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Categories
International
Making the case for international equities
Gerald Du Manoir
Equity Portfolio Manager
Sung Lee
Equity Portfolio Manager
Chris Thomsen
Equity Portfolio Manager

International equities have long been overshadowed by the market’s fascination with leading U.S. technology companies. But the tide may be shifting. A confluence of top-down and bottom-up dynamics is making the case for international equities much stronger.


From a macro perspective, the U.S. dollar has weakened significantly against the euro and other global currencies since last October. Currencies can overshoot for extended periods, and the dollar has been overvalued on several metrics for many years. That said, in the past few months, we have seen signs of a turn. And in periods of dollar weakness, currency translation effects can significantly impact total returns from equities.


Weaker dollar can help boost international equities

Chart shows both the annual currency contribution to the total return of the MSCI EAFE Index in U.S. dollar terms and the U.S. dollar index over the period 1989 to 2022. The annual currency contribution is expressed in percentage points of return. During this period, a declining dollar typically corresponded with a positive contribution from currency to the overall performance of the MSCI EAFE Index in U.S. dollars. A rising dollar also typically corresponded with a negative currency contribution to the index. Shading from 2002 to 2007 highlights prolonged period of dollar weakness. During the period 2002 to 2007, the U.S. dollar index declined significantly and the currency contribution to the index was meaningfully positive. The dollar index percent change and currency contribution to the index in percentage points for each year of that period were: negative 2.2 and positive 10.2 in 2002, negative 8.4 and positive 18.4 in 2003, negative 4.1 and positive 7.6 in 2004, positive 3.5 and negative 15.5 in 2005, negative 4.3 and positive 9.9 in 2006, and negative 6.5 and positive 7.7 in 2007.

Sources: Capital Group, Bloomberg, FactSet, J.P. Morgan. The dollar index is an effective exchange rate that measures the value of the U.S. dollar against a group of developed and emerging markets currencies. The annual currency contribution to the total return of the MSCI EAFE Index is expressed in percentage points of return. Shaded area represents prolonged period of dollar weakness. Data as of December 31, 2022.

Meanwhile, Europe has weathered the energy disruption from the Russia-Ukraine war better than expected, although a mild winter has helped. The European Central Bank’s efforts to rein in inflation had a dampening effect on the overall economy. GDP growth in the fourth quarter was flat as higher interest rates started to bite. Nevertheless, consumers have shown resilience, buffeted by savings built up during COVID lockdowns and by generous fiscal support provided to consumers during the pandemic.


China’s reopening could be another positive catalyst for Europe, given the strong trade ties between the two regions. It's also a large export market for Japan and other Asian countries.


Against this supportive macro-economic backdrop, international equities led by European stocks have had a strong run over the past six months. Yet valuations remain below long-term averages for many sectors, suggesting there could be upside ahead. 


Europe is trading at historically low valuations

Chart shows forward price-to-earnings ratios for sectors in the MSCI Europe Index and compares them against the 10-year average. The index is currently trading at 12.6 times earnings versus its 10-year average of 14.2. The energy sector is trading at 5.7 times earnings versus its 10-year average of 11.8. The materials sector is trading at 12.3 times earnings versus its 10-year average of 14. The industrials sector is trading at 17.7 times earnings versus its 10-year average of 16.8. The consumer discretionary sector is trading at 13.9 times earnings versus its 10-year average of 14. The consumer staples sector is trading at 17.3 times earnings versus its 10-year average of 18.3. The financials sector is trading at 7.8 times earnings versus its 10-year average of 10.4. The information technology sector is trading at 22 times earnings versus its 10-year average of 21. The communication services sector is trading at 14.2 times earnings versus its 10-year average of 15.2. The utilities sector is trading at 13.8 times earnings versus its 10-year average of 14.3.

Sources: MSCI, RIMES. Forward price-to-earnings ratio reflects the current share price relative to the consensus estimate for earnings per share on a forward 12-month basis. Data as of March 31, 2023.

Here, we discuss eight investment themes prevalent in our international equity portfolios and why they may be sources of returns over the next few years.


1. Semiconductors are crucial to power the digital economy


Despite the recent cyclical downturn and geopolitical headlines, the semiconductor industry appears poised to enjoy years of growth ahead. And companies outside the U.S dominate much of the industry.


The need for computing power is only increasing. Industry-wide revenue is projected to reach $940 billion by 2030, doubling from 2020, based on estimates from leading semiconductor equipment manufacturer ASML.


