David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Today's episode is on the case for international equities and has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence.

With me today is Tim Morris, Investment Specialist with our Emerging Markets and Asia Pacific Equities Group, as well as Anjali Balani, Investment Specialist with our International Equity Group. Welcome to the Center for Investment Excellence.

Tim Morris: Happy to be here.

Anjali Balani: Thank you for having us.

David Lebovitz: So it's certainly been an interesting start to the year characterized by, you know, a more resilient global economy than I think a lot of people expected, an inflation picture, which is improving, but I think that there is still some wood to chop and a lot of questions about the future direction of monetary policy. You know, you go back to the beginning of March the debate was whether the Fed would hike by 25 basis points or 50 basis points when they all got together. And very quickly with the stress that emerged in the US banking system, really the global banking system, very quickly the debate became between, you know, no hikes or a 25 basis point move.

Now when we take a step back, and think about the broader direction of travel here, we still think that growth will slow over the course of the coming quarters, probably will remain positive in the US during the second quarter, and then potentially turn negative during the second half of the year.

But what I think is particularly interesting, and very relevant to our conversation here today, is really that the rest of the world is looking pretty good and arguably looking better than what we see here in our own backyard. And so there's lots that we can discuss around the implications of that growth.

But I think in general we need to recognize that, you know, again the economy has more momentum than people originally thought. That means that inflation is going to take longer to move back to levels that are consistent with central bank targets.

And it probably means that while we're close to the end of the hiking cycle for folks like the Fed, and the ECB, and the Bank of England we are not necessarily there yet. So again, you know, a quarter of the way through the year we've learned a lot.

And one of the other things that we've learned is that international equities are actually not dead, right? They did well in 2022 outperforming the United States. So far we're off to a pretty solid start here in 2023. And so let's dive right in and kick off with the first question.

Tim, maybe I'll start with you. There's lots of theories out there about international equities and their ability to chronically underperform, but what are some of the other myths out there that you are always trying to bust in client conversations? I think the three of us can agree that there's an opportunity in markets outside of the US, but what are some of the biggest sources of pushback, or areas of pushback, that you get when having that conversation with clients?

Tim Morris: I think for US investors considering an allocation to emerging markets, or looking at their allocation to emerging markets, and how it's performed over the past couple of years. Clearly the dollar has been a headwind. It's been stronger for longer than a lot would have thought.

And I think that one of the myths that we see is that investors think that the dollar needs to reverse course, which it has to some extent recently, for international allocations or emerging market allocations to outperform. And the reality is, is that yes, that's helpful but even just the pressure from the dollar flattening out has been a positive backdrop historically for emerging market allocations and performance.

David Lebovitz: So the dollar obviously being one. Anjali, what are some of the myths that you're out there trying to bust these days?

Anjali Balani: So I'd hone in on two of them. One is that a lot of clients think that growth and innovation only exists on the West Coast of this country. And I'd love to prove them wrong.

I'd say the second one is that what's outperformed in the last cycle I think a lot of clients think that, that will continue to outperform for this cycle. And if the last cycle was all about intangible investments, about driving traffic, and eyeballs the world has more tangible challenges to deal with now. And that means investing in stuff, catching up with structural underinvestment, building resilience into supply chains, as opposed to purely optimizing around efficiency and profitability.

David Lebovitz: So I think those are both good points. A lot of this is really anchored in recency bias, which is obviously one of the biggest things that we deal with talking to investors day in and day out. I want to stick with you for a second, because again international it's seen better performance, but that's coming in the wake of an extended period of time where we saw those assets underperform.

Talk to me about the structural opportunity that you see in non-US equities and a little bit about the framework that you all use when thinking about taking advantage of that opportunity in portfolios.

Anjali Balani: So David, you mentioned that you've already started to see international outperform the US, not just in 2022 but so far year to date. We certainly had head fakes before where internationalists come out outperforming the US, and then things start to reverse course.

