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Welcome to Market Perspectives, a Mercer Advisors Podcast. In today’s episode, we’re going to be talking about the surprising return of international stocks, especially in Europe. We’ve had a really remarkable first quarter of the year in financial markets, where the S&P 500 briefly entered correction territory.
And if you’ve only been following U.S. markets, things look fairly poor. But if you’re broadly diversified, you’re probably doing OK so far this year. And it’s because international stocks, especially Europe, are doing surprisingly well. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors. And I’m joined today by Don Calcagni, our Chief Investment Officer. Don, thanks so much for being here.
Josh, thank you so much. It’s great to be here. And I look forward to our discussion.
It’s really kind of surprising, so far this year, through the end of the first quarter, the S&P 500 is down about 5%. But international stocks, developed markets are up a little over 9%, excluding the U.S. and Canada. And it’s a pretty surprising split based off what we’ve seen in recent years. So, Don, to start us off, are you surprised by how well Europe in particular has been doing to start this year, European markets?
Well, I think if we’re all being honest with ourselves, we’re all a little surprised, right? For such a long period of time non-U.S. stocks have underperformed U.S. stocks. And so as someone who is a big believer in broad diversification, it is actually refreshing to see that this part of our portfolio is contributing very nicely thus far to our year-to-date returns.
And so, Josh, yeah, I think there’s a little bit of surprise around that. I think if we step back and we look at the economics of really the public policies that are coming out of the White House as they pertain to tariffs, as they pertain to geopolitics, as they pertain to NATO and defense spending, and so on and so forth, it’s perhaps less surprising.
European stocks have traded at a very substantial discount relative to their U.S. counterparts. So as an investor, they’re pretty inexpensive relative to U.S. companies. When we look at tariffs, when we look at this adversarial tone that now exists, unfortunately, between the White House and Brussels, the Europeans have made a decision to invest very aggressively in their own defense that is going to spur GDP growth in Europe. It is going to help European-domiciled companies to do well. And we’ve seen that with respect to specific European companies already. So when we look at the economics, Josh, it is perhaps a bit less surprising.
So let’s dive into these reasons one by one. So you mentioned a handful of things there. You mentioned tariffs. You mentioned increased spending out of the European Union countries.
We mentioned valuations. We probably want to talk about currencies as well. But let’s break them down one by one. And let’s start with tariffs.
To what extent is what we’re seeing a tariff story? Obviously, that’s been the big international policy change in the U.S. so far with the new administration.
The tariff story is a little bit harder to measure at the moment because candidly, even now, we’re not exactly sure where the administration is going to land. And, Josh, just before we continue this discussion, I do think it’s important for our listeners to understand that in this conversation, Josh and I are just staying focused on the economics. We’re not interested in the politics. The purpose of the podcast isn’t to discuss politics. But it is to discuss the economic and very real market implications for certain public policies coming out of our government, whether that be Congress, or the White House in this particular instance.
So with respect to tariffs, I think that’s harder to measure, Josh, because we don’t know exactly where the White House is going to land. If anything, we’ve seen the White House flip-flop a lot on where they want to land with respect to tariffs. It wasn’t that long ago that we were going to tariff Colombian coffee. And then the next day, those tariffs were canceled. We’ve had the same pattern, by the way, with Canada, and steel, and now automobiles, and so on and so forth.
So it’s unclear where we are going to land. And, Josh, I would also argue, it’s unclear to know wherever we land, whether or not the administration is actually going to stay there or if they’re not going to change their mind the next day, or the next week, or the next month. And so I think that, by itself, creates uncertainty in markets. But that’s really hard to measure and connect it back to this European outperformance, this non-U.S. equity outperformance story. I think there’s other drivers at the moment that explain why non-U.S. equities are outperforming us.
And so the second thing you had mentioned was that there might be more spending coming out of the European Union. It’s not unrelated to the new administration actually, right? One of the reasons we think there might be this spending is because there’s a dynamic where Europe has to spend a little bit more. Walk us through your thinking on what’s driving things here.
NATO has long held a policy of I think it’s a 3% GDP or 2% GDP spending requirement for all NATO members. And the reality is, most European members of NATO have failed to hit those GDP spending thresholds in terms of spending on their own defense.
This has been an issue that the Trump administration has continuously raised, that our European allies have not been investing aggressively in their own defense. And now the administration has been very clear that the US defense umbrella that previously, for the past 75 years, that extended over Europe, that that should not be construed as being guaranteed or permanent.
