Friday, May 12, 2023
Key Takeaways:
- There has been no place like home when it comes to global equity market performance over the last 15 years. However, the tides appear to be changing as evidence builds for a shift toward international equity outperformance.
- The technical backdrop continues to improve for the MSCI EAFE Index (MXEA), a proxy and widely-used benchmark for developed international markets. Widespread participation has underpinned the recovery off the October lows, while ratio chart analysis points to further MXEA outperformance ahead.
- Dollar weakness should provide an additional tailwind for international stocks. The potential end of the Federal Reserve’s (Fed) rate-hike cycle will likely put further downward pressure on the greenback, especially if the European Central Bank (ECB) continues to tighten over the coming months.
- The MXEA looks relatively cheap based on its own historical valuations and cheap when compared to the S&P 500 Index.
- Recession forecasts for the Eurozone and Japan remain well-below recession probabilities for the U.S. Furthermore, U.S. markets face more acute risk if the debt ceiling drama continues.
Changing of the Tides
There has been no place like home when it comes to global equity market performance over the last 15 years. Technology sector dominance, exerted by some of the world’s largest companies, such as Alphabet (GOOG/L), Apple (AAPL), Meta (META), and Microsoft (MSFT), has helped the S&P 500 Index (SPX) outperform the MSCI EAFE Index (MXEA) during 11 of the last 15 calendar years. A sustained rebound in domestic growth following the Global Financial Crisis, economic stability, strong earnings growth, relatively low interest rates and inflation, and fewer geopolitical headwinds have been other key drivers of U.S. outperformance.
However, the tides appear to be changing as evidence builds for a shift toward international developed market outperformance.
For reference, the MXEA tracks mid and large cap companies operating across Europe, Australasia, Israel, and the Far East. Japan holds the highest country weighting at 21%, while Western European countries comprise nearly 70% of the index. Financials (18%), industrials (16%), and health care (14%) represent the largest sector weights.
Improving Technical Backdrop
The MXEA is trending higher within a rising price channel that began off the October lows. Broad participation has underpinned the recovery as around 75% of the nearly 800 constituents are trading above their 200-day moving average, well above the 48% reading for the SPX. All three MXEA moving averages—20-day, 50-day, and 200-day—are properly aligned above one another and advancing, adding to the evidence of a sustainable uptrend.
- In terms of upside, the next major resistance levels for the MXEA set up at 2,160 (April highs), 2,200 (March 2022 highs), 2,230 (late 2021 lows), and 2,405 (2021 high).
- Downside support comes into play at 2,115 (February highs), 2,093 (50-day moving average), and near 1,950 (200-day moving average/March lows/key retracement level).
Dollar Headwinds Turn into Tailwinds
Last year’s parabolic rally in the dollar created major headwinds for international markets. Given its status as the world’s reserve currency, a rising dollar translates into higher debt service costs as most foreign non-bank lending debt is denominated in the greenback, putting pressure on other central banks to raise rates to offset their own currency weakness. Tighter monetary policy translates into slowing growth. And while a stronger dollar helps fight against domestic inflation, it can also increase global inflation, as most commodities are priced in dollars.
With U.S. inflation moving in the right direction, as evidenced by this week’s decelerating consumer and producer price inflation reports, the Fed will likely take its foot off the rate hike pedal. Fed funds futures seem to agree, as they are currently pricing in rate cuts as early as September. Based on this backdrop, and the likelihood of continued tightening from the ECB (the euro is a 58% weight within the dollar index), we suspect further downward pressure on the dollar, which could provide a tailwind for international equity markets.
The chart below shows the U.S. Dollar Index compared to the MXEA. To better depict their inverse relationship, the MXEA’s Y-axis (left) is inverted, meaning it runs from high to low vs. the dollar’s Y-axis (right), which runs from low to high. Technically, the dollar has formed a downtrend after peaking with interest rates in October. We expect the downtrend to continue, providing further support for the MXEA.
Valuation Comparison
The MXEA looks relatively cheap based on its own historical valuations and cheap when compared to the SPX. The index trades at a blended forward 12-month price-to-earnings ratio (P/E) of 13.2, just over one turn below its 10-year average forward P/E of 14.5. Furthermore, the MXEA trades at a five-point discount to the SPX’s forward P/E of 18.2, two full turns below its 10-year average discount of 3.0. Earnings growth also looks constructive for the MXEA. Estimates for earnings per share (EPS) growth are at 3.8% for fiscal year 2023. This compares to SPX EPS growth forecasts of -1.2% this year based on consensus estimated compiled by Bloomberg.
What about a Recession?
Recession risk remains elevated for the U.S. economy. Slowing economic growth, underpinned by the detrimental impact of higher rates weighing on business and consumer spending (and sentiment), still-high inflation, loosening labor market conditions, and tighter lending standards in the wake of the recent banking turmoil are all key contributors to the recession angst. According to economists’ forecasts, the probability of a recession in the U.S. occurring over the next 12 months is 65% and holding steady. This compares to a downwardly trending 45% probability for the Eurozone and only 30% odds for a recession in Japan.
Summary
Investors may want to look for diversification opportunities in developed international markets. The technical backdrop continues to improve for the space, including consistent relative strength over U.S. markets. Weakness in the dollar could provide another tailwind to developed international equities. Their valuations appear cheap, and recession probabilities for the Eurozone and Japan remain well-below recession forecasts for the U.S. Based on this backdrop, LPL Research recently upgraded developed international equities to overweight and downgraded U.S. equities to neutral.
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