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For the first time in nearly a decade, the risks to the global economy are concentrated in the United States, and growth in much of the rest of the world is stable or accelerating. While the elongated U.S. business cycle, currently eight years and counting, will likely continue into 2018, the risks are rising. Meanwhile, most emerging markets (EM) are recovering from their 2015-2016 slowdowns and recessions, and a much-anticipated earnings rebound is underway in Europe. In addition to the stronger growth prospects available in non-U.S. markets, relative valuations in Europe and emerging markets are more favorable (Exhibit 1).
Maintaining some exposure to U.S. stocks is still warranted, but investors should proceed with caution. Elsewhere, those who are underexposed to international stocks may need to rethink their allocations. In particular, it may be beneficial for investors with longer time horizons to consider increasing allocations to emerging markets.
Attractive Growth Prospects Draw Investors to Emerging Markets
EM equity underperformance in the first half of the decade made valuations attractive relative to developed markets (DM). After bottoming out in late 2015, the cyclical economic backdrop in EM turned constructive. As EM moved into recovery mode, helped by quickening global growth, gradual interest rate hikes from the U.S. Federal Reserve (Fed) and a weaker U.S. dollar, investors began directing flows there from DM, taking advantage of the compelling equity valuations.
Today, many emerging economies have stabilized and expanded, and valuations remain attractive, with a price-to-sales (P/S) ratio of 1.4x for EM, compared with 1.7x for DM countries and 2.1x for the United States. Within EM, the most significant discounts are available in the BRICs—Brazil, Russia, India and China.
Meanwhile, leading indicators of business activity in EM are in expansion territory and continue to trend upward. Earnings growth expectations for EM companies are outpacing those of DM counterparts (Exhibit 2). Importantly, China is the biggest demand driver for many EM companies, and the country is well positioned to benefit from positive cyclical and structural forces in place there.
Attractive valuations, combined with positive economic and corporate earnings growth trends, are providing ongoing support for EM equity returns. While emerging markets tend to experience temporary spikes in volatility, adopting a long-term approach can help make up for short-term pain.
The Stage Is Set for Continued European Outperformance
Just as investors are rotating from developed markets to emerging markets, within developed markets, we are seeing a rotation away from the United States toward Europe. Equity valuations in Europe appear favorable currently, with a price-to-sales ratio of 1.3x, the deepest discount to the United States since the mid-2000s. The region is also attractive across a broad selection of valuation metrics, including price-to-forward earnings, cash flow, book value and dividend yield. Looking beneath the surface, we see that Europe’s valuation opportunities are concentrated in Portugal, Italy, the UK, Spain, Ireland and Switzerland. By contrast, Belgium, Norway and Denmark appear richly valued.
Value means little without a catalyst and, in Europe, a sound economic and earnings recovery is taking place across the continent. Eurozone gross domestic product (GDP) grew 2.3% year-over-year in the second quarter of 2017, compared with 2.2% for the United States during the same period, and leading indicators of business activity, as expressed by the Institute for Supply Management’s Manufacturing Purchasing Managers Index, are in expansion territory and trending upward. Monetary policy remains extremely accommodative, with the European Central Bank (ECB) continuing to support growth through the use of countercyclical measures. As a percentage of GDP, Eurozone central bank assets, which are high and rising at 38%, have eclipsed those of the United States, which are at 23% and falling (Exhibit 3).
Europe’s economic recovery is lifting earnings growth expectations for Eurozone companies, which source approximately 60% of their revenues from the region. Foreign flows into European equity funds, and the subsequent appreciation of the euro, are additional tailwinds.
In the past, there have been notable periods during which European equities have surpassed U.S. stocks, including 2002 to 2007. We believe we are in the early stages of another such period and that the current European outperformance regime has room to run.
In the U.S., Growth Continues to Outperform
Between 2007 and 2016, U.S. equities enjoyed their second-longest period of outperformance since 1970 as equity investors sought shelter in the United States, the first major economy to recover following the global financial crisis. Today, however, the risks to the global economy center on the United States. The U.S. Treasury yield curve, while flattening, remains positively sloped and signals a moderate economic outlook. Elevated valuations, subdued growth and tighter monetary policy all point to modest stock market returns from here.
Following the financial crisis, investors were willing to pay more for earnings growth, a scenario that has favored growth-oriented investment strategies and contributed to the longest growth regime on record. While 2016 saw value outperform, particularly following the U.S. Presidential election, as investors grew optimistic that a cyclical economic upswing was upon us, the length and magnitude of the outperformance was modest compared with past value cycles (Exhibit 4).
What’s on the horizon? In our view, there are essential ingredients to a value market, including attractive valuations, pro-growth policies, a brighter economic outlook, faster expected earnings growth and rising investor inflows. However, we do not believe all of these elements are in place today and, as the Fed normalizes monetary policy, we anticipate that investors will continue to favor growth stocks.
The U.S. Large-Cap Regime Is Likely to Persist
U.S. large-capitalization stocks have outperformed small-cap stocks since 2013. Four years of gains have expanded large-cap relative valuations, but they are not excessive yet. The S&P 500 Index has a P/S ratio of 2.1x compared with 1.2x for the Russell 2000 Index, but small caps traditionally trade at a discount to large caps because of the higher risk and lower liquidity inherent in younger companies. The last small-cap outperformance regime didn’t begin in earnest until their discount to large-cap stocks ballooned to 62% in 2000, and we’re far from that level today.
Compared with small-cap companies, large-cap firms benefit from lower effective corporate tax rates, tighter monetary policy conditions and below-trend economic growth. Further, U.S. dollar depreciation boosts large U.S. multi-national corporations through foreign sales and exports, demand creation, positive accounting translation effects and increased competitiveness (Exhibit 5). Non-U.S. markets today offer a brighter outlook than the United States, which should provide an edge to large-cap stocks. Investor fund flows support this trend, and we believe the conditions are in place for large-cap outperformance to continue.
In summary, current growth dynamics and valuations favor international markets, particularly emerging markets and Europe. Within the United States, we maintain a preference for growth stocks over value stocks, and believe that large-cap companies are well positioned to benefit in the current environment.
For more details, please download the complete Equity Strategy Playbook, and check back in six months for our updated global equity views.
This material is for informational purposes only and is not intended to be investment advice, a recommendation, or to predict or depict the performance of any investment.