Markets have a way of behaving in a very rude fashion. Last spring, as Covid-19 spread from the Northeast across America in April and May, equity prices were staging a powerful rally.
By late June of this year, the S&P 500 had soared nearly a stunning 94% from its lows on March 24, 2020. It wasn’t just America. As horrifying as the news from Brazil and India was in this year’s second quarter, their stock markets were surging.
One advantage that foreign markets currently enjoy is that the inflation fears present in the United States are largely absent abroad, leaving other countries’ central banks under less pressure to raise interest rates. It also means their equity prices could be less vulnerable.
With the American economy roaring back to life as summer began, there weren’t many things running hotter—but the U.S. stock market was still strong. America, the United Kingdom and certain other small nations ranging from Israel to Bhutan were enjoying impressive vaccination results as they approached herd immunity—and while the rest of the world was playing catch-up.
That probably helped maintain a valuation gap between the U.S. and other foreign markets that remained much wider in late June than it usually is. International stocks are selling at a 24% discount to their U.S. counterparts, according to Gabriela Santos, executive director and global market strategist at J.P. Morgan Asset Management. Historically, that discount is about 13%.
North Asian countries like Taiwan, South Korea and China took the lead in the early stages of the global economic recovery last year. Then in the first quarter, the U.S. vaccine rollout caught fire.
After bureaucratic stumbles earlier this year, Europe finally got its act together. It has now vaccinated nearly 50% of its population, Santos says. That’s one reason European stocks outperformed public U.S. companies in the second quarter.
Santos believes European equities still have more runway left. Most of the continent’s bourses have a more cyclical tilt—cyclicals, in fact, make up 55% of the European and Japanese markets while they represent only 33% of the U.S. market. That makes these stocks relatively more attractive as an early-cycle play.
Many American investors view European economies as socialist and sclerotic. The European Union’s bungled rollout of vaccinations only confirms those perceptions.
This viewpoint is understandable, according to Jim McDonald, executive vice president and chief market strategist at Northern Trust Asset Management. But it “improves the odds” that European stocks could outperform other markets, most notably the U.S., for several years.
McDonald himself expects European markets to beat the U.S. for at least the next year—for many of the same reasons Santos does. Many American investors don’t realize that European public companies generate 50% of their revenues outside Europe, he adds. (The companies are so established in emerging markets because of their colonial histories.)
For a quarter century after the Berlin Wall fell in 1989, globalization opened new market opportunities for giant multi-nationals. Following Brexit and the election of Donald Trump in 2016, there was new hostility to open borders and free trade.
Counterintuitive though it might seem, McDonald believes that de-globalization actually means less correlation in investments—and thus investors could get more tangible benefits from diversification than they have come to expect.
It also means investors who allocate more broadly in equity portfolios increase the odds of hitting their expected return targets.
McDonald warns, however, that if foreign markets outperform America’s for several years, domestic investors complacent at home may start piling into foreign securities late in the game.
Big Outperformance Odds
Some asset management firms anticipate foreign markets will trounce America’s. Vanguard Group is projecting investors outside the U.S. could enjoy equity returns of 7.5% to 8.0% between now and 2030, while U.S.-centric investors could realize only 4.5% to 5.0% over the same time period.
Roger Aliaga-Diaz, Ph.D., a principal and senior strategist in Vanguard’s investment strategy group, calls this one of the “more extreme gaps ever.” In his view, it’s very uncommon.