International equities: A lot more than meets the eye

There will be a lot more than meets the eye beneath the surface, and with valuation spreads near record highs, active managers have a chance to uncover it

Despite divergent economic growth and some disappointment in parts of the world, international equity performance has been strong: up 10% year-to-date (in U.S. dollar terms). Beneath the surface, even stronger performance has occurred as Europe ex-UK and Japanese equities are both up 15%. In emerging markets (EM), there is more strength underlying the 5% return this year, as China is substantially dragging on performance and EM ex-China is up 12% this year. Style differences have also been significant, with international value outperforming international developed value outperforming international developed growth by 3 percentage points. Lastly, time frames also matter: the rebound in international performance began in October 2022, and on a rolling one-year timeframe, international developed markets have kept pace with the U.S., especially international value which has outperformed U.S. value by 2 percentage points (Exhibit 1). 

In addition to strong overall performance, international returns have seen a healthy breadth, driven by less concentration than U.S. performance: the spread in year-to-date returns between the top ten stocks and the remaining ones is only 7 percentage points in developed markets excluding the U.S. versus 53 percentage points in the U.S. In addition, performance has been driven by an equal contribution from multiple expansion, earnings growth and dividends. Investors have taken notice of the turnaround in international performance: international equities have been the fifth strongest category for net new flows so far this year.

Despite this year’s strong performance, the starting point for international equities next year is favorable, as multiples are still sitting 5% below the 10-year average (and at double the normal discount to the U.S. at 33%). The improved long-term international outlook for stronger nominal growth and positive interest rates (vs. last decade’s weak and negative outlook), combined with a turnaround in sentiment toward China from this year’s very depressed levels, can lead to further multiple expansion. On earnings, Europe and Japan should see somewhat slower earnings growth than this year at low single digits, as nominal growth decelerates from this year’s boomy pace. However, the new focus on increasing shareholder returns through buybacks should continue to provide a boost. EM should see much better earnings growth next year at high double digits, as commodity earnings swing from a big drag to a big support given year-over-year comparisons and as Chinese earnings estimates should improve given more policy support to the economy. Lastly, international equities should continue to provide a steady income boost, with dividend yields sitting at 3% (nearly double those in the U.S.). 

Style leadership may vary by region, with value continuing to lead the way in Europe and Japan (as it often does in developed ex-U.S. led outperformance). Growth may take over the baton in EM given a better outlook for the semiconductor cycle, combined with more confidence in China’s private sector growth, which should fuel technology and consumer-related sectors. As always with international, there will be a lot more than meets the eye beneath the surface, and with valuation spreads near record highs, active managers have a chance to uncover it.