The Case for Non-U.S. Stocks

Year-to-date the S&P 500, the benchmark index of the broader U.S. market, is up 4%, while Europe is down 5% and Japan and emerging markets are up just 1%. Even amid the pandemic, U.S. stocks somehow managed to outperform their peers in most regions around the world, a phenomenon that has persisted for more than a decade.

Yet U.S. outperformance isn’t a permanent feature of markets and we have always considered it likely to end at some point. Now we think the COVID-19 recession may have accelerated that shift and believe that the market will rotate to favor non-U.S. stocks heading into 2021. 

To understand why, let’s first look at U.S. markets. As I’ve said recently, the risks to the S&P 500 are growing. The crop of mega-cap tech stocks that dominate the index reached extreme valuations recently, before they started to decline. Pandemic conditions may have resulted in peak demand for their services earlier this year. These tech favorites may not shine so bright compared to value-oriented cyclical stocks with more operating leverage once the economic recovery takes hold.

Plus, the risk of a pause in the V-shaped U.S. economic recovery is rising, as Congress continues to debate adding more COVID-19 stimulus. Improvements in the U.S. labor market may be stalling, and consumer confidence has yet to rebound. Meantime, as the presidential election race nears its end, the odds of delayed or contested results, which would likely roil markets, seem to be increasing. 

Now, let’s turn to non-U.S. markets, where most major regions of the world have growing advantages over the U.S. Consider these examples:

• China’s recovery leads other major economies by as much as a year. It is the best performing region—the MSCI China Index is up 17% this year—due to a strong pick-up in global trade, despite the overhang of trade tensions with the U.S. The renminbi is strengthening relative to the dollar, which should support China’s strategy of turning it into an international currency that is held by more central banks.

• Most emerging markets are linked to China and will benefit from the weaker dollar (down about 5% year-to-date against a basket of major currencies after a seven-year bull market) and the stronger renminbi. So far, emerging markets have lagged strong gains in commodities, which is unusual and could indicate that they are underpriced. These markets could also benefit from the Federal Reserve’s plans to keep interest rates low, even as inflation trends upward.

• Europe not only boasts more reasonable stock valuations, but its COVID-19 relief plan could be a game-changer. Europe’s recovery plan could bring about greater fiscal integration across the region and provide much-needed aid to the southern periphery. The plan also provides funds for green energy projects that should create jobs, while fighting climate change.

• Japan offers attractive valuations, ongoing economic transformation and an important break in dollar/yen correlations. Indeed, the yen’s still nascent weakening against the dollar could help boost its exports, which would become more competitive. Plus, Japan’s strength in industrial and electronic automation could be in the sweet spot of global technology spending, which we see shifting away from the current social media and cloud-based leaders. It also helps that Japan has the lowest level of unemployment and lowest mortality impact from COVID-19 of any developed country.

Investors shouldn’t be surprised if the outperformance of the U.S over the past decade ends with the COVID-19 crisis. The S&P 500, dominated by tech highflyers, may not have a lot of upside, while stocks in other regions are more likely to offer attractive valuations and could benefit from global economic reflation. My advice: Consider rebalancing your portfolio to favor non-U.S. regions and diversify within your U.S. holdings to reduce exposure to increasing risks in the S&P 500.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Sep 21, 2020, “Going Abroad.” Ask your Financial Advisor for a copy or find an advisor.  Listen to the audiocast based on this report.