The markets set to out-earn the US
The US market (MSCI US Index) crushed EAFE (MSCI Europe, Australasia and Far East Index) again in 2020, gaining 21% versus the MSCI EAFE Index’s 8% gain. This is despite the EAFE's rare marginal win in the fourth-quarter when it rose 16% versus the MSCI US's gain of 13%.
This extended the last decade’s rampant outperformance by the US, which has delivered 252% since 2010 (13.4% per year). Over this same period, the EAFE only managed 71% or 5.6% per year.
Valuation has contributed to the US outperformance, as the multiple of the next 12 months’ earnings has expanded from 13.3-times to 23.5-times, while EAFE trails on a “mere” 17.5-times. That said, the main driver has been sharply better earnings performance, with forward earnings up 73% for the US, but actually down 13% for EAFE over the 10-year period.
There are several reasons to believe it may be possible for EAFE to “out-earn” the US. The stretched US valuation might give EAFE a chance to outperform, but what is really required is for EAFE to “out-earn” the US, in contrast to the experience of the 2010s. While we're not nearly brave enough to make this a definitive forecast, there are some reasons to believe it may be possible.
Until the middle of last year, the strengthening dollar had been a relative tailwind for US earnings, as revenues earned outside the US were worth a falling amount of dollars. But if the second half 2020 dollar weakness continues, this process will go into reverse.
More broadly, the US may not sustain the faster economic growth it managed over the last decade. The International Monetary Fund forecasts average annual gross domestic product growth of 2.8% for Europe over the next five years, versus 2.4% for the US, helped by a steeper recovery in 2021 given the deeper European trough in 2020.
If accurate, this would contrast with the 2010-19 period, where the US outgrew Europe, with the US having grown 2.3% while Europe grew 1.7%.
In addition, EAFE’s sector mix may benefit more from the post-COVID recovery. Using hard cyclicals - industrials, materials and energy - plus financials as a proxy for cyclicality, EAFE is far more exposed to the macro-cycle, with 43% of the index in these sectors, versus only 24% in the US.
US profits were helped over the last few years by the Trump tax cuts, as well as broader business-friendly policies. Anti-trust legislation is a particular call-out here, in contrast to the more environment-, consumer- and labour-focused policies in Europe.
It is not yet clear how much of a challenge the Biden administration will offer to corporate profits, but it is likely to cleave closer to the European model.
More broadly, US governance has been seen as vastly superior to that of the European Union (EU). Given the successful passing of the EU’s €750 billion recovery plan supported by jointly issued debt, and the less-than-optimal current functioning of the US polity, it is rather less clear that this advantage remains.
Dependence on a few large companies is a potential source of growth for the US market, but also a potential source of vulnerability
One extra US edge since the GFC has been the far higher technology weight. Information technology now comprises 28% of the MSCI US Index, versus only 9% of the MSCI EAFE Index - even before adding to the mix “pseudo-tech” companies in e-commerce, streaming, electric vehicles, and social media. Combined, these add another 11% to the US indices tech exposure.
Technology has been a major engine of performance, returning 533% over the decade. Indeed, the sector alone delivered 62% of the MSCI US Index’s 21% 2020 return, while adding in five pseudo-tech companies (regarded by most people, if not MSCI, as technology companies) takes this share to 96%, meaning that the rest of the US market only delivered 4% of the index performance.
Another way of looking at it is that over half of the total MSCI World Index performance in 2020 was delivered by five US companies, and 78% by the top 25 companies in the index, of which only one is listed outside the US.
This dependence on a few large companies, mainly in the tech area, is a potential source of continued growth for the US market, but also a potential source of vulnerability. Unlike in the 1999 tech bubble, these are real companies generating massive earnings with significant runways for growth, but there are significant regulatory threats across the globe, around anti-trust, publishing rules and privacy.
Any significant threat to their earnings power could have a severe effect on overall US market returns. The euphoria in the growthier end of the market can be seen in the MSCI World Index’s information technology returns.
The other tech issue is at the more speculative end of the market. 2020 saw a spectacular 480 initial public offerings, amongst which there were 248 SPACs (special purpose acquisition companies), also known as “shell” or “blank cheque” companies.
This euphoria in the growth end of the market can be seen in the MSCI World Index’s information technology returns. Splitting the sector into five quintiles by adjusted 24-month forward earnings shows, as in the chart below, the seeming exuberance. The top quintile has a median price-to-earnings ratio (P/E) of 166 times adjusted earnings. This P/E is arguably generous, as using pure GAAP/IFRS numbers, i.e., deducting share-based compensation, takes the majority of this quintile into loss, even two years forward. This elevated valuation was helped by the group’s average 2020 return of 163%. Even the relatively sober second quintile has adjusted P/Es from 33 times to 56 times and saw a return of over 50%. Any deflation here could crimp the US market as well, while EAFE would be far less affected.
There are only two ways of losing money in equities: either earnings have to go away or the multiples have to go away. We would argue that the US is at higher risk of both compared to EAFE, given fairly elevated earnings and multiples, even outside technology.
The dowdy EAFE markets look less glamourous but less risky, particularly given the potential revival of Europe. Indeed, a 17.5x multiple for MSCI EAFE certainly looks less frightening than a 24x valuation.
Now more than ever, it is time to focus on keeping the lights on, rather than attempting to shoot them out, and a quality-biased portfolio in less fashionable markets does seem a reasonable way of limiting the risk of a plunge into darkness.
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Bruno is a portfolio manager for Morgan Stanley Investment Management’s London-based International Equity team. Prior to that, Bruno worked for Sanford Bernstein, where he was a Senior Analyst covering the financial sector for eight years.