Coming into 2018, the path forward for markets seemed clear: U.S. stocks would rise modestly after an exceptionally strong 2017, the dollar would continue its fall and international equities would once again outperform on the back of strong global growth and attractive fundamentals. But with the year-end looming, it is clear that this thesis has not played out.
Fueled by concerns of rising U.S. interest rates, slowing economic growth, ongoing geopolitical concerns and select disappointing earnings guidance, U.S. stocks are down roughly 7% quarter-to-date. International stocks have fared worse, with the broad ex-U.S. index down over 8%. This dynamic continues a trend in place for the better part of this year: relative U.S. equity and dollar strength despite repeated calls for international outperformance. As a result, many investors may be frustrated with the current state of their diversified portfolios, and are wondering: has recent performance affected long-term prospects?
The answer, perhaps surprisingly, is no. In our 2019 Long Term Capital Market Assumptions, published earlier this week, 10- to 15-year total return assumptions for international equities look better, in aggregate, than for their U.S. peers. Indeed, this sentiment is unchanged from last year. The reasons for this outperformance are myriad: EM should benefit from structural tailwinds, including high productivity, an emerging technology sector and generally more favorable demographics; DM ex-U.S. performance has different drivers, including a European economy not yet operating at full capacity. A falling dollar over the same time horizon should provide a boost for U.S.-based investors.
In fact, recent market volatility has only strengthened these views. As shown in the chart below, international equities have typically traded at a 10% discount to U.S. stocks over the past 20 years. But with recent price action, valuations have fallen more dramatically overseas, resulting in a nearly 25% discount, the cheapest relative valuation in over 20 years. History has shown us that valuations are strong predictors of future long-term returns; with this in mind, and considering the macro forces outlined in this year’s LTCMA, we remain confident in international equity outperformance over the long run and maintain that international equities belong in a well-diversified portfolio.
International stocks are trading at a deep discount relative to the U.S.
Relative NTM P/E ratio, International as a % of U.S.
Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management. Indices used are the MSCI All Country World ex-USA and the S&P 500. Valuations are forward looking. Data are as of October 31, 2018.