Listen to On the Minds of Investors
One month ago, we laid out 5 reasons to consider international equities besides discounted equity and currency valuations. Since then, 10-year real yields have surged 20 basis points, bringing back the importance of valuations, in addition to fundamentals. As a result, the most expensive markets have underperformed discounted ones, with the S&P 500 underperforming international by 420bps year-to-date. However, a faster policy tightening cycle is starting to lead to concerns about its impact on the U.S. economy later this year. How have international equities performed during different economic growth scenarios? In both a U.S. led boom-bust recession and global synchronous growth, international equities could outperform, suggesting a key role for the asset class in portfolio construction.
As part of creating strong portfolios, we believe in stress testing them under various scenarios in order to gauge how they may perform. The “boom-bust U.S. recession” scenario has gained interest, in which persistently high inflation forces the Federal Reserve to aggressively frontload policy tightening this year. A “soft landing” for the economy might not materialize, should consumer demand cool too quickly, tipping the U.S. economy into a recession. Bond yields could be expected to fall due to safe haven demand, while equities decline. In our scenario estimation, U.S. large caps would be down 13-14%. However, lagged recoveries and more patient central banks overseas could limit the sell-off in global equities, suffering a more subdued pullback of 2-3%. This makes the case for considering international as a layer of bubble wrap to the portfolio. It is key to highlight that this scenario does not incorporate an internationally led recession, for example caused by a sharp slowdown in China due to its continued “COVID zero” approach or a sharp slowdown in Europe driven by an energy price shock as a result of geopolitical tensions in Russia/Ukraine.
Risks to the upside are also important to consider. In a “global synchronous growth” scenario, the U.S. economy sees a soft landing back to trend growth by the middle of the year, while the international recovery accelerates due to more lagged recoveries in Europe, Japan, and emerging markets excluding China. More clarity on reforms and monetary policy easing permits China’s economy and markets to find their footing. As a result, a more robust than expected earnings recovery occurs and drives international equities higher. As the growth alpha between international and U.S. economic growth picks up and as investors flock to more discounted markets, the U.S. dollar weakens. In this scenario, U.S. equities may be positioned to provide low single-digit modest upside, while EAFE and EM equities could see 10-14% upside potential.
As volatility is expected to remain elevated this year, investors have to pick their spots when taking risks. International equities have an important asymmetric risk profile that highlights their growing (and regained) importance in portfolios. Perhaps the start of a longer-term trend, Inflows into non-U.S. equities have outpaced their U.S. counterparts in January of this year. For example, clients have allocated $6.23 billion of net new flows into the Foreign Large Blend Morningstar Category while U.S. Large Blend has seen inflows of $4.26 billion. Equally encouraging within our Portfolio Insights data, November of last year marked the start of an upward trend in the average allocation toward numerous international categories.
International allocations have started to increase since November
Average allocation to Morningstar categories within portfolios, developed international
Source: Morningstar, J.P. Morgan Portfolio Insights. Data are as of January 31, 2022.