Several demand drivers are gaining traction. One is high-performance computing chips used in cloud computing and artificial intelligence (AI) functions like ChatGPT. Another is autos: Today’s average car contains many times more semiconductors than a smartphone.


We expect companies in Taiwan, Japan and Europe to thrive from these trends. Many of them have developed specialized expertise that is hard to replicate in manufacturing, chip-making equipment and laser-inspection tools for microchips.


Western governments have also realized semiconductors are essential to national security. The CHIPS and Science Act of 2022, which provides $52.7 billion for American semiconductor development, and a new fund established in Europe are among the efforts to incentivize companies to move production back home. 


The pace of semiconductor sales is accelerating

Chart shows worldwide semiconductor industry sales from 1980 through 2021. In 1980, sales were $10 billion. By 1990, sales climbed to $51 billion. By 2000, sales rose to $204 billion. By 2010, sales increased to $298 billion. By 2021, sales were $556 billion. By 2030, sales are projected to reach $940 billion.

Sources: Capital Group, ASML, Statista, WSTS. Data as of November 2022. 2022 estimate provided by WSTS. Projection through 2030 provided by ASML. The first semiconductor was created in 1960.

2. European firms have dominated interactive online entertainment


If you got lazy about making that trip to Las Vegas and decided to play online blackjack instead, chances are the platform is powered by a European company. Gaming and sports betting are among the fastest growing areas of online entertainment. The global online gambling market was valued at $63.5 billion in 2022 and is expected to grow at a double-digit rate for the next decade, according to various estimates.


Flutter of Ireland, Entain of the United Kingdom and Evolution of Sweden command this space, having developed the technology over the past decade. Online casinos and sports betting became legalized in many European markets earlier than the U.S. Now, as legalization of online casinos and sports betting expands state by state across the U.S., European firms have been gaining market share at a rapid pace.


We are seeing innovation in other areas of technology as well. Sweden’s Spotify is one of the world’s leading music-streaming platforms. U.K.- based Ocado developed valuable technology for the online grocery business. And there’s ASML in the Netherlands, whose EUV (extreme ultraviolet) lithography machines dominate leading-edge semiconductor manufacturing for high-end phones and data centers.


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3. The energy transition is creating new opportunities


Europe’s transition to energy sources outside of Russia is creating new opportunities across a host of industries, including renewed interest in European oil giants. 


At the same time, many governments around the world are committed to reducing their reliance on fossil fuels and pivoting to renewable energies. The Inflation Reduction Act in the U.S. provides for a massive $369 billion package of tax credits, loans and grants to spur the capital investment needed to create a meaningful U.S. domestic solar and wind power-generation industry. But this energy needs to be stored using batteries that rely heavily on rare earth materials and industrial metals including copper, nickel and lithium. 


Mining companies are gearing up for the energy transition. Rio Tinto recently said it intends to double its annual copper output by 2030, while BHP Group acquired OZ Minerals, a copper and gold miner. Mining companies in Canada, Great Britain and Australia have both the resources and the highly specialized expertise. In the near term, the materials sector can also benefit from a pickup in manufacturing activity in China as factories reopen across the country.


When it comes to building new homes or retrofitting older buildings, industrial companies in Europe are rapidly transitioning to alternative energy sources and newer, less energy-intensive manufacturing technologies.


Raw materials will play an important role in the energy transition

Infographic shows the mix of minerals used in the average electric vehicle battery. Graphite is 28%. Aluminum is 19%. Nickel is 16%. Copper is 11%. Steel is 11%. Manganese is 5%. Cobalt is 4%. Lithium is 3%. Iron is 3%.

Sources: Capital Group, European Federation for Transport & Environment. Figures above reflect the mineral content of the average lithium-ion battery with a 60-kilowatt-hour capacity, which refers to the weighted average of electric vehicle battery chemistries on the market in 2020. Figures exclude materials in the electrolyte, binder, separator and battery pack casing. Data as of July 2021.

4. Consumer companies are showing pricing power


Although European economic growth has remained flat, the consumer has shown resilience, partly due to savings accumulated in the last few years amid COVID lockdowns and fiscal support from central governments. Against this backdrop, and facing rising input costs, large consumer goods giants have raised prices. In the near term, this can put pressure on operating and profit margins. Longer term, the price hikes usually stick, even as costs plateau or soften over time, which can help expand margins and profitability.