I think just broad based one of the reasons we think that this market cycle will be different from the prior market cycle is that no one really thinks that rates are going to go back to zero or negative as they had in the previous cycle. And international then broadly should benefit from that because the composition of our index has more financials, more commodities. So generally higher rate or even positive rate environments should be positive for international equities.

The way that we've been talking about this with clients about why international could sustain some of the outperformance that we've seen, we've been using the acronym CVS. Most of you may go there for your prescriptions, think of this as your prescription for international outperformance. And the C stands for currency, the V stands for valuation and the S stands for sentiment.

I think Tim already talked about currency. We've already seen the dollars start to depreciate relative to other currencies. There's a case to be made for why that can continue to happen.

On V international has been cheap for a very long time. It remains cheap versus the US, versus it's longer term average. I think what's really interesting actually is if you look at international, so just at the MSCI EAFE Index, international is actually cheaper than US value, the cheapest parts of the US market. And so it's not just cheaper than the US but even cheaper than US value.

And then S, sentiment, consumer confidence in Europe had gone to all-time lows last year. Understandably, so war in Europe, energy crisis, zero COVID policy in China. As that sentiment starts to creep up again that can be the catalyst that can close that valuation gap that is long persisted between the US and international.

David Lebovitz: I like that. Definitely the medicine that some investors may need. Tim over to you, thinking a little bit about the structural opportunity. And I know we're going to get to China in a dedicated way in just a couple of minutes, but when you take a step back how do you think about that structural opportunity in EM? And would love to get your thoughts on whether or not that trend of an emerging middle class is still something that you all are focused on when it comes to identifying opportunities?

Tim Morris: Yes, that is certainly the case. And I think you raised an interesting point about the recency bias. And from a structural perspective I think the perception is that with the Fed tightening that it's typically been an environment that's been a stressful one for many emerging economies.

But I think this is a different part of the cycle a different context that we're seeing at the moment, which is that actually central banks and emerging economies were tightening more aggressively and sooner. And we're effectively ahead of the Fed this cycle which leaves them in a pretty beneficial place at the moment in that inflation is peaking in some of these markets. And they can actually, if they need to, start to loosen policy aggressively and stimulate the economy, so that's one from a top-down perspective.

And the second is from a bottom up perspective, which is that there are still significant demographic advantages in many of these markets. There are evolutions in terms of consumption patterns, particularly as discretionary incomes in markets continue to rise. That can create a very attractive opportunity from a bottom up perspective for companies, particularly those that are very focused individually, on some of these economies.

David Lebovitz: I think that makes a lot of sense and actually is a perfect segue into the next question. And I want to stick with you given your focus on emerging markets, but one place where demographics aren't that great is in China.

And we know China's been connected to the rest of the world in various forms and fashions for really as long as a lot of people can remember. You mentioned earlier zero COVID policy, they were very much locked down relative to the rest of the world.

China's back open for business, right? That's been the story in 2023. And some of the numbers I was seeing this morning suggest that first quarter growth was actually pretty robust when all was said and done.

So how are you thinking about China's reopening, and what's the impact on EM more broadly? And then would love to jump over to you and get a sense of, you know, the impact perhaps more from a DM perspective? But let's start with you on China and EM.

Tim Morris: Simply put China's reopening as a game changer for emerging market investors. Broadly speaking it arguably took too long to happen, but it has eventually happened.

I think what we do need to recognize is that the market responded very quickly. And in fact it was actually trading up significantly even ahead of any formal announcements about reopening. So there was a lot of perfection baked into the first leg of the recovery.

We're now starting to see, one, some of the economic figures that you're highlighting start to come out, but also results from underlying companies about those that are capturing the reopening story quite effectively, were well positioned and have been able to execute. It's a story that will continue to play out.

