There is an interesting change taking place in global equity markets. Investors are shifting their focus from US equities towards global stocks. Emerging markets are leading the charge, but demand for other regions is growing too. The trend is partly a result of valuation. Last year, the valuation premium of US versus international equities reached more than “three standard deviations over the long-term average since 1970”, says Steve Nguyen, fundamental portfolio manager at US investment management group Causeway Capital.
“Even with the underperformance of US vs. international this year, the US valuation premium is still around the two standard-deviation level.” After 17 years of lacklustre performance, European equities, as measured by the MSCI Europe index, are extremely discounted relative to their US counterparts (using the MSCI USA index as a benchmark). They are on a two-year forward price/earnings (p/e) ratio of 13 (MSCI Europe) compared with 21 for the US index.
Within emerging markets, the gap is even wider. Since the beginning of 2021, they’ve underperformed developed market equities by 55%, says JPMorgan. Go back to 2010, and the gap widens to 200%. Much of this is due to China’s performance, or rather lack of it. However, JPMorgan has observed a broadening participation in Chinese equities beyond the country’s world-leading tech sector. There are still plenty of clouds hanging over China’s economy, but policymakers are starting to shift away from regulation towards stimulating the domestic economy.
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As a whole, according to JPMorgan, emerging markets are trading at one standard deviation below the 20-year average, relative to developed markets. There has been only one other occasion when they have been this cheap: after 2000, when Asian financial markets were still recovering from the double whammy of the 1997 Asian financial crisis and the dotcom bust. On a price-to-book basis, emerging markets are trading one standard deviation below the 30-year average at 0.5 of book value, the lowest level since 2000 (in 1997-1998 the ratio fell to 0.3).
Emerging markets are both cheap and under-owned, according to analysts. That implies scope for a recovery in both sentiment and valuation. JPMorgan’s team likes India, Korea, Brazil, the Philippines, the UAE and Greece. The latter is an interesting play. The bank notes that investors can book a 10% shareholder yield from the country’s formerly distressed banks, while the economy is also set to grow by 2% this year, with tourism offsetting any tariff hit.
Finding value in global equity markets
The valuation story is highly appealing in international markets. Martin Connaghan, co-manager of Murray International Trust (LSE: MYI), notes that there is “compelling valuation support in Europe and emerging markets, particularly in Latin America and Asia”. He adds: “Investors can still access many of the same structural growth themes found in the US, but at significantly lower valuations.”
While some countries may now look as if they’re heading for turbulence as a result of Donald Trump’s trade war, the reality is more nuanced, says Connaghan. “[Consider] the nature of the business. For example, while India may face high tariffs on physical goods, IT services firms such as Infosys or Tata are less directly affected. Their offerings, such as software, cloud and consulting, aren’t subject to the same tariff structures.”
Small caps present another opportunity for investors. Over the past five years, small caps have faced the same macroeconomic headwinds as large caps, but have still delivered fairly robust returns. The MSCI International Small Cap index has outperformed the MSCI International index (both ex-US) by 250 basis points annually.
“Smaller companies tend to be more domestically focused, which can insulate them from some of the cross-border complexities,” says Connaghan. And while international small caps have traded at a premium to international mid and large caps over the past 20 years, the current valuation is at a slight discount, says Nguyen.
Meanwhile, US management teams used to be far ahead of their international counterparts when it came to deploying buybacks. But recently there’s been an increase in buybacks in regions such as Japan, Europe and the UK. As a result, total shareholder return yields are now often “significantly higher outside of the US [while] the UK total yield is now more than double that of the US,” he adds.
An example is Italian financial services provider Intesa Sanpaolo. Recently added to Murray’s portfolio, Intesa is the number-one domestic bank in Italy. It has a common equity Tier 1 capital ratio of 14%, a cost-to-income ratio of below 40% and a dividend yield of 7%. In addition to Murray International, some of the best trusts to play global value are the Scottish American Investment Company (LSE: SAIN), which has an 86% allocation to global equities with the remaining allocation to infrastructure, bonds and real estate. STS Global Income and Growth (LSE: STS) and JPMorgan Global Growth and Income (LSE: JGGI) all offer dividend yields of between 3% and 4%.
In the global small-cap sector, region-specific trusts have produced the best returns over the past decade. Options include the European Smaller Companies Trust (LSE: ESCT), which has outperformed its sector by 41% over the past five years, or the JPMorgan US Smaller Companies Investment Trust (LSE: JUSC), which has outperformed the small-cap benchmark Russell 2000 index by 0.5% per annum over the past decade. For a play on Japan, consider the Nippon Active Value Fund (LSE: NAVF).
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
