Europe and Asia may be a mess, but long-term investors can find opportunities there

The U.S. economy and equity markets might currently be considered among the strongest in the world, which could represent the perfect opportunity to zig when so many other investors are zagging.
As contrarian moves go, there’s nothing quite like increasing exposure to non-U.S. markets when so many analysts are intent on describing the U.S. as “the best house in a bad neighborhood” or the “cleanest dirty shirt.”
Focusing on the fact that U.S. economic growth has been sluggish, stock market valuations are high, and falling oil prices are adding new risks to employment, doesn’t necessarily make the strongest case for investing in places that are even worse off.
Unless, of course, you’re able to think longer-term.
“Those looking at the momentum trade, and shorter-term investors, will continue to favor the U.S., but longer term, if you’re looking at valuations and fundamentals you have to consider international equities,” said Zoe Brunson, director of investment strategies at AssetMark.
Even with the new volatility that has kicked into high gear this month, the U.S. stock market is hovering around historic highs, which should underscore the risk associated with such valuation levels and help make a case for diversification outside the U.S.
“Just looking at valuations, the U.S. is the most expensive market relative to the world, but it is also the most expensive, historically,” Ms. Brunson said. “A lot of that has to do with the Fed being one of the early positioners in terms of taking [quantitative easing] action, and that’s also why people are leaning more toward the U.S. right now.”
(More: China, and the world’s hottest stock exchange, beckons for American investors)
But that same type of Fed policy that has given the U.S. market such a boost is also waning with the central bank having wrapped its official bond-buying program last October, and expectations now pointing toward the advent of higher interest rates later this year.
By contrast, much of Europe is just ramping up its quantitative easing programs.
“The U.K., France and Germany may look expensive relative to their own histories, but they are fairly cheap relative to the rest of the world, that’s why managers focused more on fundamentals are tilted more toward developed international markets,” Ms. Brunson said. “It’s been beaten up and it is a contrarian play, but you also have to remember that their central banks are getting ready to put accommodative policies in place while the U.S. is wrapping it up.”
Considering the general state of international markets, which are heavily impacted by the strength of the U.S. dollar, any overweighting of international markets should be embraced from a longer-term investment perspective.
“We would favor U.S. equities and think they should be a larger portion in portfolios than normal, but U.S. and international markets will not move in sync, and at some point we’ll see an improvement, and a diversified portfolio is the way to benefit from that,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.
Along those lines, Mr. Rosenbluth recommends gaining diversified exposure to European equity markets through the Vanguard FTSE Europe ETF (VGK).
“We like it because it has relatively large exposure to some of the stronger economies, including the U.K. and Switzerland, which is still strong despite its recent moves to separate its currency from the euro,” he said.
Specific exposure in the United Kingdom, he added, can be gained through iShares MSCI United Kingdom (EWU).
“The U.K.’s economy is stronger than the rest of Europe, and we think the stock prices don’t fully reflect the stronger fundamentals,” Mr. Rosenbluth said.
In the emerging markets, he favors China, exposure of which can be gained through iShares MSCI China (MCHI).
“Even though economic growth is likely to slow, China is still the strongest large economy in world, with 7%-plus econ growth,” he said.
Why investors shouldn’t forget emerging markets

In terms of the emerging markets, investors also have mean reversion on their side.
On a three-year annualized basis, the MSCI Emerging Markets Index has averaged a 4.4% gain, but on a 10-year annualized basis the emerging markets benchmark is double that at 8.8%.
“There are near-term headwinds facing the emerging markets, including the strong dollar and the flight to safety,” said Ms. Brunson. “But longer term, specific emerging markets are seeing pockets of opportunity.”
That mean reversion scenario also applies to both the U.S. and developed international markets in a way that should stand as a reminder to advisers to diversify.
The three-year annualized return of the S&P 500 is 20.4%, while the 10-year annualized return is 7.7%. Mean reversion suggests that, over the longer term, the annualized index returns will fall closer to 7.7%. For the MSCI EAFE Index, which represents developed international markets, the three-year annualized average is 11.6%, compared with 4.9% for the 10-year annualized performance.
“It’s a case that the U.S. has run away from the international markets, and the consensus says that the dollar stays strong, which is why people have been leaning toward the U.S.,” Ms. Brunson said.
The U.S. dollar, which last year had its biggest gain against global currencies since 1997, is no small factor in the current U.S.-centric investing mindset.
Last year, for example, a German citizen investing in the German equity markets would have gained 3%. But because of the impact of the strong U.S. dollar, a U.S. investor who invested in the same German stock market last year would have lost 10%.
The same scenario applied to Japan would have Japanese investors gaining nearly 10%, while the realities of currency markets would have left the U.S. investor down almost 4%.
“For any U.S. investor with international investments, those returns have been negatively impacted by the strong dollar,” Ms. Brunson said. “Shorter term, investors like that backdrop. But, longer term, they should like developed international and emerging markets.”

Related Topics: Federal Reserve