Consumer demand has been surprisingly resilient in many parts of the world. Now, with China’s reopening, we expect demand for luxury goods and travel to shoot higher. Prominent luxury goods companies LVMH and Hermès both reported strong first-quarter results, bolstered by demand from customers in China. While there is a degree of risk, given the potential for an economic slowdown, rising demand from China should offset slower demand in other markets. And importantly, European brands have become synonymous with luxury around the world, building leading market share positions and a level of expertise that is difficult to replicate, affording them a degree of pricing power.  


5. Aircraft makers, suppliers should benefit from secular growth in travel


Air travel is picking up again in a post-pandemic world and should get a big boost from China ending its three-year lockdown. Travel is a secular growth industry in a lot of countries, and demand is growing for new airplanes. Only about 20% of the world’s population has ever been on a plane. So there is huge room for growth, especially in emerging markets, where the middle class is growing, and air travel is still in its infancy.


More than 39,000 new aircraft are projected to be built by 2040, with roughly 40% slotted for Asian countries, according to Airbus and Boeing, who dominate the market. While U.S.-based Boeing specializes in wide-body aircraft, Airbus in France leads in midsize planes used for short-haul flights — the segment seeing the fastest growth. European companies also build engines and components, led by Safran, the world’s largest maker of engines for single-aisle planes as well as landing gear.


The dynamics of aircraft orders benefit the manufacturers. Airlines pay in installments and have prepaid most of the cost by the time the planes are delivered. Given the backlog, they don’t like to lose their place in the queue for deliveries. This provides a strong baseline for forecasting cash flows and revenue streams.


Commercial aircraft production has a long runway

The image is a horizontal bar chart. It compares aircraft orders vs. trailing 12-month deliveries between Airbus and Boeing. Airbus has an order backlog of 7,239 aircraft and 661 trailing 12-month deliveries, while Boeing has a reported backlog of more than 4,500 and 480 trailing 12-month deliveries.

Sources: Capital Group, company reports. Boeing's last reported order backlog is over 4,500, while Airbus has an order backlog of 7,239 planes. Data as of December 31, 2022.

6. Japanese companies are showing signs of reinvention


Japan’s corporate world doesn’t garner much headline attention. But several companies are undergoing transformations. Olympus is known worldwide as a camera brand, but that’s no longer its emphasis after a multiyear restructuring. Leveraging technology developed over the decades, Olympus has transformed itself into the world’s leading supplier of endoscopes used in medical procedures. Fujifilm is another example. The company has evolved into a major player in health care, offering drug development and manufacturing services to multinational pharmaceutical companies. It has also expanded into the semiconductor materials business.  


In other areas, Japanese firms have carved out unique technologies used in industrial automation equipment and inspection tools for semiconductor manufacturers. These companies will likely play a central role as we see an industrial renaissance in developed economies and ongoing industrialization in developing economies. 


Corporate Japan has been on a journey to improve profitability, capital allocation and corporate governance since 2012 under policy reforms advocated by former Prime Minister Shinzo Abe. And more recently, Japanese companies have seen a rise in shareholder activism, with investors asking for a better return on investments. As many companies tend to have high levels of cash on their balance sheets, this could lead to companies paying out more of their excess cash in dividends.


7. Innovation could benefit pharmaceutical giants


Innovation is ramping up in health care. Europe is home to many high-quality pharmaceutical companies. Many have invested heavily in drug discovery in recent years and have built deep pipelines of pioneering treatments to tackle some of the world’s biggest health issues.


Some pharmaceutical companies such as AstraZeneca are transitioning from a broad suite of health care drugs toward specialty care; roughly 40% of AstraZeneca’s drugs are now related to oncology. This allows companies to create dominant franchises in select areas of health care.


As investor optimism has risen, valuations have expanded, making us somewhat cautious in the near term. That said, with better visibility on future growth and no major patent expirations in the coming years, pharmaceutical companies may see higher price-earnings multiples than they did in the prior decade.


In an uncertain macro environment, the strong capitalization of many pharmaceutical companies is another positive factor. Many have plenty of cash on their balance sheets to pay dividends or fund their own growth through acquisitions. This could help in a higher interest-rate world where raising debt capital will be more expensive.


