well below their pre-war levels. Natural gas prices have plunged nearly 80% since their summer peak in 2022 and dropped another 20% in December. This trend reflects Europe’s success in finding alternatives to Russian gas, and warmer-than-normal temperatures this winter have also helped limit the overall demand for gas.
We believe this remarkable turnaround in energy prices will be supportive of economies that are the biggest net importers of natural gas: not only European countries, but also Japan, South Korea, and China. Furthermore, lower energy prices will help alleviate global inflationary pressures and reduce the overall drag on global economic growth prospects.
#4. China’s Reopening
The unexpectedly rapid shift towards the reopening of China, the world’s second-largest economy, is brightening many global investors’ outlook. China’s reopening will undoubtedly be a bumpy ride, as the economic hit from rampant COVID-19 infections has yet to play out. However, we believe China’s reopening will be a net positive not only for the country, but also for the broader international landscape.
For example, we have seen estimates that Chinese households have accumulated an additional 2 trillion to 5 trillion renminbi of savings during the lockdown. This could have very positive implications for certain segments of the world economy — in particular for European companies, which generally have stronger ties and more revenue exposure to China than do U.S. companies. Furthermore, as Chinese people resume their pre-pandemic habits and consumer demand there rebounds, we think European luxury goods, travel and other consumer discretionary companies will be key beneficiaries.
#5. Less Concentrated Markets Provide More Room for Opportunity
The bulk of U.S. equity outperformance vs. international in the last 10 years has been driven by a small set of technology companies, most notably the FAANG companies, and the sector has become an increasingly prominent component of U.S. equity indices: It comprised roughly 40% of the total U.S. equity market in the fourth quarter of last year. International markets, by contrast, offer a much more diversified basket of companies — the technology sector only comprises 7% of European markets and 20% in emerging markets, for instance. This greatly reduces concentration risk and leaves more room for investors to uncover growth opportunities that may be unavailable in the United States.
As seen in the table below, the story also holds true for two of the well-known indices that many active managers benchmark themselves against when looking for opportunities in the U.S. and international markets.
Sector Composition of U.S. vs. International Markets
| Sector | S&P 500 | MSCI ACWI ex-US |
|---|---|---|
| Information Technology | 25.7% | 10.8% |
| Health Care | 15.8% | 9.8% |
| Financials | 11.7% | 21.0% |
| Consumer Discretionary | 9.8% | 11.4% |
| Industrials | 8.7% | 12.3% |
| Communication Services | 7.3% | 5.9% |
| Consumer Staples | 7.2% | 8.9% |
| Energy | 5.2% | 6.0% |
| Utilities | 3.2% | 3.4% |
| Materials | 2.7% | 8.4% |
| Real Estate | 2.7% | 2.3% |
Source: Bloomberg
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