More Overseas Outperformance May Be In Store
As outflows hit U.S.-focused equity mutual funds, international and emerging market stock funds are seeing massive inflows, bolstering strong share price performance of overseas markets this year. Despite the investor rush abroad, plenty of upside could remain.
After years of excellent equity returns at home, U.S. investors appear increasingly interested in moving their chips into less crowded trades abroad, where economic growth is on the upswing, earnings cycle peaks are still a ways off and valuations are more reasonable. Mutual fund flow data reflect growing optimism about the prospects for overseas equities, so much so, in fact, that now this trade, too, looks like it might be getting crowded. How much upside may still be left? Perhaps a lot.
In its latest monthly global fund manager survey, BofA Merrill Lynch noted that the long eurozone equity allocation trailed only the long Nasdaq positioning in June, and was the second-most crowded trade in the month with a net 58% of those polled overweighting the region, near two-year highs. Likewise, the net overweight to emerging market equities hit 42%. Meanwhile, fund managers’ net underweight positioning in U.S. equities generally stood at 15%.
Investor flows into foreign developed market and emerging market stocks in April alone were starkly reflective of the trends underway. U.S. equity mutual funds (excluding ETFs and funds of funds) that invest overseas saw net inflows of $6.3 billion, while those that invest primarily in the U.S. suffered outflows totaling $19.8 billion, according to the Investment Company Institute. April’s flows brought the totals for the first four months of the year to $13.1 billion net inflows, and $47.8 billion in net outflows, respectively.
Given the strong run in U.S. equity performance since the financial crisis, it’s no wonder many U.S. investors would want to allocate more to regions where share price performance has turned robust, valuations are less demanding and earnings still a ways from cycle peaks. The MSCI EAFE returned 21% in the twelve months through mid-June, outperforming the 17% return in the S&P 500 Index. Developing country stocks have done even better, with the MSCI EM Index posting a 25% return in the same period.
More overseas outperformance may be in store. As a Thornburg report on international investing shows, historically U.S. and overseas stocks alternate in terms of cycle performance, with one taking the lead after half a dozen or so years of trailing the other. Different earnings cycles are clearly one key factor driving that dynamic. The below chart shows how S&P 500 companies have already well exceeded their previous forward earnings peak, while next 12-month MSCI EAFE earnings estimates are still 30% below their peak level and the MSCI EM earnings forecasts remain 25% below their peak.
That’s why forward price/earnings multiples also reflect more room for expansion abroad than at home. The S&P 500 forward P/E stands at 17.5x, versus the MSCI EAFE’s 14.9x and the MSCI EM’s 12.4x. Strikingly, calendar year MSCI EM earnings per share estimates have also turned positive for the first time in six years.
Quite apart from the tactical reasons for U.S. investors to shift some money overseas, there are plenty of structural drivers to consider. Faster economic growth overseas, largely among emerging markets, means that the U.S.’s share of global gross domestic product has declined from more than a quarter to about a fifth since 1980. Moreover, as the Thornburg report shows, nearly half of global stock market capitalization is also comprised of overseas stocks, up from about a third in 1970.
U.S. investors can improve portfolio diversification and downside protection by having meaningful allocations to overseas equities, and not just when relative valuations and earnings cycles are more compelling. But for those who have yet to build such exposure, now that it seems we’re closer to the beginning of a new cycle of overseas returns outperformance, it’s certainly not a bad time to start.