8.  Select opportunities may exist in European and Asian financials


Credit Suisse’s merger with UBS in late March generated headlines about weak links in the banking system. But overall, the European banking sector is arguably in its strongest operating position since the great financial crisis. Banks have built up significant capital reserves to absorb potential loan losses, which should protect earnings in a recession. Capital ratios and profitability are at all-time highs. Furthermore, positive interest rates should help net interest income (a key profitability measure) for the rate-sensitive banks.


Compared with their U.S. counterparts, European banks do not take on large amounts of interest-rate risk due to tighter regulations. Banks in Europe also tend to be relatively well diversified, with large funding bases built on retail branch deposits. Our banking analysts anticipate returns on capital should improve. Given a less restrictive regulatory environment, dividends could increase, and buybacks may rise.


Similarly, domestic-focused Asian banks appear relatively sound for several reasons. Besides operating in countries where economic growth rates are projected to outpace the developed world, they have limited exposure to U.S. regional banks and Credit Suisse. They are well capitalized and tend to have smaller investment portfolios. 


European and Asian bank stocks have held up relatively well

Chart shows 2023 year-to-date cumulative returns for major global bank indexes. The MSCI Europe Bank Index was up 13%. The MSCI AC Asia Banks Index was up 1.6%. The MSCI USA Banks Index was down 8.9%. The S&P 1500 U.S. Regional Banks Index was down 24.5%.

Sources: Capital Group, MSCI, RIMES, Standard & Poor's. Data reflects period from December 31, 2022, through April 14, 2023.

An increased focus on dividends


We are also seeing a greater-than-ever focus on and commitment to dividends. Corporate managements, particularly in Europe and Japan, seem to be balancing capital expenditure and operating cash flow needs with a stronger desire to return cash to shareholders via dividends.


International dividends projected to grow

Chart shows dividends per share of the MSCI Europe Index and MSCI Japan Index and the estimated compound annualized growth rate. In 2012, dividends per share for the MSCI Europe Index were $53.84. That figure was $52.74 in 2016, $50.10 in 2020 and is projected to be $75.10 in 2025. For the 2020 to 2025 period, that puts the estimated dividend compound annualized growth rate for the MSCI Europe Index at 8.4%. In regards to the MSCI Japan Index, dividends per share were $11.96 in 2012, $18.50 in 2016, $23.01 in 2020 and projected to be $35.98 in 2025. For the 2020 to 2025 period, that puts the estimated dividend compound annualized growth rate for the MSCI Japan Index at 9.4%.

Sources: FactSet. Data for 2023-2025 is based on consensus estimates as of February 17, 2023. CAGR = compound annualized growth rate.

A broad opportunity set spans growth and value


Inflection points in markets tend to prompt investors to take a fresh look at asset allocation. The rise in interest rates around the world triggered by tighter monetary policy has been a reset of sorts for all financial assets. Growth stocks pulled back last year and have rebounded as the monetary tightening cycle appears closer to the end than the beginning.


Nevertheless, portfolio flows over the past six months can be read as a signal that investors are looking to broaden their equity exposure beyond the dominant U.S. technology companies. International equities spanning many industries across the growth and value spectrum provide a diversified opportunity set with valuations that appear reasonable by many measures. 



Gerald Du Manoir is an equity portfolio manager with 34 years of industry experience (as of 12/31/2023). He holds a degree in international finance from the Institut Supérieur de Gestion in Paris.

Sung Lee is an equity portfolio manager with 29 years of experience (as of 12/31/2023). He holds an MBA from Columbia Business School and a bachelor’s degree in marketing from Pennsylvania State University.

Christopher Thomsen is an equity portfolio manager with 26 years of industry experience (as of 12/31/2023). He holds an MBA from Columbia Business School and a bachelor’s degree in international economics from the School of Foreign Service at Georgetown University. Chris is based in London.


All indexes are unmanaged, and their results include reinvested distribution but do not reflect the effect of sales charges, commissions, account fees, expenses, or U.S. federal income taxes.

 

The MSCI Europe Index captures large and mid-cap representation across 15 developed market countries in Europe. With 424 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European developed markets equity universe.

 

The MSCI AC Asia Index captures large and mid-cap representation across developed market countries and emerging markets countries in Asia. With 1,425 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

 

The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 237 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.

 

The MSCI USA Banks Index captures 17 large and mid-cap banks in the United States.

 

BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg’s licensors approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

 

The S&P 1500 Regional Banks Sub-Industry Index (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2022 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part is prohibited without written permission of S&P Dow Jones Indices LLC.

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