International equity markets: balancing cyclical recovery and structural growth exposure
While international markets are still more cyclical than U.S. ones, the representation of more growth-oriented sectors has grown over the past decade, offering investors the sweet spot of cyclicality and growth in these better-valued international markets.
Global Market Strategist
2022 should be a strong year for international equity market performance across regions, driven by solid fundamentals and reasonable valuations. 2021’s strong nominal economic growth has translated to a surge in international earnings growth of 51% year-over-year this year (represented by the MSCI All Country World Index ex-U.S.). While the outlook for 2022 includes another year of above-average nominal economic growth, consensus earnings expectations for next year are of modest 7% growth (right in line with the 20-year average), suggesting room for earnings expectations to move higher. In addition, international valuations (represented by the next 12 months’ price-to-earnings ratio) have contracted a substantial 14% this year, leaving less room for multiple contraction next year. In addition, the discount versus the U.S. is still at record highs (three times the average discount of 10%).
As the global recovery continues in 2022, cyclically oriented international markets offer investors exposure to strong earnings growth in sectors like energy, materials, industrials and financials. In particular, the strongest cyclical bang for the buck can be found in Europe and Japan, where cyclical sectors make up 55% of the market. In addition, these international markets also offer investors a hedge against inflation, a topic that will remain under debate for the better part of next year. 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 high commodity prices.
Lastly, Chinese equity markets will likely find their footing as investors feel more comfortable around the visibility of this latest reform cycle, turning China from a big drag on EM returns this year to potentially a big boost to it in 2022. Looking at historical episodes of reform cycle-induced 30% plus corrections in Chinese markets (2011, 2015 and 2018), markets have been positive on average 28% six months after the market trough. While reforms are unlikely to be rolled back, investor confidence about the end of surprises should help the market find its footing sooner rather than later. Returning inflows to Chinese markets since September is an encouraging early sign.
As the year progresses and the global economy goes from recovering to recovered, it is also key to focus portfolios on structural post-pandemic growth opportunities. These include themes like technological innovation, the growth of the EM middle class and the global push for decarbonization. These are themes that can be found across regions, for example in hard-technology companies listed in China, Korea and Taiwan; luxury goods companies listed in Europe that derive the majority of their revenue from emerging consumers; and renewable energy and electric vehicle companies listed in Europe and China. While international markets are still more cyclical than U.S. ones, the representation of more growth-oriented sectors has grown over the past decade, offering investors the sweet spot of cyclicality and growth in these better-valued international markets.
Exhibit 9: International markets are still cyclical, but increasingly offer access to growth too
change in sector weightings, % point change from Dec. 31, 2005