Guest columnists Benjamin Segal and Elias Cohen look at international stocks in relation to recent market performance.
In down markets, it’s common for correlations to increase and markets to move in tandem. However, it is the job of active managers to determine whether the decline in individual securities is deserved and whether it offers potential opportunities.
October’s broad market selloff, which accelerated last week, is a case in point. Major equity indices fell by 7% or more month-to-date through Thursday, in large part due to concerns around higher interest rates in the U.S. and trade conflict between the U.S. and China. In our view, these issues are likely to impact some areas of the market more than others. Employment data in the U.S. shows an ever-tighter labor market, which is driving the Federal Reserve to raise short-term interest rates–now at 2.25% and expected to increase further over the next 12 months. Regarding trade, the focus of recent concern has been the bilateral relationship between the U.S. and China, which has seen a new round of U.S. tariffs on $200 billion of imports from China, starting at 10% but potentially rising to 25% by early 2019.
Given these headwinds, the U.S. equity market’s retreat (-7% month-to-date) was not altogether surprising, especially with corporate profits and stock valuations at the high end of the historical range. However, international stock markets fell even more (over 9% in USD), despite the fact that interest rate and trade concerns do not directly affect markets in Europe or developed Asia.
Policy and Trade Distinctions
Unlike the Fed, European Central Bank policy remains very accommodative. With lower growth and higher unemployment in Europe, we do not believe that the ECB will raise rates any time soon—regardless of actions taken by the Fed. The Bank of Japan is also unlikely to join the Fed’s rate rises due to Japan’s persistently low inflation.
Regarding trade, worries beyond the Sino-U.S. relationship have largely eased. Although U.S.-China tariffs would be negative for global growth, by far the most significant effects will be felt in those two countries specifically.
Disconnects are also apparent at the sector level. Technology shares have fallen sharply, particularly in developing Asia, which reflects the exposure of tech hardware companies to potential trade restrictions. Autos have declined on a global basis, justified to some degree by their high profile in trade debates, not to mention the demand slowdown in the U.S. and China. However, locally driven international stocks have fallen broadly as well—even those with revenue streams that have proven to be resilient in the face of weaker economic conditions. Although tariffs could undermine global growth, the economic cycle in Europe is on sound footing and at an earlier stage than that of the U.S., while Japan’s growth has remained positive.
Valuation Advantage and Improved Profitability Potential
In terms of valuation, as of October 25, the MSCI EAFE Index traded on a price/earnings multiple of 13.0 compared to 16.9 for the S&P 500. Some discounting is deserved; however, we continue to see many cases of international companies trading at meaningful discounts to U.S. peers. In Japan, consumer and industrial automation companies offer very attractive long-term revenue prospects, while in Europe we are finding niche industrial, financial and communication services firms that generate similar growth and profitability to their U.S. peers, but trade at a 20–30% valuation discount. Should U.S. economic growth slow—due to trade policies, interest rate increases or other factors—or should growth outside the U.S. accelerate, we believe this valuation discount can narrow. Moreover, as outlined in our recent paper, we see signs that management teams outside the U.S. are beginning to embrace more shareholder-friendly practices—similar to those that are now commonplace in the U.S.—which could enhance profit-growth potential over time.
Headline Risks: Italy, Brexit
That being said, we are mindful of near-term issues that could hamper European stocks. Markets remain concerned about the sustainability of Italy’s fiscal position—which is causing tension with the EU and Germany currently. As has been the case before, we believe Italy will reach a compromise with the EU. Meanwhile, the lack of an agreement between the U.K. and EU over the terms of Brexit adds to uncertainty in the U.K. Although it’s hard to see particularly positive outcomes, the majority of British companies generate much of their revenue outside the U.K. For the remainder, lower share prices and a weaker sterling may indicate that a negative scenario is already largely reflected in share prices.
