We’ve warmed up to developed international stocks recently for several reasons. For one, the U.S. stock market has staged a tremendous rally—this week notwithstanding—since last March which has prompted us and others to start looking for other opportunities that aren’t pricing in so much optimism. Valuations, though not great timing tools, are more attractive in Europe and Japan. And we expect the US dollar to weaken which could boost non-US stock returns.
Another reason to take a closer look at international is the recent resurgence of value stocks. The developed international equity market (mainly Europe and Japan) is much more value-focused than the U.S. market, based on the MSCI EAFE Index and the S&P 500 Index. As shown in the LPL Chart of the Day, the relative performance of value stocks versus their growth counterparts has been well correlated to the relative performance of developed international stocks compared to those in the U.S. In other words, international tends to work when value works.
“Should strong performance by value stocks continue—and we suspect it might—international stocks will have their best chance in over a decade to sustain outperformance,“ explained LPL Equity Strategist Jeffrey Buchbinder. “The strength in cyclical value stocks such as financials, industrials and natural resources, coupled with tech sector weakness, gives European and Japanese markets a fighting chance of keeping up with the U.S. as those economies fully reopen.”
We can see how developed international stocks are more value-focused when looking at sector breakdowns for key indexes. As shown in the graphic below, the U.S. equity market (represented by the S&P 500 Index) has a much higher technology sector allocation, making it a more growth-oriented index than the MSCI EAFE Index benchmark for developed international equities. If digital media (think Google and Facebook, which are categorized as communication services) and e-commerce (think Amazon, which is in consumer discretionary) are included in this sector comparison, the technology gap widens even further. In essence, for international to outperform, U.S. technology leadership needs to hand the baton over to cyclical value. That transition has been happening over the last couple months and very well could continue.
At this point the primary factor holding us back from upgrading our view of developed international stocks to neutral from our current negative view is the pandemic. As Europe and Japan fully reopen and see the accelerating economic growth that the U.S. is seeing now, those markets may be in an even better position to outperform. Until then, we maintain our slight preference for U.S. stocks over developed international.
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