I think it's one that's going to drive more attractive earnings recovery, not just within China, but also elsewhere within our investible universe because the reality is, is that for the region it has a significant economic impact in terms of tourism picking up, in terms of supply chain issues that were holding back potentially investment decisions beginning to see some relief. So it's a multifaceted story that I think has months, if not years, to play out.

David Lebovitz: Well that certainly sounds pretty positive. And obviously tourism is one that we've heard a lot about and kind of the increase in tourism and the beneficial impact that has on APAC specifically. What about the rest of the world? I mean what does this mean for companies in Europe, and companies in other parts of the developed markets going forward?

Anjali Balani: So I think the first thing to say on that is China reopening certainly benefits Europe and Japan. If you look at the international index about 15% of our revenues come from China. And you compare that to the S&P 500, where about 7% of revenues come from China, so international broadly does benefit from China reopening.

I think the second part about that though is if you are thinking about where do you want to access the opportunity for China? Is it by investing in China directly or perhaps indirectly by owning some of those developed international companies?

We could argue that you could potentially have a little less of the volatility with being invested directly in that ZIP Code by investing in international developed companies. Think about luxury goods for example in Europe, you could think about some of the diversified minors that certainly benefit from China reopening, or even if you think about some of the life in healthcare products that are selling into Chinese markets. Certainly all of these types of categories can benefit from China reopening, and we've seen that come through in performance.

David Lebovitz: Excellent. Well I'll let you guys duke it out separately about the best way to generate exposure to China because the animosity in the room is, you know, I would need a big knife to cut through it. This has been a very positive conversation and I feel like we haven't really had very many positive conversations about international equities in a while.

Let's talk a little bit about the risks. And Anjali maybe I'll stay with you, what are the big risks that you see going forward? What could undermine or upend the very positive story and very useful framework that you have laid out for us today?

Anjali Balani: So there's obviously a lot of talk about US recession. And I think we would be kidding ourselves if we said that if the US undergoes a recession or in other words if the US sneezes that the rest of the world wouldn't catch a cold. And so with the elevated risk of US recession that's certainly something we're looking at, and we're thinking about.

I think if anything though even if there is that pause in terms of all of the performance that we've seen come through from international versus the US, we would expect that this recession is going to be a mild one. That's our base case. And we do also expect that a lot of the drivers that are helping propel international outperformance will come back even afterwards, even if we do have that pause.

And so essentially all the drivers in place for international outperformance don't suddenly go away if the US undergoes a recession. Having said that, yes, that would be a reason for us to watch closely and think about the types of exposures we want to have in a time like this.

David Lebovitz: All right, so US recession being one risk. Tim, what risks are on your radar?

Tim Morris: In our markets I'd say geopolitics and regulation. And it's not just in a China isolated situation, but clearly these are emerging markets for a reason. And if you come in expecting that it's a perfect operating environment, that there's always going to be exactly the type of rule of law that you would see and develop markets that's just not going to be the case.

As investors in these markets though we learn to evaluate those risks. We think about how we price them in when evaluating underlying companies. Also understanding how some of these uncertainties from a macro perspective, if you will, might influence specific sectors, specific areas of the market, specific types of businesses.

So it's an opportunity often for us to reposition and think about is the market responding perhaps to extremely to some very short term news? And how do we think about capturing the longer term opportunity and some of those factors that we discussed earlier.

David Lebovitz: I love that. And I think that that's a perfect place to end on, which is that volatility creates opportunity, right? And without any risk, there's not any reward. And so perhaps you're taking on a little bit more risk, but as we've seen over the course of the past 12 months the reward can be there even though it wasn't necessarily as present as we all would've liked in the ten years after 2008.

And so guys this was an absolutely awesome conversation. Thank you so much for joining me. And looking forward to having you back on the podcast sometime again soon.

Tim Morris: Thanks for having us.

Anjali Balani: Thanks again.

David Lebovitz: Thank you for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful you can find more episodes anywhere you listen to podcasts and on our Web site. Recorded on April 17, 2023.

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