U.S. stocks have outperformed globally over the past several years, but for precisely that reason investors may want to start looking to foreign markets for new opportunities. The divergence in performance between U.S. and foreign markets over the recent past has made the former look extremely overvalued compared to the latter. But with a pivot towards foreign markets likely underway, international stocks and exchange-traded funds (ETF) look poised to outperform in the near future, according to a recent story in Barron’s.

Key Takeaways

  • U.S. markets have outperformed foreign markets over recent years. 
  • U.S. equities look overvalued compared to foreign equities.
  • Foreign equities have made a comeback over the past year.
  • Foreign ETFs may provide investors opportunities for outperformance.

What It Means for Investors

The S&P 500 has risen 52% over the past five years while the iShares MSCI All Country World Index Ex-U.S. ETF (ACWX) has risen just 6%. The stark contrast in performance reflects the favor U.S. equities have garnered over the past half decade as foreign markets have suffered from slower economic growth and negative interest rates. The fact that the U.S. is home to a number of large-cap secular growth stocks has also helped push its markets higher in this current low-growth climate. But those factors have also contributed to U.S. equity valuations that look rich compared to their foreign peers.

A shift towards foreign equities is underway as U.S. valuations reach lofty highs and earnings growth. Meanwhile, the global economic slowdown is starting to catch up to the U.S. economy, which is beginning to be reflected in more recent stock performance. Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management, points out that the MSCI Europe Total Return Index has outperformed the S&P 500 Total Return Index over the past year. 

While the global economic slowdown does not bode well for either U.S. or foreign markets, the grim outlook has likely been mostly priced in. Markets are forward looking and have largely discounted the impacts of the U.S.–China trade war and Brexit, according to Shalett. Of course, if any of those conflicts worsen, there could be more negative fallout for equity prices across the globe.

However, central banks around the world have begun shifting towards easier monetary policy, ramping up asset purchases and lowering interest rates in attempts to stimulate growth. Barring any worsening of geo-political and trade relations, those efforts should provide a tailwind for foreign markets, especially cyclical, export-oriented ones. “[T]he rate of change of deterioration and stock prices have stabilized,” says Shalett. “For us, that’s a sign that the worst may already be discounted.”

One option for investors looking for exposure to foreign markets is the iShares MSCI EAFE Value ETF (EFV), the four biggest holdings of which include, Toyota Motor Corp. (TMAmerican Depositary Receipt), HSBC Holdings PLC (HSBC; ADR), BP Plc. (BP; ADR), and Royal Dutch Shell Plc. Class A (RDS.A; ADR). Year to date, the fund is up 9.3% and shares trade at a price-to-earnings ratio (P/E ratio) of 12.56, compared to the S&P 500’s P/E ratio of 21.96.

Another option is the iShares Core MSCI Emerging Markets ETF (IEMG), with the following top four holdings, Alibaba Group Holding Ltd. Sponsored ADR (BABA), Taiwan Semiconductor Manufacturing Co. (TSMAmerican Depositary Share), Tencent Holdings Ltd., and Samsung Electronics Co., Ltd. The fund has risen 10.2% since the start of the year and shares trade at a P/E ratio of 13.89.

The iShares MSCI Japan (EWJ) is also an option for investors looking for specific exposure to Japanese equities. The funds four biggest holdings are Toyota, Sony Corporation (SNE; ADR), Mitsubishi UFJ Financial Group, Inc. (MUFG; ADR), and SoftBank Group Corp. Year to date, the fund has gained about 17% and shares trade at a P/E ratio of 14.50.

Looking Ahead

While these three international ETFs have lagged U.S. equity markets this year, their relative undervaluation amid a U.S. economy that is showing signs of slowing are likely going to provide positive tailwinds for their performance over the next year.