London - The European equity market has outperformed the US equity market for three consecutive weeks. Is this significant? Can this continue? We think so.
Looked at from a range of perspectives, including valuation levels and geographical market rotation, we believe international stocks offer a compelling opportunity for long-term investors — particularly in contrast to US equity markets. Collectively, Europe, including the UK, represents about 67% of the MSCI EAFE Index, while Japan represents 26%.1
The US market, as measured by the S&P 500 Index, has been driven to a large extent by FAANG stocks — Facebook, Apple, Amazon, Netflix and Google — and Microsoft. Each of these stocks is at or very close to all-time highs. These companies represent just over 20% of the S&P 500 and many investors are rightly questioning how much farther they can run, particularly if the growth and momentum factors that have propelled them to these heights give way to value and cyclical leadership.
While the S&P 500 has nearly recovered from its lows seen earlier this year, Europe, in stark contrast, is trading 10% BELOW its most recent April 15, 2015 high point in the MSCI Europe Index, while the TOPIX Index in Japan is 10% below its peak levels of February 2007. The past 13 years in the European and Japanese equity markets have been dramatically different from the US experience, but we are more interested in what will happen going forward.
Numerous drivers of international equities
We believe international equities deserve a place in well-diversified portfolios and now may be a particularly good time to initiate or increase an allocation to this space. The European Central Bank continues to aggressively buy bonds. Even more importantly, we would draw your attention to the proposed euro 750 billion European Recovery Fund. This initiative is historic as it represents a dramatic step forward in promoting European cohesion by sharing debt between the rich and poor nations of the region. In turn, since May 22, the euro has been rallying against the dollar.
While the equity risk premium of the S&P 500 in the US is close to its long-term average, the risk premiums of the MSCI Europe and MSCI Japan indexes are well above their long-term averages.2 Given monetary policy and the outlook for continued low interest rates in Europe and Japan, there is strong support for these equity risk premiums to decrease toward their longer-term averages, which could potentially boost European and Japanese equities.
Long-term market rotation is another consideration. Europe has significantly underperformed the US in the 10 years following the global financial crisis. Over this time frame, international equity has decreased from 60% of the MSCI World Index to 34%. This is a remarkable structural shift in the global equity market. However, we expect geographic reversion to the mean will occur in the coming years, and, historically speaking, there is a good chance that it will persist for an extended period of time.
Notably, European and Japanese markets are more value oriented and cyclical compared to the US equity market. As the global economy continues to reopen following the Covid-19 crisis, the export-oriented nature of the European and Japanese economies makes them well positioned to benefit.Finally, forward-looking valuations also favor international equities — Europe is trading at roughly a 20% discount to the US, while the discount in Japan stands at around 25%.3 This is an attractive point for diversifying a portfolio with international exposure or increasing an existing allocation.
Bottom line: We have seen a rebound in European stocks in recent weeks and believe international stocks overall represent a significant opportunity for equity investors. We think a number of factors, including valuations, rotation of geographic markets, and the proposed European Recovery Fund may prove supportive of international stocks for years to come, particularly relative to US equity markets.