A sea change in international markets

Author: Matthew Poterba, CFA, Senior Analyst

With the volatility in global equity markets this year, it may be comforting for investors to focus solely on US markets. However, it may be riskier to be geographically myopic now.

Global markets tend to go through cycles when US stocks or international stocks outperform, and investors’ decisions how to position across these markets can have significant implications for performance. In a typical year, returns on US and international stocks differ by more than 10 percentage points (Chart 1).

Two of the key drivers behind these meaningful return differences are sector exposures and country-specific factors.

International markets are less exposed to tech stocks

The US market is highly concentrated in technology and other expensive growth stocks, with tech-related sectors making up nearly half (43%). Most non-US markets are much less exposed, and ex-US has a third less exposure overall than the US (Chart 2). While tech-related sectors performed well during periods of lower interest rates, high liquidity, and strong growth, today’s macro fundamentals are the opposite. So, international markets currently look attractive for their lower exposure to these vulnerable sectors.

Last cycle’s leadership is rarely the next cycle’s leadership. If we are correct that inflation and interest rates will remain higher for longer, international markets’ sector exposure might boost performance. Materials and Energy stocks likely benefit from higher commodity price inflation. Financials, especially European ones, may see improved profitability after having been hamstrung for years by low and negative interest rates. Although concerns about banks have recently surfaced globally, policymakers seem committed to preventing banks’ future liquidity issues turning into solvency concerns.

Returns across regions are increasingly different

If differences in US and international market returns were only driven by sectors, there would be little need to invest globally; one could simply invest in US sectors. Many regional and country equity markets have moved in lockstep for much of the last two decades, helped in part by increased globalization. However, global equity markets may be going through a sea change.

In 2017, the last year before global uncertainty began to flare, it didn’t matter much where someone invested in consumer discretionary stocks, but just simply that one owned them. US discretionary stocks were up 23% while those in Europe returned 26% (in USD). But recently, sector returns have been less homogenous. Last year, consumer discretionary stocks were down -38% in the US while only down -21% in Europe (Chart 3).

This variability in sector returns across regions has been broadly increasing in recent years (Chart 4). Retreating globalization as policymakers emphasize domestic activity and growth cycles’ decoupling as countries exited the pandemic at different times may explain part of the story. Increasing geopolitical turmoil and the Russia-Ukraine war may also contribute to less similar country returns.

It will be increasingly important to correctly allocate across countries (in addition to sectors) if this trend continues. While US stocks have led global markets over the last decade, it may now be wise for investors to look for opportunities internationally. Regions with more supportive liquidity and weaker investor sentiment may be some such opportunities abroad.

US liquidity is retreating more quickly than elsewhere

The Federal Reserve has been the most aggressive central bank in raising rates among developed markets and yet it is still struggling to rein in inflation. A central bank’s policy stance and outlook can be assessed through the slope of the country’s yield curve. Inverted curves tend to indicate monetary policy is restrictive and tightening, and currently 17 of the 23 developed market countries have inverted yield curves. The US is the most inverted of them all at -104bps (Chart 5).

Bank lending standards paint a similar picture. US banks are rapidly tightening access to credit, outpacing banks in other major regions (Chart 6). In the wake of the recent US bank failures, it appears likely that regional and smaller banks will increasingly tighten standards even further. This means US companies may face higher borrowing costs and have less access to credit, which would weigh on future growth and the prospects for US stocks.

European banks were more restrictive than their US counterparts for nearly 5 years following the Global Financial Crisis, which may have contributed to Europe’s slower recovery. But recently, Europe’s banks have been slower to restrict lending than their US counterparts, which may benefit European companies relative to those in the US.

Large valuation cushion in international markets

International markets trade at a huge discount to the US, reflecting investors’ more negative sentiment toward them. Given the war in Ukraine, the property malaise and rising Sino-US geopolitical tensions in China, and political uncertainty in EM, there are reasonable concerns about investing internationally. But, while ex-US markets’ cheaper valuations price in these risks, US markets still appear stubbornly ignorant of risks within the US.

Admittedly, cheap markets aren’t always attractive investments. Those with deteriorating earnings may appear cheap, only to have fundamentals converge downward to price. While we want to avoid these “value traps”, growth expectations for international markets are largely similar to or stronger than those for the US (Chart 7).

Yet, investors still appear fixated on the drivers of growth over the last decade rather than on the drivers of growth in the coming years. If analysts’ estimates for long-term EPS growth end up correct, investors in US stocks could end up paying nearly twice as much for less growth than in many ex-US markets (Chart 7). While valuation is not an effective tactical timing indicator, it provides important insight into the balance of risk and reward within markets and has enormous importance for long-term returns.

The rising tide that drove stellar US performance last decade may now be going out. International markets’ cheaper valuations and relatively more accommodative liquidity suggests that investors with US-heavy portfolios may want to consider diversifying with opportunities outside the US.