We continue to favor the United States and emerging markets (EM) over developed foreign markets for global equity allocations. We see the U.S. economy as the primary driver of our forecast for 3.8% global gross domestic product (GDP) growth in 2018, supported by new fiscal policies, while Europe and Japan may lag.* The United States remains a global earnings standout as well. Despite underperformance this year, we continue to see upside potential in EM due to attractive valuations, recent economic growth, favorable demographics, and the potential for resolution to the U.S.-China trade dispute later this year [Figure 1].
INTERNATIONAL DEVELOPED EQUITIES 2018 OUTLOOK
At a high level, when comparing economic and earnings growth in the United States to international developed economies (mainly Japan and Europe), the United States is the clear winner.
U.S. GDP grew 4.2% annualized during the third quarter, may hit 3% for the year (based on Bloomberg consensus forecasts calling for 2.9%), and is accelerating. Meanwhile, GDP growth in the European Union has slowed each quarter this year and is not expected to reach 2% in the second half of 2018. The rise of populism, particularly in Italy, has highlighted the structural challenges and political risk that still exist in the region.
Japan’s economy bounced back nicely in the second quarter after contracting in the first, but consensus forecasts are calling for GDP growth marginally over 1% this year and next. Based on the latest purchasing manager’s surveys, Europe and Japan are both losing some momentum (see this week’s Weekly Economic Commentary for more on the economic outlook for international economies).
The story is similar for global earnings. Even without the benefit of the new tax law, the S&P 500 Index would be growing earnings at a low-double-digit rate (the tax reform boost to S&P 500 earnings is about 7%). That pace is still well ahead of consensus estimates** for MSCI EAFE Index earnings growth, at about 4% this year (EM is better at 7%) [Figure 2]. Revisions to developed international earnings estimates have also lagged the United States and, over the past month, EM as well. A strong U.S. dollar has been a drag on overseas earnings, but relative economic momentum in the U.S., buoyed by fiscal stimulus, is playing a bigger role.
One of the most popular arguments in favor of developed international equities is cheaper valuations. The MSCI EAFE is currently trading at a nearly 20% discount to the S&P 500 on a forward price-to-earnings (PE) basis. That is quite a bit larger than its historical 20-year average discount at 6%. However, the sector makeup of the international index suggests that a discount is probably warranted. The international equity benchmark has a higher allocation to sectors that tend to trade at lower valuations, while the domestic equity benchmark (the S&P 500) has more exposure to sectors that tend to be more expensive such as technology and communication services, which now includes the mega-cap internet stocks. The technology sector, which tends to be more expensive, carries a 21% weight in the S&P 500 while the weight in the new communications services sector is about 10%, compared with 6% total in technology in the MSCI EAFE Index.