Foreign stocks may be a tough sell to investors, following years of poor returns. But their deep unpopularity may be what makes them a good buy now.
Foreign markets look cheap, compared with the U.S. Negative economic trends in Europe and China appear to be priced into multiples. Central banks have eased up quite a bit, stimulating growth. And if geopolitical storms such as the U.S.-China trade dispute and Brexit can be resolved, then foreign stocks could mount a comeback.
The rationale for foreign markets isn’t particularly popular among investors, based on positioning reports among hedge funds and mutual funds. But the stars are starting to line up, according to Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management. In a note published Monday, she argues that investors should consider adding “active international value managers,” especially those that don’t hedge the U.S. dollar.
The U.S. equity market has beaten foreign markets for years, partly because the U.S. is dominated by large-cap secular growth stocks that hold appeal in a low-growth world, Shalett writes. The allure of the U.S. has helped inflate the dollar, creating a headwind for dollar-based investors abroad. Negative interest rates and slowing global economic growth have made the U.S. much more attractive for equity investors.
But a pivot to foreign markets may be under way. Shalett points out that the MSCI Europe Total Return Index, priced in euros, has beaten the S&P 500 Total Return Index in the past 12 months. Valuations are high in the U.S., while earnings growth has flattened. A year ago, foreign markets were priced for Fed tightening and a U.S. recession. When the Fed signaled it would start to cut interest rates, early this year, that headwind turned into a tailwind for foreign markets, which are dominated by cyclical, export-oriented businesses, she writes.
Economic data appear grim, but that may be priced in. China’s growth has weakened to the slowest pace in 26 years. Europe’s manufacturing PMI index is at its lowest level in six years. And global economic growth may not even reach 3% over the next 12 months, Shalett points out.
But markets are forward-looking, discounting mechanisms, and what is important is the direction or pace of change. Along those lines, “the rate of change of deterioration and stock prices have stabilized,” Shalett writes. “For us, that’s a sign that the worst may already be discounted.”
Foreign markets do look cheap. European and Japan trade at just under 14 times current earnings, according to Morgan Stanley. The U.K., bogged down by Brexit fears, trades at 10 times earnings. Europe’s price/book ratio is at a 40-year low. Emerging markets, hurt by concerns about a slowdown in China and trade-war frictions, goes for 12 times earnings.
Valuations are “washed out,” Shalett writes, and signs of buying are appearing. Companies have picked up their pace of share repurchases, private-equity capital is pouring in. Foreign markets may be pricing in a U.S. recession next year. But if growth instead reaccelerates—nudged by global central bank easing—cyclical, export-oriented foreign markets would benefit.
“The pay-off from this type of positioning could be large as non-US markets are inherently more cyclical in their composition and thus more operationally leveraged to improvements in global growth,” Shalett writes.
One final tailwind for foreign markets may be a weaker U.S. dollar. Morgan Stanley’s currency strategist, Hans Redeker, expects the dollar to turn down. Negative rates abroad prevent much more easing by foreign central banks, while the Fed still has room to cut. Capital flows into the U.S. have weakened, and the Fed has been injecting reserves into the U.S. banking system, a move that should weaken dollar demand, Shalett writes.
How to invest? The iShares MSCI EAFE Value exchange-traded fund (EFV) holds 488 global stocks with relatively low valuations. The ETF has a price/earnings ratio of 11.6 and yields 3.8%. Other ETFs to consider include iShares Core MSCI Emerging Markets ETF (IEMG) and iShares MSCI Japan (EWJ).
Vanguard International Value (VTRIX) is a low-cost mutual fund that has beaten 89% of peers in its category over the past 15 years with a 5.5% annualized return. Tweedy, Browne Global Value (TBGVX) is the top-ranked foreign large-cap value fund over the past decade, beating 99% of rivals, according to Morningstar. It has gained an annualized 7.5% over the past 10 years, despite a steep 1.37% expense ratio.
Analysts have long argued that cheap foreign markets offer more upside than the U.S. So far, they have been wrong. But it may be time to ditch America’s hot-dog stocks for their foreign equivalents.
|For more news you can use to help guide your financial life, visit our Insights page.|