While US stocks have dominated the last decade, we believe we’re nearing an inflection point which could mark a period of prolonged outperformance in international equities. Amid a market polarized by value traps and potentially overpriced growth at either end of the spectrum, the opportunity for active investors to add value utilizing a selective approach can be massive.
We believe the backdrop for international equities to potentially outperform domestic equities has grown more favorable as many of the tailwinds that have benefited the US equity market appear to be fading or are under threat:
- Growing prospects of a multi-year period of a weaker US dollar (USD) (FIGURE 1)
- Consensus earnings estimates indicate stronger growth outside the US (FIGURE 2)
- The mega-cap1 tech stocks in the US have pushed domestic market breadth to its narrowest levels since 1998 and now face increased political and competitive pressure
- Comparative global valuations suggest there is better relative value outside of the US
The relationship between the double deficits and the US dollar suggests the currency could remain weak going forward. The US has some advantages in that the USD remains the global funding currency so it can sustain imbalances better than most other currencies, but the dollar’s weakness still carries negative implications. It most certainly increases financing risks, limits fiscal policy expansion, and can lead to significant currency weakness. This is further supported by the Federal Reserve’s “looser for longer” policy and its willingness to tolerate inflation, which is consistent with a likely preference for inflating away the mountains of debt rather than raising taxes. In aggregate, this should be relatively supportive for commodities, emerging markets (EM) and, more broadly, international equities.
The US Dollar Is Likely To Depreciate in the Coming Years
US dollar vs twin deficits
Source: Schroders, Bloomberg. Data as of 12/31/20. Past performance does not guarantee future results. A twin deficit is a fiscal deficit (a budget shortfall) combined with a current account deficit (spending more for goods overseas than the country receives).
Consensus Earnings Estimates Are Indicating Stronger Growth Outside the US Over the Short-To-Medium Term
Year-over-year expected EPS* growth %
Source: IBES, Datastream Refinitiv, MSCI, and Schroders. Data as of 1/29/21. Notes: Japan EPS for 2022 is 4 quarter sum until March 31 of following calendar year, e.g. 2022 = 3/31/22 – 3/31/23. * Earnings Per Share is the projected growth rate in earnings per share for the next five years. There is no guarantee that any forecasts or estimates will be realized.
Equities Offering Attractive Value Relative to Bonds in Developed International Markets
Forward 12-month equity dividend vs. bond yield,%
Source: IBES, Datastream Refinitiv, MSCI, ICE, and Schroders. Data as of 1/29/21. Equity yield = forward 12-month dividend yield. Corporate bond yield = unhedged local currency yield (unhedged currency indicates that there is no financial contract to help protect against changes in currency exchange rates), except for EM, which is in USD. Yields fluctuate over time. Equity dividends, unlike bond coupons, offer no guarantee of future income potential. A forward dividend yield is the percentage of a company’s current stock price that it expects to pay out as dividends over a certain time period, generally 12 months.
We continue to see tentative signs of stabilization and gradual normalization in a number of markets. Leaving aside the reality of a second wave of COVID-19, we believe it is likely that the recovery may continue to build and that equities may perform well in a more normalized environment. Ongoing high levels of support by central banks globally have been very significant and have helped markets recover from the sharp losses seen earlier in the year at the start of the pandemic. Despite the support, there may remain substantial financial stress in many parts of the economy in a number of countries, even at a time of continued low interest rates.
Despite the ongoing support from central banks, there may remain substantial financial stress even at a time of continued low interest rates.
The rising political tensions between the US and China are also clearly creating additional risks for many companies operating globally—that investors need to be mindful of. We may see new competition as China is encouraged to localize more of its technology. Many companies may also be exposed to higher costs from supply-chain de-globalization. US companies may face increased risks from retaliatory action by China aimed at cutting off its consumer from US companies. Ultimately, companies with significant exposure may require higher risk premiums in their valuations. That being said, retail-sales data from China appears to show a move from the recovery phase to expansion, and the healthy economic activity is reflective of the proactive response by the government to the COVID-19 pandemic.
As gloomy as the overall short-term economic picture clearly is, we are keen not to lose sight of the fact that COVID-19 will eventually pass, and that business and consumer confidence will eventually recover, bolstered by unprecedented levels of monetary and fiscal support. Additional waves of COVID-19 are likely to be less economically disruptive. Governments around the world are now better prepared and likely to take pre-emptive measures to avoid additional lockdowns. Test-and-trace systems are up and running in many parts of the world, and there is greater optimism since several effective vaccines are now being administered.
