Equity Outlook  |  Q3 2017

Non-U.S. equities: Compelling fundamentals and valuations

Equity insights

Non-U.S. equities: Compelling fundamentals and valuations

Looking forward to the second half of 2017, we think the disappointments of U.S. policy change will become increasingly less relevant to the markets. Although we anticipate the White House will attempt to resuscitate parts of its original policy agenda — such as tax reform and plans for large-scale infrastructure investment — we think it is unlikely that anything comprehensive will be accomplished quickly in the current political environment. Against this backdrop of stalled U.S. policy, we expect international markets will remain attractive for investors, both for their distance from U.S.-based uncertainties and for what we consider their compelling fundamentals and valuation profiles.

Also, where the markets have occasionally tripped up on non-U.S. uncertainties — as with the United Kingdom's volatile political transformation as it lurches toward Brexit — we find reason for optimism. Historically, the U.K. economy has managed political uncertainty fairly well, and the country has strong policy mechanisms to help stabilize its economy. In the short term, we expect political uncertainty may take a toll on U.K. domestic markets, but in the medium term, some of today's oversold U.K. companies, particularly U.K. multinationals, may emerge from the temporary crisis looking remarkably strong.

Europe slowly accelerates

In the first half of the second quarter, all eyes were on the unfolding political situation in France, where the general election promised to deliver either a stunning blow to EU institutions or a resounding victory for foundational EU principles. With far-right French presidential candidate Marine Le Pen vanquished by political centrist Emmanuel Macron, European markets have risen on the improved prospects for a more unified European Union and the promise of economic reforms in France.

Economically, the European Union has recently exhibited more signs of a slow but steady advance. Industrial production and employment indicators have risen, while inflation outside the United Kingdom has largely remained controlled. Meanwhile, assessments of economic activity in key markets such as Germany are brighter. All of these indicators feed into positive expectations for the European economy, funneling attention toward the earnings potential of EU-based businesses.

A solid first half for international equity markets

With far-right French presidential candidate Marine Le Pen vanquished by political centrist Emmanuel Macron, European markets have risen on the improved prospects for a more unified European Union and the promise of economic reforms in France.

As France and much of Europe benefit from the macro-economic bounce, we see relatively fertile ground for adding to select equity positions. In the United States, by contrast, we see more classic signs of late-cycle economic conditions: Consumer credit is slowing while delinquencies are rising; auto sales are depressed; the labor market is near full employment; and policymakers are tightening interest rates. In Europe, therefore, where we prefer to focus on stock-specific stories that exhibit promising catalysts for change, we think the lagging nature of Europe's cyclical recovery relative to the United States enhances the potential of European equities to perform well.

"Brexit means …" more political uncertainty

Whereas politics in France bolstered the case for investors to bulk up their non-U.S. stock exposures, politics in the United Kingdom have delivered a more volatile ride for investors. In yet another surprise political outcome in the United Kingdom, the U.K. general election in June resulted in a hung parliament, with no party winning the necessary majority to govern alone. Following this upset for Prime Minister Theresa May's Conservative Party, the pound sterling fell almost 2% against the U.S. dollar and domestically focused U.K. companies temporarily sold off.

Amid the political confusion, formal Brexit negotiations began on June 19. While it is difficult to forecast what will come next in this process, we think a "softer" approach to Brexit will probably be adopted by Prime Minister May. The election result has been viewed as a repudiation of her "hard" Brexit stance, and she has since struck a more conciliatory tone in her approach to Brexit negotiations.

As investors, we are particularly attuned to the positive earnings momentum that we see in a variety of U.K. based multinationals. For those companies that have revenue exposure to the United States, for example, earnings converted back into pounds are now worth more. In addition, we think that the Bank of England is likely to keep interest rates low for the foreseeable future — unless inflation, which has been running high on the back of higher import costs, threatens to outpace expectations. Moreover, while business confidence has weakened, we believe a looser fiscal stance by the government — including a renewed commitment to social welfare programs, which garnered popular support for the U.K. Labour Party in the June election — is likely to bolster economic prospects.

Overall, if the May government continues to take a more pragmatic approach to Brexit, allowing U.K. companies to maintain their access to important export markets as well as to non-U.K. labor sources, this should be an important tailwind. Lastly, while short-term political fallout may cloud the perspective of many, we think the fundamental strength of a variety of U.K. businesses will not go unnoticed down the road.

Emerging markets soar

A steady drumbeat of political shocks across the emerging markets has done little to deter investors so far in 2017. The president of South Korea was forced from office. Turkey convulsed with a military coup attempt and subsequent consolidation of power. Economic crisis deepened in Venezuela, driven by both oil market weakness and political corruption. And in Brazil, Michel Temer, the VP-turned-president, appeared to become caught up in a corruption scandal. But as of the end of June, emerging-market stocks, as measured by the MSCI Emerging Market Index [ND], had risen by 18.43% year to date — outpacing virtually every other equity asset class.

We anticipate that the strength in non-commodity-exposed emerging markets — such as India, South Korea, Taiwan, and Argentina — may continue, if certain conditions remain in place. Generally speaking, the U.S. dollar's relative stasis can give some breathing room to emerging-market stocks, as can relatively low developed-market interest rates. Despite higher risks, we believe yield-seeking investors will continue to pour money into both the equity and debt markets of the world's emerging economies if the currency, interest-rate, and policy back-drops remain supportive.

China's perennial risks

Economic stability in China is the consensus expectation, at least until it passes through its next political transition during the 19th National Congress of the Communist Party of China this fall. The market's expectation of stability is based on Chinese policymaker's willingness to supply continued stimulus to the Chinese economy. But we expect volatility to be a rising risk in China and in those countries and markets that are tied to China's economic fortunes.

China poses key risks, but we anticipate these are unlikely to fully emerge until after China undergoes a political transition this fall.

Indeed, we are already seeing the precursors of this volatility emerge. For example, corporate borrowing and inter-bank interest rates have risen in China on the back of new concerns regarding borrowers' ability to pay their debts. For years, China's real estate bubble has continued to grow, and no sustained measures have been adopted to curb the excesses involved in this unbridled market advance. Now, further attempts are being made to control some of the underlying problems. But the quandary for Chinese policy, as we see it, is that any cooling driven by policy could be too much — that is, it could slow the economy more than anyone can anticipate. This carries the risk of either triggering the "hard" economic landing that market observers have formerly considered but in recent quarters have tended to forget, or resulting in a sharp policy reversal from a mode of modest tightening to a mode of aggressive easing.

More from Equity Outlook

For U.S. equity investors, the second quarter offered a number of familiar themes: relatively low volatility, new record highs for major indexes, and a modest advance for stocks.