Like the economy, international earnings have begun to recover from the pandemic hit, which caused earnings for the MSCI All Country World Index ex-U.S. to contract 28% in 2020. Given the expected surge in nominal international growth, international earnings are expected to grow 37% this year. Going forward, investors should ask themselves: 1) Which markets are more geared toward the global recovery?, 2) Which markets are more geared toward the next cycle’s themes, like inflation, technology and the rise of the EM middle class? and 3) Where is the valuation starting point most favorable for the recovery and expansion ahead?

The strongest international earnings growth is occurring in cyclical sectors like energy, financials, industrials and materials, which are the most exposed to the improvement in the real economy. As a result, earnings this year are expected to be particularly strong in regions that have the most exposure to these cyclical sectors, namely Europe and Japan, where cyclical sectors make up 55% of the market. In addition to providing investors the biggest cyclical recovery bang for their buck, these international markets also offer investors a hedge against inflation, a topic of debate that will likely continue to characterize the expansion ahead. In particular, financials and materials can offer an inflation hedge, as the banking sector benefits from steepening yield curves and the mining sector benefits from rising commodity prices.

So far this year, regional equity performance has been a tale of two quarters. In 1Q, MSCI Europe ex-UK underperformed the S&P 500 by 250bps, while it has outperformed by 360bps in 2Q as the wave of enthusiasm about the recovery has rolled over the Atlantic. As a result of the previous decade’s underperformance versus the U.S., European equity valuations are still at a steep discount versus the U.S at 18% compared to a 20-year average discount of 12%.

For emerging markets, this is a different beginning to a new cycle. With China now making up nearly 40% of the MSCI Emerging Markets Index, combined with technology-heavy Taiwan and Korea making up an additional 25% of the index, emerging markets now has only 44% of its index represented by cyclical sectors versus 63% in 2009. As a result, it is not unexpected for emerging markets to be underperforming in a year characterized by growth underperformance over cyclicals. Instead, emerging markets offer investors access to the most powerful structural growth themes of the expansion ahead: technological innovation and the rise of the EM Asia middle class. Compared to the start of the year, EM multiples have moved down 7%, offering investors a better entry point to themes that will likely come back into favor once investors look past the initial early cycle economic growth surge.

Exhibit 9: International equities offer a mix of cyclicality and growth
Global earnings growth, calendar year consensus

Source: FactSet, MSCI, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. *Cyclical sectors include consumer discretionary, financials, industrials, energy and materials. The Internet and direct marketing subsector has been removed from the cyclicals calculation. In our judgement, companies in this space do not yet fit into the cyclical category, as they are still in a transitional growth phase and are not being directly impacted by the business cycle. Earnings use MSCI indices for all regions/ countries, except for the U.S., which is the S&P 500. All indices use IBES aggregate earnings estimates. Data are as of May 31, 2021.