What to Watch: Opportunities Abroad
What to Watch

February 7, 2023

Opportunities Abroad

The US equity market has been dominant over the past decade, handily outpacing both international developed and emerging markets. Investors with a home country bias have been rewarded. However, with low growth expectations for 2023, equity investors in search of higher risk premiums may be well suited to look outside of the US. There are several potential catalysts driving this view, such as low valuations, a weakening dollar, and the accelerated reopening of the Chinese economy, none of which come without their own unique set of risks. In this week’s What to Watch, we explore both the opportunities and potential risks in investing outside the US.

Low Valuations

Both international developed and emerging markets are trading at a steep discount relative to the global equity market. While a discount is typical, both developed and emerging markets are trading well below the historical spread relative to the global equity market as shown below. These low valuations have made international equities more attractive relative to the US.

Source: Bloomberg LP, MSCI MXEA Index, 4/28/2006 – 1/31/2023

Source: Bloomberg LP, MSCI MXEF Index, 4/28/2006 – 1/31/2023

Source: Bloomberg L.P., Monthly valuation data is measured by the forward price to earnings ratio from 4/28/2006 - 1/31/2023. U.S. = S&P 500 Index, Europe = STOXX Europe 600 Index, Japan = Nikkei 225 Index, China = Hang Seng Index, International Developed = MSCI EAFE Index, Emerging Markets = MSCI Emerging Markets Index. Valuation is measured by z-score, which is the number of standard deviations a data point varies from the mean.

The Recovery Leaders

Furthermore, international equities have outperformed US equities in almost every historic market recovery, with emerging markets having the highest return in every instance since 1993. With US equity valuations already elevated and earnings facing continued headwinds, investors looking to play a recovery may be well suited to look outside of the US.

Equity Rebounds Post Bear Markets

Source: Bloomberg LP, Emerging Markets = MSCI MXEF Index, International Developed = MSCI MXEA Index, 1993 = 12/31/1992 – 12/31/1993, 2003 = 12/31/2002 – 12/31/2003, 2009 = 12/31/2008 – 12/31/2009, 2020 = 12/31/2019 – 12/31/2020, YTD = 12/31/2022 – 1/30/2023, Total Return posted. Past performance is not a guarantee of future results. One cannot invest directly into an index.

A Weaker US Dollar

Since topping out at 20 year highs at the start of Q4 2022, the US Dollar has fallen almost 9%. Generally, a weak US dollar has been beneficial for international equity returns, as the dollar consistently has a negative correlation to both International Developed and Emerging Markets. The US Dollar may have more to fall as the US economy softens on the backs of higher interest rates. The quantitative tightening cycle that started in the summer of 2022, with the Fed letting $95 billion worth of Treasuries and Mortgage-backed securities roll off its balance sheet each month, has finally started to have its effect on the dollar as well. We expect this trend to continue as the Fed reaches restrictive levels, and could make international equities more attractive.

Source: Bloomberg LP, USD Strength Index, MSCI MXEF Index, 12/31/1999 – 1/31/2023

Source: Bloomberg LP, USD Strength Index, US Condition of All Federal Reserve Banks Total Assets, 12/31/2007 – 1/31/2023

China Reopening a Potential Boone for Emerging Markets

Within the past month, China has reversed course and accelerated the reopening of its economy after years of strict zero-COVID policies. This change in policy has acted as a catalyst for growth within Emerging Markets and could propel growth in international economies as a whole. China is a major source for exports and overall business activities for surrounding countries. According to a recent report by Goldman Sachs, a 0.01% increase in China’s GDP may boost overall Emerging Markets GDP by as much as 0.40%. China’s plan to reopen should have positive impacts on international markets as growth starts to pick up again.

Risks in Chasing the Reward

International equities may pose a greater reward based on current fundamentals, there are geopolitical uncertainties that can heavily influence the performance in the foreseeable future.

However, any setbacks could be detrimental to the reopening, and will likely be a headwind for international equities.

The Russia/Ukraine War is another risk that face global equities, both international and US. A prolonged war would likely mean continued instability in commodity prices and uncertainty about the state of the world. Nevertheless, an end to the war in 2023 would most likely mean economic growth for international economies as supply chain bottlenecks should ease and commodity prices should stabilize.

Implementation strategies

Investors have started to look towards international equities for opportunities and in preparation for slower growth in 2023. However, there are still many headwinds that face international equities. Defined Outcome ETFs such as IJAN, the Innovator International Developed Power Buffer - January, and EJAN, the Innovator Emerging Markets Power Buffer – January, seek to allow investors to participate in meaningful upside exposure, with caps above 20%, while buffering against further losses should international equities tumble.

The MXEA Index is composed of large and mid-cap companies from 21 developed countries excluding US and Canada.

The MXEF Index is composed of large and mid-cap companies from 24 emerging markets countries.

The USD Strength Index indicates the general international value of the USD. Value is the average exchange rate between the USD and other major world currencies.

The SPX Index is the S&P 500 price weighted index composed of 500 large-cap US companies

The STOXX Europe 600 Index is composed of 600 large, mid, and small-cap companies, across 17 developed European countries.

The Nikkei 225 Index is composed of 225 domestic common stocks of the Tokyo Stock Exchange

Hang Seng Index is a free float capitalization-weighted index from the Stock Exchange of Hong Kong, composed of 66 stocks

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