Opportunities Emerging in Some “Unloved” Areas
While the technology sector is likely to retain its leadership in terms of growth, we expect this leadership to broaden out with healthcare and industrials gaining as the global economic recovery gathers pace. Financials, conversely, may continue to struggle amid low rates and rising credit losses. While the sector faces challenges in aggregate, there remain many attractive opportunities for selective investors. There are a number of well-capitalized, high-quality international financial franchises that are seeing lower-than-expected losses, showing profit improvements in their overall businesses, and still trading well below their book value, offering compelling opportunities for long-term investors.
European risk assets2 have continued to benefit from the recent Euro-currency appreciation and fiscal support from the €750bn EU Recovery Fund. More importantly, this burden-sharing structure marks a landmark moment for the region, taking another step toward fiscal consolidation. Much of the stimulus will be focused on “green” initiatives and digitalization in Europe. In fact, nearly 30% of this stimulus will be focused on climate investment through further investment in renewables and utilities infrastructure. Late last year Europe announced its Green Deal, which is expected to translate into €7 trillion in investments to target net-zero carbon emissions by 2050. Utilities could account for nearly half of that and kick off an era of earnings growth and regulatory stability within the sector. Amid a government-mandated and Europe-wide commitment to rebuilding the power infrastructure, many European utilities are looking attractive from a growth perspective for the first time in decades.
Many governments have also discovered a clear alignment between the need for investment programs to stimulate growth and their ambition to accelerate the transition away from fossil fuels. The European Union, in particular, has focused its recovery plan on renewable energy, upgrading building stock, and accelerating the transition to electric vehicles. We have attempted to position our portfolios well for all of these trends and are optimistic that this period of change and innovation could remain a robust environment for fundamental active management.
It’s also worth mentioning that the impact of the virus in some cases may be lasting. The many unexpected outcomes of lockdowns, social distancing, and remote working may hasten the demise of established businesses in some areas (for example in travel, business interaction, retailing, etc.). It may also strengthen new business models in others, such as video communications, data centers and cloud service, e-commerce, and sports, as we adjust to a new way of living and working. We remain focused on watching for potential market dislocations and carefully weighing the trade-offs between risk and reward as we assess opportunities for unanticipated growth.
Capitalizing on Opportunities Through a High-Conviction Selective Approach
With “value traps” in disrupted industries lurking at one end of the spectrum and quality growth franchises that may already be priced for perfection lurking at the other, this invariably remains an attractive environment for active stock-picking. The market’s fixation on the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google’s parent company, Alphabet) and US-dollar strength of the past nine years has led many to overlook the great stock opportunities outside of the US. In fact, the majority of the best-performing stocks over the last five years has come from outside of the US and spread out across a wide range of industries, whereas the best-performing US stocks have nearly all come from the tech sector.3 The substantially greater market breadth within the international-equities investable universe would certainly argue for greater inefficiency and alpha4 opportunities for active investors. We remain in a period of heightened volatility, with huge variability in consensus earnings estimates and many companies reluctant to provide guidance. We are arguably in a golden period for active management within international equities and believe investors are best served by a high-conviction selective approach.
The majority of the best-performing stocks over the last five years has come from outside of the US and are spread out across a wide range of industries.
Talk to your financial professional to discuss your allocation to international equities and visit our Market Perspectives to learn more.
Hartford Funds 4- and 5-Star International Funds
1 Mega cap is a designation for the largest companies in the investment universe as measured by market capitalization.
2 Risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies) have a significant degree of price volatility.
3 Source: Schroders and Refinitiv
4 Alpha is the measure of the performance of a portfolio after adjusting for risk. Alpha is calculated by comparing the volatility of the portfolio to some benchmark. The alpha is the excess return of the portfolio over the benchmark.
Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political and economic developments. • These risks may be greater for investments in emerging markets. • Focus on investments that involve climate change opportunities or sustainable and environmental initiatives may result in foregoing certain investments and underperformance comparative to funds that do not have a similar focus. • There are risks of focusing investments in securities of companies in the utilities and industrials sectors which may cause the performance to be sensitive to developments in those sectors. • Risks of focusing investments on the healthcare related sector include regulatory and legal developments, patent considerations, intense competitive pressures, rapid technological changes, potential product obsolescence, and liquidity risk.• Different investment styles may go in and out favor, which may cause underperformance to the broader stock market.
Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.
The views expressed herein are those of Schroders Investment Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Schroders Investment Management or Hartford Funds.