2017 marked only the second time in the last eight years that international markets outperformed the U.S., with the MSCI All Country World Index (ACWI) ex-U.S. returning 27.19%, and the S&P 500 Index returning 21.83%.1 So is this the beginning of a sustained shift in outperformance? On one hand, there is a list of risks facing international markets, from Brexit to a potential slowdown in China. But on the other hand, international companies have recently been trading at a substantial valuation discount compared with the U.S., and we have been seeing strong profit expansion.
What is the EQV landscape for international markets?
Before discussing the macroeconomic risks, it’s critical to note that all of our bottom-up stock-picking decisions are grounded in our Earnings, Quality and Valuation (EQV) investment process. The Invesco International and Global Growth team has used this process for the past 25 years to help us identify attractively valued, high-quality growth companies.
Earnings. We are in the midst of the first synchronized global earnings recovery since 2010, with global earnings around 16% for 2017 and expectations for 12% growth in 2018.2 We are still seeing positive earnings revisions from most regions. Therefore, it is likely the synchronized earnings recovery will continue in 2018, in our view.
The U.S. market is seeing some of the strongest revisions, possibly driven by the recently announced corporate tax cuts, but there are also strong revisions in emerging markets and Asia.2 From a sector perspective, most of the upgrades are coming from cyclicals, while defensives are lagging. Cyclicals are specifically led by financials, energy and industrials.2
Quality. While the U.S. has seen strong profit growth and margin expansion since the last recession, returns outside of the U.S. are still looking somewhat depressed, especially in Europe, emerging markets and Asia ex-Japan. As of Dec. 31, 2017, U.S. aggregate profit levels were more than 30% above the previous peak seen in 2007, while the MSCI ACWI ex-U.S. was significantly below its previous peak.3 We believe this indicates a potential for further profit expansion for international markets that can better support what looks to be full valuations.
Valuation. Despite the strong earnings recovery, markets rerated in 2017, and most are trading above long-term valuation averages. This has made it difficult for us to find new ideas or deploy our cash. The valuation discount for international markets versus the U.S. is close to multi-decade highs, trading at a 22% and a 44% discount for next-12-months price-to-earnings (P/E) and price-to-book (P/B) ratios, respectively.3 Dividend yields are over 50% higher in international markets than in the U.S.3
Risks to international markets
Geopolitical risk persists partly due to the ongoing Brexit negotiations, 2018 elections in Italy and Brazil, and a volatile situation in North Korea. Additionally, volatility could resurface when central banks begin to pull back from ultra-low interest rates and quantitative easing programs. The U.S. Federal Reserve is expected to continue to hike rates, and the European Central Bank is likely to begin tapering in 2018.
The Chinese government has done a very good job of deleveraging their economy and trying to take the wind out of the sails of the shadow banking system. While they’ve been doing a masterful job, in our view, there is a risk that they could tighten too much, too quickly, and that could slow the economy much faster than anticipated. This potentially poses a risk to all of Asia as the entire region engages in trade with China.
When we look back over time, we see that performance of international markets versus the U.S. tends to go in cycles. While the U.S. market has led in recent years, we believe that the pendulum may be ready to start swinging back. We are cautiously optimistic on international markets, especially relative to the U.S. market.