We are long believers in the power of international diversification. However, since 2009 the US S&P 500 has returned over twice the international market (EAFE). The increased domestic equity performance over international equity has been beneficial to domestic investors but has also created a wide dispersion in valuation. The international equity markets are cheaper.
Through the second quarter of this year, we’ve begun to see signs of life abroad as the international index EAFE has returned 14.23%, and the Emerging Markets index earned 18.43% year to date compared to the S&P’s 9.34%. What factors are driving this performance? Will it continue into the future? We took a deep dive into the research to find out in this KnowRisk report.
As you know, at Equitas we do not attempt to predict future events, only recognize current opportunities. Sometimes opportunities can take a while to manifest into profitable investments. We have been researching the possibility, probability, and timing of a change in market leadership to capture the low international market valuation. We are starting to see evidence.
John Vogelstein of New Providence Asset Management is moving to a 30% domestic 40% international mix. We have known Mr. Vogelstein from his time as President and CIO of Warburg Pincus, and partner with Lazard Freres. The move is aggressive and would have been inefficient and too early for the last nine years, but the timing may be correct today.
After the Global Financial Crisis in 2007-2008, the US Central Bank was one of the first central banks to respond with liquidity measures. The Federal Reserve implemented not one, but four separate programs to inject cash into markets that were starved of liquidity. The chart below shows the timing of those programs.
The chart also shows the European Central Bank (ECB) beginning their bond buying program years later in 2015. While some government bond programs began earlier, they were much smaller in size. All of the ECB stimulus measures only amounted to half of the balance sheet by 2012, whereas the US’s measures quadrupled the balance sheet. All of the cash added to markets needs a place to go and the effects are beginning to be felt in both the European economy, and the stock market.
Earnings growth is a major factor that can help push up stock prices. This is a key metric that we watch closely. We pointed to an earnings rebound in our third quarter 2016 KnowRisk to identify an opportunity in US Equities. This chart shows earnings growth has been flat to negative in international markets since 2011. In 2017, we are beginning to see signs of life.
To summarize, below are some points which differentiate between domestic and international equity which helps paint the picture. US profits are currently +30% above their pre-crisis levels while International profits are roughly -30% below. Since the trough in profits in 2009, the S&P has returned approximately 210%, over two times as much as the ACWI ex-US.
- Since 2009, the US Federal Reserve has remained more consistently accommodative than other central banks. Therefore, US economic growth and profits remained in expansionary territory while many international regions faced multiple recessions (Europe 2011-13, Japan 2010-12 & 2014-15, Emerging Markets 2014-15).
- We think the profit and performance gap between the two regions should close to favor the ACWI ex-US. International growth estimates are expected to accelerate vs. the US, which should help close the gap in profits seen above and could fuel a multi-year period of better International returns relative to US.
Earnings projections are painting an even more optimistic picture.
In order to weigh how much equity risk should be taken domestically vs abroad, there are a few other factors to examine. There is a lot of optimism currently built into the US market resulting in over $3 trillion in market gains in the last seven months. If the anticipated 15% corporate tax rate is enacted there should be a further surge in US corporate profits. However, if it is delayed or fails, a lot of the optimism may turn to disappointment.
The US is much further along in taking corrective action after the Great Recession and it shows in earnings and market performance. The result is the international markets have underperformed and are now priced cheaper than the US. The question is the timing of when this reverses and reverts to the mean. No one knows the exact timing of a market change like this, but a reversion to the mean is certainly closer than it has been since 2009, and may have begun.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC, located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high-net-worth family offices.