Broaden Your Investment Horizons

It may be time to look beyond the U.S. for equity market performance, especially if early signs of a cyclical economic recovery persist.

A month ago, I wrote about how the second wave of the artificial intelligence investment theme could broaden stock market performance beyond the “Magnificent Seven.”

For the sake of simplicity, I mentioned some other U.S. stocks as potential beneficiaries. But what if this phenomenon was just one part of a bigger, more global theme of broadening performance?

If we are seeing a rotation away from a small number of fully valued, defensive, mega-cap technology stocks into a broader range of cheaper, cyclical stocks, what might that mean for regional equity allocations?

Fundamental Support

Before broadening regional allocations, investors are likely to seek some fundamental economic support for the idea. After all, it’s no surprise that U.S. stocks have outperformed over the past five years when U.S. GDP has grown by more than a quarter while the rest of the world has stagnated.

We believe some of this growth gap could close over the next couple of years, because at least a portion of it is due to the enormous monetary and fiscal stimulus the U.S. has applied since the pandemic. As that impulse begins to fade, a budget deficit running at 6% will make another round more difficult.

By contrast, the European Union has yet to spend its €750 billion pandemic recovery fund, and an average government deficit of around 3% gives it more fiscal headroom. We also believe the renewed importance of military, energy and supply-chain security has changed the politics of government spending in Europe.

It also looks increasingly likely that Europe could cut its interest rates sooner than the U.S. The Swiss National Bank fired the starting gun last month, and even some of the more hawkish European Central Bank policymakers have started hinting at a rate cut in June.

Last week’s eurozone inflation data helped this narrative. Both headline and core inflation declined in March, undershooting economists’ forecasts, while more recent U.S. inflation metrics have been stickier. Just as investors have pulled back from pricing for three Fed cuts this year, they have moved to price for three full cuts from the ECB.

Looser monetary and fiscal policy could add momentum to what already appears to be a global cyclical recovery.

The World Manufacturing Purchasing Managers’ Index (PMI) has edged back into expansion since the start of the year. Europe’s Manufacturing PMI remains in contraction but has seen one of the fastest recoveries over the past six months. Even struggling China has seen its PMI turn expansionary, hitting its highest level in 13 months. This recovering activity could get a boost from further stimulus this year, to meet the country’s growth targets. That, in turn, could feed into faster growth for manufacturers in Europe.

Cheapness and Cyclicality

If the economic fundamentals are in place, which markets might be favored?

To answer that question, recall the two characteristics we are looking for when broadening market exposure: cheapness and cyclicality. Can investors find U.S. cyclical stocks? For sure. But there is more cyclicality available at lower valuations elsewhere in the world.

The MSCI USA Index has a forward price-to-earnings (P/E) multiple of 21. MSCI Japan is on a multiple of 16. The Japan index has about half the USA Index’s exposure to Technology, and the difference is redistributed mainly to cyclical sectors like Industrials (more than twice the USA Index’s allocation), Consumer Discretionary (almost twice the allocation) and Materials (again, almost twice the allocation).

Japan’s stock market rally enjoys a high profile, due to its sheer strength but also its newsworthy monetary policy and regulatory background. The comeback in Europe has been less heralded and less pronounced.

But that means the MSCI Europe Index looks even cheaper than the Japan Index, at a forward P/E of just 14. Europe’s Technology allocation is almost four times smaller than that of the U.S., and while Consumer Staples is an important sector, much of the rest of the difference is redistributed to Financials, Industrials and Materials.

If Europe’s market recovery has been modest and underappreciated, China’s has been nonexistent. Few emerging market investors appear even hopeful about China’s prospects. Most prefer India.

In our view, however, India’s economy and market are very different from, and complementary to, China’s. Moreover, its time in the spotlight has left the MSCI India Index even more expensive than the USA Index, on a forward P/E multiple of 22. Meanwhile, China’s economic data is quietly improving, and its market languishes on a multiple of just nine.

Out of Favor

Later this week, we will release our latest Asset Allocation Committee Outlook. A key theme will be the Committee’s growing optimism on the global economy, paired with our inability to get excited about that all-too-common proxy for “global risk assets,” the S&P 500 Index. We believe it’s simply too dominated by a few stocks on full valuations.

Instead, we believe exposure to the broad economic story increasingly requires broader market allocations, and that means adding styles and regions that have been out of favor. Japan has been out of favor for decades, and in our view it’s not too late to participate in its comeback. Europe’s recovery may be just getting underway. For the true contrarian, even China could be worth a look.

The world of equity market performance has been getting smaller and smaller for 18 months. Now may be the time to broaden our horizons.