In Summary

Diverging economic conditions and healthier valuations overseas may lead to a changing of the guard, with international equities overtaking domestic equities as the market leader. Stabilizing or appreciating foreign currencies could enhance returns for U.S. investors in international equities, mitigating past headwinds from a strong dollar.

International developed equities are currently trading at discounts to U.S. stocks, and signs of economic recovery in Europe and Japan suggest a favorable risk/reward outlook.

Asset Class Change:
International Developed moved from slightly negative to neutral.
Slightly Negative to Neutral
For more information see the asset class detail below.

The United States was quick to recover from the depths of COVID-19, and the economy remained resilient even as monetary tailwinds turned to headwinds. Relative macro strength, significant fiscal stimulus, and the eventual tailwind from the emergence of generative artificial intelligence drove the dominance of U.S. equities over their international counterparts. Although OAM Research remains relatively cautious in our outlook for global equities, as the tides potentially begin to shift, international stocks could be poised for a rebound in relative performance. With investors typically maintaining a home country bias, OAM Research recommends considering diversifying equity exposure and increasing international allocations from slightly underweight to neutral positions.

Historically, U.S. stocks have experienced extended periods of outperformance, but these strong market environments do not persist in perpetuity. There are signs that could be pointing to a potential shift in market leadership, and we observe several other factors that could drive superior returns for U.S. investors investing in international developed equities:

Dollar Momentum

International equities have performed well in local currency terms. The MSCI EAFE 100% Hedged Index, which aims to strip out the currency effects, has performed in line with the S&P 500 over the last three years. Non-U.S. developed equities protected much better during the 2022 drawdown and mostly kept pace in the 2023 recovery. However, for U.S.-based investors, the dollar strength has notably hampered the returns of international stocks. The U.S. Dollar Index gained more than 5% over the last three years, rallying significantly as the Fed raised rates more aggressively than many other central banks. The more attractive U.S. Treasury yield, combined with the dollar’s safe haven status, led to the depreciation of most other major currencies such as the Euro and the Yen. If these currencies stabilize or even start to appreciate against the dollar, the currency headwind has the potential to become a tailwind for domestic investors in non-U.S. developed stocks.

Valuation Discount

International developed equities trade at considerable discounts to U.S. stocks, despite valuations that are in line with longer-term averages. U.S. large cap indices, particularly the growth benchmarks, appear expensive after the significant appreciation of a number of heavily-weighted positions. Large cap growth equities are trading at a 37% premium to their 15-year average, while European and Japanese equities are trading at their 15-year average. In an environment where most risk assets are trading at rich valuations, reasonably priced non-U.S. developed market stocks appear to have a favorable risk/reward outlook.

Economic Divergence

The U.S. economy has thus far weathered the combination of inflation and interest rate hikes, and even emerged much stronger than many expected. However, there are an increasing amount of cautionary signs that could indicate weakness on the horizon. Disappointing GDP growth in Q1, a weakening consumer, tighter lending standards, and a rising unemployment rate all point to a domestic economy that is cooling, albeit from robust levels.

By contrast, several European countries, including the U.K., experienced zero to negative GDP growth in 2023, and Japan’s economy was similarly weak in the back half of last year. These economies are more cyclical than the U.S. (and therefore more sensitive to rising interest rates), did not experience the same level of stock performance from AI compared to the U.S., and lacked the magnitude of fiscal spending that occurred domestically. However, more recent data show that growth may have troughed and that recoveries may be underway. If this positive momentum can be sustained, it may indicate the start of the next cycle for these regions.

Central Bank Divergence

Monetary policy is expected to be less restrictive overseas. The European Central Bank, as well as other central banks in the region, have begun to cut rates, and the Bank of Japan remains extremely accommodative. On the other hand, inflation in the U.S. has remained sticky, and the expectations for rate cuts domestically have been tempered. A more restrictive Fed should pressure U.S. equities, while non-U.S. stocks can benefit from some interest rate relief if other central banks continue to diverge.

Earnings Growth Inflection

International corporate profits in recent years have been disappointing, as these businesses tend to be more cyclical, and earnings were curtailed by a pullback in spending overseas. In the U.S., meanwhile, staggering earnings growth from just a few large companies has masked more muted growth for the other areas of the domestic market. Going forward, international corporate profits are expected to rebound meaningfully.

Risks to our Outlook

In tandem with upgrading our outlook for International Developed Equities to neutral this quarter, it is important to consider potential risks that could be disruptive for global equities. There has been a downshift in global growth this year, and even if international economies remain on solid ground, a slowdown in other regions will likely have ripple effects across the world. Inflation has also remained stubborn in a number of areas, and if inflation remains above target it will limit how much room central banks have to cut. Outside of the macro picture, geopolitical risks also remain heightened, and escalations of existing foreign conflicts or upcoming elections could trigger more volatility.

Given these risks, OAM Research remains relatively cautious in our allocation to and positioning within global equities overall, with neutral to slightly underweight allocations relative to our targets, and a bias towards higher quality strategies that should provide better downside protection in a more volatile environment. Investors should remain aware of potential concentration in portfolios to a given style, geography, or handful of stocks moving forward. We also continue to emphasize the importance of remaining diversified through allocations to high quality core fixed income and other diversifying strategies such as real assets and event driven, which continue to be attractive with interest rates remaining elevated, and could provide a cushion to portfolios in the event of a pullback in equities.

While this cycle of U.S. outperformance has been much longer than past periods, the stated potential catalysts could spark the broadening of market leadership to include international developed equities. Given that many investors’ portfolios are overweight to U.S. equities, we believe that now is an opportune time to revisit allocations and consider a rebalance to add more international exposure. Please refer to OAM’s Strategic Asset Allocations to identify an appropriate allocation to international equities based on your risk profile.