In a previous post, I discussed three themes that should support continued international equity outperformance. But where, exactly, should an investor seek opportunities—and what are the risks?
Europe Yes, United Kingdom No
Our portfolio weighting in continental European equities has increased over the past two years, coinciding with the economic recovery and reflecting improved corporate fundamentals. Our primary exposures are to companies domiciled in France, Germany, Sweden, and Switzerland.
In contrast, we have reduced exposure to the United Kingdom over the same period as economic and political uncertainty amid the ongoing Brexit “divorce proceedings” with Europe have weighed on the U.K. growth outlook. The stronger British pound has also been a headwind for export-oriented companies based in the United Kingdom.
Industrials and Technology: Compelling Opportunities
From a sector perspective, industrials and technology stocks continue to represent more compelling investment opportunities, in my view.
The acceleration in global industrial production volumes and broadening growth environment have bolstered the outlook for capital goods, professional services, and building-product companies, where we maintain larger portfolio exposures.
Within the technology sector, we are finding attractive growth opportunities in the electronic equipment, semiconductor, software, and IT services industries.
All eyes will be on the Fed in 2018.
Key Risks to Monitor
The recent U.S. tax cut and expectations for future fiscal stimulus measures out of Washington have helped rekindle inflation expectations, sending the 10-year Treasury yield above 2.75% for the first time in three years. Government bond yields have also trended higher in Germany and Japan, reflecting the firming economic data previously discussed.
In my opinion, as long as the U.S. 10-year yield does not break through the low 3% range, we should be in a position to sustain positive stock market returns. A break above this range would threaten to derail the equity bull market, as the next key level would likely be 3.5%.
It is also important to consider downside risks to bond yields. If inflation does not materialize and the yield curve flattens, it would be extremely negative. Although we have seen reasonably good employment numbers, wage growth in the United States has not materially accelerated.
That has dampened the prospects for consumer spending and inflation. As a result, there is continued risk that interest-rate hikes stall the economy before it finds its footing.
Needless to say, all eyes will be on the Fed in 2018. New Fed Chair Jerome Powell has been widely expected to continue the slow policy normalization process that began under his predecessor, Janet Yellen. But the recent uptick in bond yields indicates that the market is now anticipating a more aggressive policy path.
If growth ends up disappointing, and inflation remains below the Fed’s 2% target, the share prices of banks would be particularly vulnerable as expectations for higher rates and profit margins are reversed.
From a geopolitical standpoint, the biggest risk I see is a further escalation of tensions on the Korean Peninsula.
From a geopolitical standpoint, the biggest risk I see is a further escalation of tensions on the Korean Peninsula. If military action were to unfold, safe-haven currencies such as the Swiss franc and Japanese yen would likely benefit. This would be negative for the Swiss and Japanese stock markets, given their dependence on exports.
Lastly, in the United States, the ongoing investigation into Russia’s meddling in the 2016 election could hinder the Trump administration’s efforts to push forward its agenda, including the long-awaited infrastructure program. This could serve as an additional headwind for the stock market.
The Time May Be Right
In sum, international equities appear poised to outperform for some time, so I believe the time is right to increase allocations to international equities versus U.S. equities. The key, in my opinion, is to find a portfolio that is quality-based and managed with low volatility in mind. The potential to capture upside when international markets perform well is important, but so is downside protection.
Investing involves risks, including the possible loss or principal. Equity securities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks. These risks may be enhanced in emerging markets. Any investment or strategy mentioned herein may not be suitable for every investor.
Holdings information should not be considered investment advice. There can be no assurance that a strategy will continue to hold any particular security or stay invested in any sector or region. Holdings are subject to change at any time.