Thursday, October 19, 2023
LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) has downgraded its outlook for international equities to neutral from overweight amid deteriorating technical analysis trends and weakening economies in Europe. The move comes despite attractive valuations and a still favorable outlook for Japanese equities.
U.S. Economic Outlook Superior to Europe
Despite sticky inflation and higher interest rates, the U.S. stock market has had a good run this year with a near 14% total return, outpacing the developed international equity benchmark, the MSCI EAFE Index, by more than seven percentage points.
The U.S. outperformance reflects several factors, but superior economic momentum is high up on the list. The U.S. economy will likely grow gross domestic product (GDP) by more than 3% in the third quarter, compared to the Eurozone which according to Bloomberg consensus is likely to be flat. Recent purchasing managers’ surveys in Europe point to stalled economic growth in the near term. What some might call stagflation in Europe with Germany teetering on the edge of recession makes the European Central Bank’s (ECB)ongoing inflation flight difficult. Meanwhile, inflation continues to come down steadily in the U.S., setting up an imminent Federal Reserve (Fed) pause.
Better economic growth in the U.S. recently also sets corporate America up for better earnings growth in the quarters ahead. Earnings estimates in the U.S. have steadily increased in recent months while estimates in Europe have fallen, as shown in the chart below.
Shout out to Japan, though, which has seen its earnings outlook improve recently as companies increasingly focus on shareholder returns. LPL Research continues to like the opportunity in that market.
Deteriorating Technical Momentum
Waning momentum in European markets is another reason for our international equity downgrade. From a technical perspective, the MSCI EAFE Index (MXEA) has recently broken down from a head and shoulders top formation after violating support at 2,040. The breakdown was further confirmed by a bearish moving average crossover between the 50- and 200-day moving averages. While the index has staged a modest relief rally off oversold levels, breadth within the index is deteriorating along with momentum.
Perhaps most importantly, relative strength is fading. The MXEA vs. S&P 500 ratio chart remains in a downtrend and recently hit a fresh year-to-date low, and we see no technical evidence pointing toward a trend change away from U.S. leadership.
International Valuations Remain Attractive
The primary reason LPL Research was previously more positive on international was valuations and that is a reason to be neutral rather than negative at this point, in our view. Despite recent outperformance, the gap between price-to-earnings (P/E) ratios for the MSCI EAFE Index and the S&P 500 Index is still quite large. The current forward P/E of 12.5 for the MSCI EAFE is 13% below its 10-year average, while the U.S. is 3% above average by the same measure. Meanwhile, better performance has left Japan at average valuation levels but still at a sizable discount to the U.S.
Strong Dollar Presents Another Headwind for International Equities
After falling to 2023 lows in July, the U.S. dollar has rebounded strongly, rising more than 6% amid a stronger-than-expected U.S. economy and the Fed’s higher-for-longer monetary policy. While the Fed continues to fight inflation, Europe’s situation is tougher with a worsening economic situation and even higher inflation. War in the Middle East may add safe-haven flows to the dollar and further constrain returns on international investments. Bottom line, further strength in the dollar is a key risk for U.S. based investors in international equity markets.
The STAAC recently recommended reducing allocations to developed international equities and increasing allocations to the U.S. A better economic growth outlook in the U.S. and deteriorating technical analysis trends in Europe are the primary reasons for the change, while currency risk is elevated. Keeping us at neutral, rather than negative, are attractive valuations and a still-bullish outlook for Japanese equities.
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