The tide may be turning: 2 reasons to favor Europe and Japan over the U.S.

It’s easy to see why some investors have been enamored with U.S. stocks (represented by the Russell 3000® Index) in their portfolio over the past 5 years: They’ve done really well. Compared to returns in Emerging Markets, Europe and Pacific (represented by MSCI Emerging Markets Index, MSCI Europe Index, MSCI Pacific Index, respectively) over the past 5 years ending March 31, 2016, the U.S. stock market has dominated, with an annualized return of 11.1% versus the next closest region (Pacific) at 3.0%.

But biases within a portfolio can be limiting. Historically, it has often been the case that when assets are out of favor – like Europe and Emerging Markets have been recently – their price eventually drops to a point that offers better value and opportunity going forward than the assets that have most recently been in favor.

Regional performance for the previous 5-year period, ending 2010, is a visual reminder of exactly that dynamic: market leadership rotates and what happened in one period doesn’t forecast what will occur in the next one. In 2010, Emerging Markets had been the leading region for 5 years, with an annualized return of 13.1% (MSCI Emerging Markets Index) while the Pacific lagged at 1.8%.

Regional stock market leadership rotates

As of March 31, 2016 Sources: EM – MSCI Emerging Markets Index; Europe – MSCI Europe Index; U.S. – Russell 3000® Index; Pacific – MSCI Pacific Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Identifying potential opportunities outside U.S. borders

While the U.S. has been the dominant region lately, Russell Investments currently sees more potential opportunities in Europe and Japan in the coming year for two reasons:

  1. Divergent central bank policies.

Central bank policies around the world have begun to diverge after years of coordinated stimulus. Supportive monetary policy introduced in response to the Global Financial Crisis has lifted stock markets globally. The U.S. Federal Reserve (Fed) was the first to implement monetary stimulus in 2008 and became the first to start unwinding it as of 2014. Following a first rate hike in December 2015, Russell Investments’ North America investment strategist, Paul Eitelman, expects the Fed to raise rates two more times in 2016 – potentially as early as June. While this move would reflect the Fed’s confidence in the strength of the U.S. economy, it could potentially represent a headwind for the U.S. equity market compared to other regional stock markets.

Across the globe, the European Central Bank (ECB) and the Bank of Japan (BoJ) have introduced a negative interest rate policy. The goal: to help shift the economy out of neutral and into growth mode. The policy encourages banks to lend and businesses to spend, which hopefully increases the value of the stock market and potentially increases inflation expectations, which both Europe and Japan have struggled with over the last year.

A comparison of U.S., Euro area and Japanese economies and markets

As of March 31, 2016 Sources: Trading Economics, U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, Eurostat, Japan Ministry of Internal Affairs and Communications, National Bureau of Statistics of China. Market returns: S&P 500® Index, MSCI Europe Index , MSCI Japan Index, MSCI China Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

As of March 31, 2016 Sources: Sources: U.S. – Trading Economics, U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics. Euro Area – Eurostat. Japan – Japan Ministry of Internal Affairs and Communications. Market returns: U.S. – S&P 500® Index, Europe – MSCI Europe Index, Japan – MSCI Japan Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

                           2. Relative valuations.

From a valuation perspective, Europe and Japan currently look attractive relative to the U.S. What might be most interesting is the recent 5-year performance relative to each market’s historical average 5-year return. The U.S. is the only market whose recent 5-year return is above its average 5-year return. For those investors who believe in mean reversion – the tendency for a stock’s price to revert to its average price over time – the data in the table suggests that the U.S. is unattractive while Europe and Japan are attractive.

For example, European stocks returned 2.1% during the most recent 5-year period, which included the debt crisis and double-dip recession. That market showing was paltry compared to its historical average 5-year return of 10%. If the European market reverts to “normal,” we would expect to see a higher return. Europe also currently boasts a higher dividend yield on stocks and fair valuations (based on a price-to-earnings measurement). The old adage “buy low, sell high” comes to mind when we see this data on price and returns.

The bottom line

Being a global investor isn’t always easy. It requires patience and persistence. But, there are a number of reasons why we at Russell Investments think opportunity in the coming year is likely to be greatest outside the U.S.

MSCI EAFE (Europe, Australasia, Far East) Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

MSCI Europe Index: A free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. The MSCI Europe Index consists of the following 15 developed market country indexes: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.

The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 318 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.

The MSCI Pacific Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed and emerging markets in the Pacific region. The MSCI Pacific Index consists of the following 12 developed and emerging market countries: Australia, China,
Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore, Taiwan, and Thailand.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The S&P 500® Index is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500® are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ.

Diversification does not assure a profit and does not protect against loss in declining markets.

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group.

Copyright © Russell Investments 2016. All rights reserved.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

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