Why Invest in International Stocks Now?

by Anwiti Bahuguna, Ph.D., Senior Portfolio Manager, Global Asset Allocation, ColumbiaThreadneedle Investments US

The first quarter of 2017 was a good time to take equity risk; expectations of fiscal policy changes and reassuring elections in Europe unleashed a surge in the price of risk assets, like stocks. However, as we pass the mark of U.S. President Donald Trump’s first 100 days in office, it may be worthwhile for investors to re-evaluate the composition of their equity allocation. We see reasons for caution on U.S. equities going forward, while international equities and emerging market equities are more compelling.

Three reasons for caution on U.S. equities

1. U.S. equities are expensive. U.S. equity valuation measures are at highs, which means that U.S. stocks are expensive, especially compared with international stocks. This holds true even after accounting for low bond yields. We are concerned that after Trump won, U.S. markets priced in positive expectations for pro-business policy reform too much and too early.
2. The benefit of corporate tax cuts is uncertain. Both the timing and magnitude of corporate tax cuts could improve U.S. companies’ earnings. However, market participants have already largely paid for these tax cuts in the form of higher equity multiples, which rose in late 2016 on the assumption that the incoming Trump administration would reform tax policy. Therefore, how much more the actual implementation would benefit investors remains unclear.
3. U.S. stocks are not priced in alignment with monetary policy. The Fed is on a path to tighten interest rates and potentially make changes to its balance sheet in 2017. We believe that U.S. stocks are not reflecting this expectation. As long as this disconnect remains, there may be more downside risk than upside potential for U.S. stocks as monetary policy evolves.

Mind the gap between “soft” and “hard” data

Economists refer to consumer confidence surveys on the state of the economy as soft economic indicators, whereas data that reflects actual spending and production are referred to as hard indicators. In its March meeting minutes, the Federal Open Market Committee drew attention to the soft vs. hard data debate. Since the U.S. election, soft indicators have improved, and the stock market has risen along with them. However, hard data on actual business activity has not shown a similar increase, with Q1 GDP falling below expectations. We believe the economy will continue to grow and the hard data will rise to catch up with the soft data. On the other hand, soft data could reflect excessive optimism, and hard data may fail to meet these expectations.

Reasons to consider international equities

Given our cautious view on U.S. equities, we believe investors should consider the relative attractiveness of other equity markets.

• International developed markets. In Europe and Japan, markets benefit from continued quantitative easing, a type of monetary policy used to stimulate economic growth, and equity valuations are more attractive compared with the U.S. International growth is in the early stages of recovery after a long period of subpar returns.
• Emerging markets. Economic growth in emerging markets is projected to grow faster than in developed markets. After two years of declines, emerging market earnings are growing again, and equity valuations are attractive relative to other markets and their own historical average.

Bottom line

U.S. stocks have performed well so far in 2017, but given high equity valuations and ongoing policy uncertainty in the U.S., we believe some caution is warranted. Within our equity allocation, we continue to favor non-U.S. equity markets in general and emerging market equities in particular for their attractive valuations and growth prospects.

Foreign investment risks include political, economic, market, social and others within a particular country, as well as to currency instabilities and less stringent financial and accounting standards generally applicable to U.S. issuers. Risks are enhanced for emerging market issuers.

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