Topic Tags: International Equity - Developed

Currency Effects on International Equity Returns

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities.

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities. In some instances, the impact of the stronger dollar has flipped positive returns denominated in local currency to negative returns when translated to U.S. dollars. In fact, this phenomenon has occurred year to date in 2014: the local currency return for a primary international equity index (MSCI EAFE) is positive (red bar; 4.2%), but becomes negative when denominated in dollars (blue bar; -2.4%).

In our Chart of the Week, we examine the retrospective returns of the MSCI index, denominated in both local currency and U.S. dollars. Based on the chart, two conclusions seem straightforward:

  • The “winner” each year will vary over time, which is not surprising since the U.S. dollar strengthens in some years and weakens in others.
  • Over the long term, the relative strengthening or weakening of the U.S. dollar is more or less balanced out, as the cumulative returns of each index – local and dollar – suggest, shown by the convergence of the two cumulative return streams.

If nothing else, this week’s chart should provide some comfort to investors whose returns have been negatively impacted by a stronger dollar: although the dollar acted as a drag on international returns this year, it is highly unlikely this will be a consistent pattern in the coming years, and should certainly not serve as a worry for long-term international equity investors.

Impact of Profit Margins on Stock Market Valuations

This week’s Chart of the Week looks at U.S. (measured by the S&P 500) and Developed International (measured by the MSCI EAFE) equity market valuations. Over the last five years U.S. equity markets have outperformed their developed market peers by almost 10% on an annualized basis (14% vs. 5.3%).

This week’s Chart of the Week looks at U.S. (measured by the S&P 500) and Developed International (measured by the MSCI EAFE) equity market valuations. Over the last five years U.S. equity markets have outperformed their developed market peers by almost 10% on an annualized basis (14% vs. 5.3%). Perhaps most surprising is that, as this week’s chart shows, U.S. markets trade at only a modest premium to other developed market peers (16.5 price to earnings ratio for U.S. stocks versus 14.9 for developed market international stocks). However, non-U.S. stocks are actually much cheaper when normalized for profit margins. Profit margins have a strong tendency to mean revert over time (high profits attract competition which drives down profit margins) and U.S. profit margins, at 9.5%, are at an all-time high. Conversely, non-U.S. developed market profit margins are just 6.6%, below their long-term average. Not since 2009 have international profit margins exceeded U.S. profit margins.1 Investors should be aware that as profit margins revert to their long-term averages it could leave U.S. stocks looking pricy, and their developed market peers looking cheap.

1This is shown in the graph when the red area (EAFE profit margins) completely covers the blue area (S&P 500 profit margins).

An Alternative to U.S. Small-Cap Equity

This week we examine the valuation of developed non-U.S. small-cap equity (MSCI EAFE small-cap) compared to U.S. small-caps (Russell 2000). The chart displays the relative price-to-earnings (P/E) and price-to-book (P/B) ratios for the two asset classes. A lower number indicates the U.S. is more expensive compared to non-U.S small-cap stocks.

This week we examine the valuation of developed non-U.S. small-cap equity (MSCI EAFE small-cap) compared to U.S. small-caps (Russell 2000). The chart displays the relative price-to-earnings (P/E) and price-to-book (P/B) ratios for the two asset classes. A lower number indicates the U.S. is more expensive compared to non-U.S small-cap stocks. Based on the historical averages for both P/E and P/B, non-U.S. equity looks relatively attractive.

Small-cap companies in the U.S. have performed well in this historically low interest rate environment. Now five years into the economic recovery, market participants expect a rate hike from the Fed to occur sometime mid next year. With U.S. small-cap stocks lacking extraordinary earnings growth, many investors are questioning their valuations. In the Eurozone and Japan, two areas that account for over 40% of the MSCI EAFE small-cap index, the economies are earlier in their respective recoveries and experts anticipate lower interest rates to persist in these regions, which should be accretive for equities in those markets. Investors looking to reduce their U.S. small-cap exposure should consider developed non-U.S. small-cap, given the accommodative central bank policies and relative valuations.

2014 Market Preview

January 2014

Similar to previous years, we present our annual market preview newsletter. Each year presents new challenges to our clients, and 2014 is no different: We are coming off a banner year for U.S. equities, low interest rates continue to stymie fixed income investors, and while developed market equities enjoyed a strong 2013, emerging market stocks sputtered. In the alternative space, real estate and hedge funds proved accretive to portfolio returns, while growing dry powder in the private equity space is starting to raise a few eyebrows.

