PM Corner: In conversation with the International Equity Group
Co-portfolio managers discuss opportunities in international equity in the midst of market volatility and recent underperformance.
We are balancing long-term structural winners with some cyclical names and finding ideas across the style spectrum.
International equities have lagged their U.S. counterparts for several years. Why should an investor continue to allocate to this asset class?
It’s a legitimate question. The scale of international equity underperformance is extraordinary, but it also sows the seeds of a reversal.
From the 2008 financial crisis through 2021, U.S. equities have outperformed international equities every single year (2017 was the sole exception), their longest-ever winning streak. During this period, U.S. stocks outperformed by 262%. Of course that’s a significant gain, but it is dwarfed by the 374% outperformance international equities enjoyed between 1982 and 1989. Relative performance of the U.S. market vs. international markets can be highly cyclical and can last several years.
Although positive catalysts are always difficult to predict, the valuation gap between U.S. and international equities may signal why performance could reverse. International equities now trade at a 32% P/E multiple discount vs. U.S. equities, a much greater discount than the 20-year average of 14%.
How would you describe your general approach to investing?
The International Focus strategy is a flexible, actively managed, core international equity strategy – a concentrated portfolio of our best ideas outside the U.S. The portfolio focuses on our highest-conviction stock ideas rather than the index. We see bottom-up stock selection as the primary driver of risk and return. So we capitalize on the fundamental insight of our research team to find and express our stock conviction.
War in Ukraine continues to dominate headlines, along with inflation and recession risk. How are you assessing the current environment?
The current global macroeconomic backdrop is bleak. Inflationary pressures, which had been present at the beginning of the year, have been exacerbated by the war in Ukraine and zero-COVID mandated lockdowns in China. Central banks globally have been forced to raise rates further and faster than market participants had expected at the start of the year. A recession now seems increasingly likely.
Importantly, we think it will probably be a mild downturn. We note, too, that the 30%-40% year-to-date derating of industrial and consumer cyclical stocks suggests that the market is already discounting a cut to earnings commensurate with a mild recession.
What is your team’s bottom-up earnings outlook?
Our five-year expected return framework generated by our global team of research analysts points to some very attractive returns. Aggregating all our bottom-up forecasts, we expect about 10% five-year compound earnings growth for the ACWI ex-U.S. universe, supplemented by a 3% dividend yield. Given limited valuation headwinds from this point, we see some very attractive total returns for long-term investors.
How have you navigated the sharp shifts in market leadership, and how is your portfolio positioned today?
As well as a large drawdown in markets, this year investors have had to contend with a severe rotation in style performance as value has strongly outperformed growth. Higher cost of capital has pressured growth stocks whose valuation is typically underpinned by cash flows farther into the future. In addition, some overly optimistic expectations of future earnings growth have been downgraded, especially in sectors such as e-commerce and digital entertainment that had seen demand pull forward due to the pandemic. We started reducing exposure to these areas in the fourth quarter of 2021 and have continued paring positions in 2022.
At the same time we have been increasing exposure to commodities, particularly energy. We have found some of the more attractive risk-adjusted returns in more defensive parts of the market, and we’ve been adding utilities, pharmaceuticals and consumer staples stocks so far this year.
Despite these moves we still retain a modest tilt to cyclicality. Equity markets always bottom before the economy does. We therefore retain selective cyclical exposure where we think a company has the earnings resilience to weather short-term headwinds and capitalize on a recovery, whenever it comes.
What opportunities are you most excited about today?
As always, we are balancing long-term structural winners with some cyclical names and finding ideas across the style spectrum.
Many of the companies we have identified as long-term structural winners (some of which now face cyclical pressures) appear extremely cheap. Examples include semiconductor companies such as ASML and TSMC. In the luxury goods sector we see enormous potential in demand from emerging markets for the likes of LVMH, L’Oreal and Diageo. Similarly, the under-penetration of financial services in large, emerging economies, such as China, India and Indonesia, look to be a huge source of opportunity for companies like HDFC Bank (an Indian Bank), AIA (an Asian life Insurer) and BCA (an Indonesian Bank). We continue to find companies exposed to long-term structural themes that will endure.
The International Focus strategy remains a high conviction, core portfolio. If we don’t like the long-term fundamentals of a company or industry, we don’t own it.
The companies mentioned herein are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell. The use of these company names is in no way an endorsement for J.P. Morgan Asset Management investment management services