After many years of underperformance, European and other international equity markets generally outperformed the U.S. in 2017. Although 2018 has not been kind to non-U.S. equity markets, we believe the combination of lower expectations, the potential for improved profitability, and this latest move down in stock prices offer investors a chance to capture an attractive long-term opportunity.
In Case You Missed It
- Japan Purchasing Managers’ Index: +0.6 to 53.1 in October
- U.S. Purchasing Managers’ Index: +0.3 to 55.9 in October
- U.S. New Home Sales: -5.5% to SAAR of 553,000 units in September
- Euro Zone Purchasing Managers’ Index: -1.4 to 52.7 in October
- U.S. Durable Goods Orders: +0.8% in September (excluding transportation, durable goods orders increased 0.8%)
- European Central Bank Policy Meeting: The Governing Council made no changes to its policy stance
- U.S. Q3 2018 GDP (first estimate): +3.5% annualized rate
What to Watch For
- Monday, 10/29:
- U.S. Personal Income and Outlays
- Tuesday, 10/30:
- U.S. Consumer Confidence
- S&P/Case-Shiller Home Price Index
- Bank of Japan Central Bank Meeting
- Euro Zone Q3 2018 GDP (first estimate)
- Wednesday, 10/31:
- Euro Zone Consumer Price Index
- Thursday, 11/1:
- ISM Manufacturing Index
- Friday, 11/2:
- U.S. Employment Report
Statistics on the Current State of the Market – as of October 26, 2018
|S&P 500 Index||-3.9%||-8.7%||1.0%|
|Russell 1000 Index||-3.9%||-8.9%||0.6%|
|Russell 1000 Growth Index||-3.9%||-10.5%||4.8%|
|Russell 1000 Value Index||-4.0%||-7.3%||-3.7%|
|Russell 2000 Index||-3.8%||-12.5%||-2.4%|
|MSCI World Index||-3.9%||-9.2%||-3.8%|
|MSCI EAFE Index||-3.9%||-9.9%||-10.7%|
|MSCI Emerging Markets Index||-3.3%||-10.3%||-16.9%|
|STOXX Europe 600||-3.5%||-9.9%||-12.1%|
|FTSE 100 Index||-1.5%||-7.4%||-6.4%|
|CSI 300 Index||1.3%||-7.7%||-19.5%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.3%||0.2%||0.4%|
|Citigroup 10-Year Treasury Index||1.1%||0.0%||-3.7%|
|Bloomberg Barclays Municipal Bond Index||0.3%||-0.4%||-0.8%|
|Bloomberg Barclays US Aggregate Bond Index||0.5%||-0.3%||-1.9%|
|Bloomberg Barclays Global Aggregate Index||0.3%||-0.5%||-2.9%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.2%||0.0%||4.0%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.7%||-1.7%||0.8%|
|ICE BofA Merrill Lynch Global High Yield Index||-0.8%||-1.7%||-1.2%|
|JP Morgan EMBI Global Diversified Index||-0.2%||-1.7%||-4.7%|
|JP Morgan GBI-EM Global Diversified Index||-0.8%||-1.1%||-9.2%|
|U.S. Dollar per British Pounds||-1.7%||-1.7%||-5.2%|
|U.S. Dollar per Euro||-1.1%||-2.1%||-5.3%|
|U.S. Dollar per Japanese Yen||1.0%||1.9%||1.1%|
|Real & Alternative Assets|
|Alerian MLP Index||-6.4%||-7.5%||-2.1%|
|FTSE EPRA/NAREIT North America Index||-0.3%||-3.2%||-0.9%|
|FTSE EPRA/NAREIT Global Index||-0.9%||-4.3%||-5.1%|
|Bloomberg Commodity Index||-1.1%||-0.1%||-2.1%|
|Gold (NYM $/ozt) Continuous Future||0.6%||3.3%||-5.6%|
|Crude Oil (NYM $/bbl) Continuous Future||-2.2%||-7.7%||11.9%|
Source: FactSet, Neuberger Berman.