These three metrics show global valuations are compelling

June 9, 2017

3 minute read

by Dr. Brian Jacobsen, CFA, CFP, Wells Fargo Asset Management

Non-U.S. markets may have had a good start to the year, but non-U.S. equity prices still have a ways to go before they come close to catching up to U.S. valuations.

Year-to-date, developed market stocks are up 12.49%, according to the MSCI World ex USA Index
Meanwhile, emerging market stocks, according to the MSCI Emerging Markets Index, are up 18.59%
For U.S. investors, currency effects (the U.S. dollar’s weakness) contribute 4.49 percentage points to developed market returns, and 4.51 percentage points to emerging markets returns

Considering the decent year-to-date returns, is this the best investors can expect? I don’t think so.

Non-U.S. equities—both developed and emerging—seem poised to benefit from an improving global economy. While the U.S. had a disappointing first quarter of growth, global growth has been improving. Consider these economic data points:

Gross domestic product growth (first quarter of 2017, annualized)

U.S.: 1.2%
Japan: 2.2%
Germany: 2.4%

The non-U.S. manufacturing sector has also shown potential. Purchasing manager indexes—in which a reading above 50 indicates an improvement from the previous month—turned from contraction in June 2016 to expansion.

Non-U.S. central bank policies are still very accommodative, even as the Federal Reserve looks to normalize U.S. monetary policy. European Central Bank (ECB) President Mario Draghi said that while growth is improving in Europe, labor utilization rates are still recovering and inflation is still below the ECB’s target. Emerging markets are being helped by three factors: improving domestic demand, higher commodity prices than what prevailed a year ago, and stronger growth in developed markets.

While the fundamentals seem to be improving in non-U.S. regions, non-U.S. market prices—I believe—are early in catching up with the fundamentals. Many non-U.S. markets were priced for long-lasting deflation and stagnation. That picture is changing and investors may be early in recognizing and acting on that change. At the beginning of the year, many people were fixated on the political risks emanating from Europe, but now those risks are looking less looming than they looked just a few months ago.

The French election brought about a leader who is pro-business and pro-European Union, which could strengthen EU integration even as the UK executes on Brexit. I believe the UK general election on June 8 will likely strengthen the political majority of the ruling conservative party. If anything, with a five-year term, this outcome will likely bring about stability in terms of who negotiates Brexit, as well as people’s perceptions on whether the negotiators can execute.

With political risks fading and economic growth accelerating, valuations across a number of dimensions look compelling outside the U.S. The following chart shows the contrast between U.S. and non-U.S. regions, in the context of three metrics:

Price-to-earnings ratio (P/E): Calculated by dividing the price of a share of a stock by its earnings per share (EPS), typically using the latest year’s earnings
Price-to-book ratio (P/B): Calculated by dividing the current closing price of a share of a stock by the latest quarter’s book value of equity (the value of a company’s assets as stated on its balance sheet).
Price-to-sales ratio (P/S): Calculated by dividing a company’s market capitalization (number of shares multiplied by the share price) by its total revenue, typically using the latest year’s sales.

Here are a few takeaways from the data:

P/E ratios outside the U.S. have been relatively more attractive than in the U.S. Even though P/E—like most valuation measures—is imperfect, it’s harder to make the case that valuations are stretched more outside the U.S. than in the U.S.
P/S ratios outside the U.S. have been at a significant discount to P/S ratios in the U.S. Some of this is because of sector composition, with consumer staples stocks trading at a lower multiple than financials and information technology. Still, even within a given sector, non-U.S. stocks have been at a discount to U.S. stocks.
P/B ratios have also been lower—significantly lower—outside the U.S. than in the U.S.

No single valuation metric is a fool-proof guide to determining value, but most metrics you can measure seem to tell the same story: While non-U.S. equities may have had a good start to 2017, their prices still have a distance to go before they come close to catching up to U.S. valuations.