International equity allocation reached a low of only 18% of a portfolio’s equity in November – but sentiment is changing quickly.
After underperforming the U.S. for 14 years by 277 percentage points, international equities have been outperforming for 1.5 years by 3 percentage points. Since October 2022, China, the eurozone, Japan and emerging markets (EM) have outperformed by 18 percentage points, 15 percentage points, 11 percentage points and 6 percentage points respectively (in U.S. dollars). As we argued late last year, expectations for the global economy had become too gloomy, suggesting this strong rebound. Going forward, is this international leadership sustainable?
Absolute and relative valuations are still favorable, the U.S. dollar is still too strong and positive surprises on international economic growth suggest upgrades to earnings expectations (versus downgrades in the U.S.). This divergence in earnings expectations is key for returns going forward, as this year’s 8% return for the MSCI All Country World Index ex-U.S. has been driven by multiple expansion and the currency. While multiples and currencies still have room to contribute in some regions (Europe, Japan, Canada) given discounted valuations, the next catalyst for international performance is likely to come from upgrades to earnings expectations, especially for emerging markets. While China’s 2023 economic estimates have been revised up significantly (4.8% in December to 5.5% today), Chinese earnings estimates have moved up only 1.0 percentage points and EM earnings estimates have fallen 1.9 percentage points year-to-date. More confidence in China’s recovery, combined with a strong 1Q earnings season and upgraded corporate guidance, should provide a catalyst for an upswing in earnings estimates. This should allow EM to go from a laggard to a leader.
However, the key argument for a new cycle of international outperformance is a change in sector leadership. International markets have a much greater tilt toward value sectors (industrials, financials, energy and materials) versus the U.S.: 47% versus 27% of market capitalization. The long-term change in the macroeconomic picture (and hence the earnings picture) provides a catalyst for those sectors to lead: from low to normal inflation, from negative to positive interest rates and from fiscal austerity to public/private capex spend. These changes are powerful tailwinds instead of headwinds for developed markets ex-U.S. We have seen this change in leadership before: following the bursting of the “dot com bubble” and before interest rates were slashed post-“financial crisis” (2000-2007), value outperformed growth by 54 percentage points and international outperformed the U.S. by 83 percentage points.
It is key for investors to be positioned for the cycle ahead, not the cycle behind us. International equity allocation reached a low of only 18% of a portfolio’s equity in November – but sentiment is changing quickly. As of April, this allocation is already up to 23%. With that said, this still represents a 12 percentage point underweight to international versus “neutral” – an important call to action for investors to not be caught offsides with the next decade’s leadership.