After years of earnings recession, improving corporate earnings and relatively low valuations are making overseas investments more attractive. For the all consternation over and discussion of geopolitical and macro-economic issues, what ultimately drives stocks everywhere are corporate earnings, and earnings almost everywhere are increasing. Furthermore, analysts’ estimates of future earnings have also been increasing, despite lingering uncertainties around the impact of the Brexit vote and the U.S. election. We have already seen a dramatic increase in earnings for emerging markets (EM) in 2016, while 2017 expectations for both EM and developed market stocks, as measured by the MSCI EAFE Index, continue to improve. The biggest positive surprise may be coming from Japan as its market climate restructures. Valuations are generally attractive on both an absolute and relative basis across most markets. We have been relatively constructive on EM for most of 2016 and are now looking at other international markets.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging market.
End Of The Drought
Before something can go up, it must stop going down. Corporate earnings have been declining since Q2 2011 for both the MSCI EAFE Index and MSCI Emerging Markets Index [Figure 1]. Note that what gets referred to as the earnings recession for the S&P 500 was very shallow by comparison, and only began in Q3 2014. Only a handful of companies in the MSCI EAFE Index have reported Q4 2016 earnings as of January 20, 2017. However, expectations are for a strong quarter and for calendar year 2016 earnings to end with just over 1% growth. While hardly inspiring, if the year should show positive growth as expected, it would be the first annual growth since 2011. Some of this growth will come from the energy and energy-related industrial sectors, in which earnings have been declining along with oil prices in 2015 and early 2016. The positive impact of oil over $45/barrel will be evident in Q4 2016 earnings, but it will not be until 2017 that the effect is more fully apparent.
The drought in EM earnings growth turned in Q1 2016. Though less than 3% of EM countries have reported earnings yet for Q1 2017, market expectations are for over 17% earnings growth for the index for 2016. As in developed markets, earnings for energy, but also materials stocks have been rebounding with higher prices globally.
When It Rains, It Pours
We often say it’s earnings that determine stock market performance in the long run. However, we are also very interested in the shorter-term impact of estimate changes for future earnings. For almost all international markets, earnings forecasts for 2017 have increased since September 30, 2016 [Figure 2]. A number of major geopolitical events have occurred since then, including the likelihood the U.K.’s departure from the European Union will happen with more substantive changes (the so-called “hard Brexit”), an anti-European vote in Italy, and the election of Donald Trump, who has promised a more protectionist U.S. trade policy. Each of these events could have dampened earnings forecasts and they still may diminish earnings as the year unfolds. Yet despite these events, and others looming on the horizon, analysts have been increasing their 2017 estimates.
Valuations continue to be attractive in overseas markets [Figure 3]. Typically, we look at this sort of data over a shorter time frame. This longer perspective shows how harmonized global equity markets (including the S&P 500) have become. Market movements are more synchronous now than they used to be, which is a negative for investors looking for increased diversification overseas. However, if markets are indeed more correlated to each other, that implies that buying when markets are attractively valued may be even more important. The earnings acceleration overseas, combined with lower valuations, strengthen our conviction on emerging markets, despite the heightened risks, and suggest that developed markets may be looking more attractive as well.
The East Looking More Western
The Japanese economy, and for the most part its stock market, has been waning for so long it’s hard to remember that Japan used to matter to global investors. However, even after years of stagnation Japan is still the world’s third-largest economy and second-largest stock market by overall capitalization at approximately 8% of global stock markets combined. Japan may finally represent a long-term investment opportunity. Why? First, there is earnings growth potential, likely to be 4.5% for 2016 and expectations for 11.7% growth for 2017.
The bigger issue for Japan is the potential change in how investors view the country and its stocks as a result of a significant change in how the country and the companies in it operate. This shift usually only happens in emerging markets. Japan has seen major changes since its equity market peaked in 1989. Historically, the Japanese market had features that made the market relatively unattractive. Many of these attributes have evolved [Figure 4] in some ways making the Japanese market more conventional, and therefore perhaps more attractive to foreign investors.
Japan used to be an expensive market with price-to-earnings (PE) ratios regularly above 70, and at times in the hundreds, during some of the market peaks, such as 2002 and 2008. Valuations in Japan were high for two reasons. First, Japan had extraordinary low interest rates for years, but Japan is no longer alone in having low or negative interest rates. Second, for all their success in gaining market share and creating major global brands, Japanese companies were not as efficient, as measured by statistics like return on equity (ROE) and were not as profitable as similar companies based in other countries.
There were many reasons for why the Japanese market was different from western markets, and many of these reasons are changing. Japanese companies often offered lifetime employment; firing or laying off workers was a rare concept in Japan, even during periods of recession or changing business conditions. Today, fewer than 10% of Japanese companies still use lifetime contracts. Being able to lay off workers has had several impacts on business in Japan; they are now more profitable because they are able to react to economic changes. But also, Japanese companies are more inclined to hire and Japan’s workforce is growing, despite an overall aging population. This increase in workforce has increased consumer spending, and therefore boosted Japanese consumer stocks.
The final structural component in the potential Japanese equity revival is the undoing of the system of cross holdings across Japanese companies, known as the keiretsu. Under the keiretsu system, Japanese companies often own shares of each other. This suggests that sometimes corporate decisions are made for the benefit of other companies under the umbrella, rather than profit maximization or shareholder return. The number of shares held within the keiretsu system has declined dramatically. As a result, the percentage of Japanese shares held by foreigners has increased, as investors gain confidence that corporate managers are working for