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Eurozone Valuations Outpace GDP Growth

This week’s Chart of the Week examines GDP growth and valuation levels in the eurozone. The chart above depicts eurozone quarterly GDP growth compared to both the prior quarter and year. As the chart shows, eurozone GDP growth is at very low or even negative levels.

This week’s Chart of the Week examines GDP growth and valuation levels in the eurozone. The chart above depicts eurozone quarterly GDP growth compared to both the prior quarter and year. As the chart shows, eurozone GDP growth is at very low or even negative levels. Growth versus the prior year has been negative since the first quarter of 2012, while growth versus the prior quarter only recently turned positive (albeit very slow at .26%) in the second quarter of 2013.

The eurozone GDP growth or lack thereof does not seem to accurately correspond to eurozone valuation levels. As seen in the chart, the eurozone’s P/E ratio has continued to increase over the past 8 quarters despite little to no growth. The P/E ratio was 14.5 at the end of the fourth quarter of 2011. Since then, the P/E ratio has climbed to 21.6 on speculation that Europe will experience a strong recovery. However, despite continued investor optimism, the main question still remains: will the European recovery truly come to fruition?

Examining International Market Returns for U.S. Investors

This week’s COW looks at the year-to-date returns of the major international markets (Europe, Japan, and Emerging Markets) through September 25, 2013. This chart disaggregates the returns that U.S. investors have realized so far this year between the currency return and the local stock market performance

This week’s COW looks at the year-to-date returns of the major international markets (Europe, Japan, and Emerging Markets) through September 25, 2013. This chart disaggregates the returns that U.S. investors have realized so far this year between the currency return and the local stock market performance. While the depreciation of the Yen has helped drive the Japanese stock market to levels not seen since the late 1980’s, U.S. investors have only partially benefitted from the strong Japanese equity returns because of the fall in the Yen relative to the U.S. dollar. Interestingly, weak emerging market currencies were a theme for most of 2013, but with the Fed’s recent decision not to start tapering their quantitative easing (QE) program in September, emerging market currencies and equities have rallied significantly, pulling the year-to-date U.S. investor return close to even.

Buying Opportunity for European Stocks?

Developed Europe has some tough economic challenges ahead. Italy and Spain just had their credit ratings downgraded putting further pressure on banks holding sovereign debt from the PIIGS nations. While Greece may not be saved from default, European leaders have indicated their commitment to not let its major institutions fail without a fight.

Developed Europe has some tough economic challenges ahead. Italy and Spain just had their credit ratings downgraded putting further pressure on banks holding sovereign debt from the PIIGS nations. While Greece may not be saved from default, European leaders have indicated their commitment to not let its major institutions fail without a fight. Talks surrounding the establishment of a fund to stabilize European banks began to materialize when Belgo-French bank Dexia, crumbling under the weight of its exposure to sovereign debt and toxic assets, was guaranteed a 90 billion euro bailout by Belgium, France, and Luxembourg. For those who believe that the Eurozone will weather the storm, the good news is that stocks are quite cheap for the major European nations as measured by P/E ratios. For example, Germany’s major stock index has a P/E ratio of 9.8 vs. its 15.8 historical median. Compare that to the S&P 500 at 12.4, and you are still looking at some intriguing bargains if you believe that not all of Europe is as weak as its weakest links. Germany’s seasonally adjusted unemployment rate at just 6.9% vs. 9.1% in the U.S. seems to suggest just that. While risks abound, the U.S. stock market is not free of exposure to Europe and Germany and France have shown resolve to keep the Eurozone intact, so maybe it’s time to consider cheaper European stocks once again.

The Euronext 100 Index is comprised of the largest and most liquid stocks traded on the exchange, encompassing French, Dutch, Belgian, and Portugese stocks. The FTSE 100 Index tracks the largest UK companies on the London Stock Exchange. The DAX Index measures the performance of the largest German companies on the Frankfurt Stock Exchange. P/E ratios are sourced from Bloomberg. Historical medians are calculated from the maximum number of data periods available for each respective index

Understanding Currency Overlay

As portfolios have expanded to include international investments, investors must be aware of the currency risk inherent in foreign assets. Currency overlay programs provide a mechanism to mitigate currency risk. This paper examines how currency overlay programs can be used to reduce the currency risk embedded in foreign denominated portfolio allocations.

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