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 nine years and counting—will likely continue through 2018, the risks are rising. Meanwhile, most emerging markets (EM) are recovering from their 2015–2016 economic slowdowns or 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 EM are more favorable (Exhibit 1).
We believe that 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 EM.
Attractive Valuations and 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—which was helped by quickening global growth, gradual interest rate hikes from the Federal Reserve (Fed) and a weaker U.S. dollar—investors began directing flows there from DM, taking advantage of compelling equity valuations.
Today, many emerging economies have stabilized and expanded, and valuations remain attractive, with a price-to-sales (P/S) ratio of 1.4 times for EM, compared with 1.7 times for DM and 2.2 times for the U.S. Within EM, the most significant discounts are available in Brazil, Russia, India and China (or the BRICs).
Despite a recent slowdown, 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 their 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 DM to EM, within developed markets we are seeing a rotation away from the U.S. toward Europe. Equity valuations in Europe appear favorable currently, with a P/S ratio of 1.2 times, the deepest discount to the U.S. since the early-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 U.K., Spain, Ireland and Switzerland. By contrast, Norway, Belgium 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 2.7% year-over-year in the fourth quarter of 2017—compared with 2.6% for the U.S. 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 accommodative, with the European Central Bank (ECB) continuing to support growth through the use of counter-cyclical measures. As a percentage of GDP, Eurozone central bank assets, which are high and rising at 39%, have eclipsed those of the U.S., which are lower and falling at 23% (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 U.S., the first major economy to recover following the global financial crisis. Today, however, the risks to the global economy center on the U.S. The U.S. Treasury yield curve, while flattening, remains positively sloped and signals a moderate economic outlook. Elevated valuations, below-average 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 significantly brighter economic outlook, faster expected earnings growth and rising investor inflows. However, we see few of these elements in place today and, as the Fed tightens monetary policy, we anticipate that investors will continue to favor growth stocks.
The U.S. Large-Cap Regime Is Likely to Persist
Generally speaking, U.S. large market-capitalization stocks have outperformed small market-capitalization stocks since 2013. Five 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 2.2 times compared with 1.3 times 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 heightened volatility, lower effective corporate tax rates, higher exposure to faster international growth and better earnings 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 offer a brighter outlook than the U.S., which should provide an edge to internationally-oriented 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 valuations and growth dynamics favor international markets, particularly EM 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, read the complete Equity Strategy Playbook and check back in six months for our updated global equity views.
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The MSCI AC World Index is a free float-adjusted, market-capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.
The MSCI EAFE Index (Europe, Australasia, and Far East) is designed to measure the equity market performance of developed markets, excluding the United States and Canada.
The MSCI Emerging Markets Index is designed to measure equity market performance of emerging markets.
The MSCI Europe Index captures large- and mid-cap representation across 15 Developed Markets (DM) countries in Europe. With 445 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.
The MSCI World Index is designed to measure the equity market performance of developed markets. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Index represents approximately 31% of the total market capitalization of the Russell 1000 companies.
The S&P 500 Index is a market-capitalization weighted index of the 500 largest domestic U.S. stocks.
The Institute for Supply Management (ISM) Manufacturing Purchasing Managers’ Index (PMI) is a diffusion index designed to measure U.S. manufacturing output.
Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
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Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investments in securities of growth companies may be volatile.
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