Senior Vice President, Senior Portfolio ManagerResearch
In recent years, U.S. equities have generally outperformed stocks elsewhere in the world. We believe this trend has led many U.S. investors to focus primarily on domestic equities, leaving them under-allocated to international stocks relative to long-term target levels. Some investors have no international allocation at all, ignoring opportunities that are present in developed markets outside of the U.S. We believe that relative valuations offer good reason for U.S. investors to now consider restoring or increasing their international equity allocations, and we highlight the attractiveness of accessing these markets via active strategies.
Valuations suggest that it could be an ideal time to increase exposure to international stocks. MSCI EAFE (Europe, Australasia and Far East) represents a conventional international benchmark for U.S.-based investors. Based on several common valuation metrics, stocks in this index are currently trading at an average 30% discount to the MSCI USA index, a close proxy for the S&P 500. (Table 1) In contrast, since the mid-1970s EAFE stocks have traded nearer to a 10% average discount. EAFE equities look particularly cheap relative to the U.S. on the basis of Price/Book, Price to Cash Earnings, and Dividend Yield. EAFE’s current valuation discounts are on par with or larger than their averages from the most recent 10 years.
EAFE’s current valuation discounts in part reflect the recent relative strength of U.S. equities, evident in Figure 1.
Index Source: MSCI Copyright MSCI 2017. All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
Since mid-2008, U.S. equities have outperformed EAFE by 7.7% annually, of which 3% per year is due to dollar appreciation. This is unusual – since 1970, the dollar has depreciated 1% annually relative to EAFE currencies. This recent dollar strength, should it continue, will pose possible pricing challenges for U.S. exporters and profit headwinds for domestic companies with international operations.
As Figure 1 suggests, the outperformance of U.S. equities versus EAFE has not been a consistent phenomenon. Over the last 47 calendar years, EAFE has outperformed in 25. Figure 2 shows the annual outperformance of EAFE relative to U.S. It is interesting to note that out- and under-performance of either equity region often persists for a few years then reverses. This pattern provides diversification opportunities for U.S. or EAFE portfolios.
Index Source: Copyright © 2017, Standard & Poor’s Financial Services LLC. All rights reserved.
Active Management In Non-U.S. Markets
Struggles of active U.S. equity strategies in recent years have been well documented. Table 2 summarizes the evidence, showing the distribution of five-year, net-of-fee performance for 1,055 U.S. Large Cap Equity strategies found in eVestment. The median manager underperformed the index by 0.63%.
EAFE equity managers, in contrast, have demonstrated superior ability to add value. Over the same period, the median EAFE Core Equity strategy added 1.14% per year, net of fees. We believe the reasons for greater success include less efficiently priced securities, a broader opportunity set, and ability to add value through country and currency selection—all motivations for taking an active approach in accessing non-U.S. markets.
Several years of U.S. equity outperformance have drawn investor attention away from international markets. We see the resulting relative valuation discount in EAFE equities as compelling reason to consider increasing international exposure now. And we see international markets as offering potentially promising ground for active, systematic approaches, as they have throughout Acadian’s 30 year history.
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