And so I think that has led to a lot of concern among our European allies, and certainly in Brussels. And so they have subsequently made a decision to invest more aggressively in their national defense, especially coming on the heels of Russia’s invasion of Ukraine. So we’ve seen Germany has made some pretty big pronouncements in terms of what they intend to spend on defense. And all of that, naturally, is going to ignite and spur, support GDP growth within the European Union.
So that’s really part of the story here, is that planned spending. There are certain stocks that — we are seeing certain defense industry stocks in Europe that have done quite well over the past several months given this new announcement. So I think it was Brussels had announced that they would spend up to 800 billion Euros, that’s $866 billion on defense. And that’s a very substantial commitment.
We saw the statistic cited in one place that the tank maker, Rheinmetall, was briefly more expensive than Ferrari this month, which tells you a little bit about the mood over there.
Yeah, that brings me back to the guns and butter conversation, that framework that characterized defense spending in the United States during the Cold War. For those of us who are old enough to remember, the Ferraris would be the butter and the tank maker would be the guns. And it’s interesting to see that now the tank maker has a higher valuation, or at least it did briefly than Ferrari.
Now, whenever we think about international stocks versus US stocks, a big part of that equation is going to be what’s going on with currency. Whenever the U.S. dollar is down, that would tend to make international stocks a little more expensive in U.S. dollars. Conversely, when the dollar is up, the international stocks do a little bit more poorly. What are we seeing so far this year when it comes to currency? How does that factor into what’s happened?
It’s actually quite substantial, Josh. If we actually look at year-to-date returns, especially on European stocks, almost half of that return, that outperformance is purely due to the fact that the value of the US dollar has declined a bit, about 3% or 4% year-to-date. So that currency effect is quite substantial. That accounts for quite a bit of outperformance thus far this year.
So why is the U.S. dollar weakening? So contrary to the administration’s claim, the administration’s claim is that tariffs would strengthen the value of the U.S. dollar. That it would actually appreciate given the fact that we have this new tariff regime. Frankly, we’ve not seen that. And there’s very good economic science that explains why that’s the case.
Tariffs are anti-growth. Tariffs are also inflationary. And when you combine those two things together, it pushes down the value of our currency, all things equal vis-a-vis other currencies. And so given this newfound interest in tariffs by the U.S. government, by the administration, the reality is the dollar is likely to be heading South, not North for the foreseeable future.
The final piece of what you mentioned was valuations. So at the end of last year, start of this year, U.S. companies, especially some of the big tech companies, had incredible, unusually high valuations. When you compare the price of the stock to the earnings of that stock, the PE ratio was really high. European stocks were not quite in that same situation. Talk about the role that valuations have played in the movements we’ve seen so far this year.
Well, frankly, quite a bit. If we actually look at the returns on European stocks and non-U.S. stocks globally relative to their U.S. counterparts, multiple expansion has actually driven close to 50% of that outperformance that we’ve seen so far this year.
So what that means, Josh, in English, is that investors are willing to pay more now for every dollar of earnings earned by European companies, for example, than they were last year. So investors are more willing to hold non-U.S. stocks than they are U.S. stocks.
What we’ve seen in the U.S. market is that multiples have contracted. So it’s a risk off trade in the United States. It’s a risk on trade outside of the United States. What we’re seeing is a redeployment of capital, in my view, where investors have harvested profits in U.S. tech companies, for example, and are reallocating that capital to what are arguably more defensive investments overseas.
More defensive because they own those in non-U.S. currencies. These are non-U.S. currency based investments. These are also investments that trade at a much lower valuation. So there’s a cushion built in to those downsides when you’re buying stocks at lower valuations.
So I think a big part of it is evaluation story. Another big part of it is a currency story. That’s also a little bit a dividend story, a little bit an earnings story. The tariff story is still TBD. Tariffs are having a more direct impact on U.S. equities. The impacts on non-US equities at the moment is still TBD.
And what can we say about the outlook for these international stocks going forward? What are you going to be watching for the rest of the year to see how this folds out?
I mean, we continue to look at earnings.
To quote Jeremy Siegel at the Wharton School of Business, “earnings are the mother’s milk of stocks.” Earnings drive the value of stocks. And European earnings projections over the next 12 months still look pretty good. Somewhere in the 8.5% growth range, that’s very attractive.
US earnings at the moment still look pretty attractive, in that low double digit range, 11%-12%. I think the challenge on the U.S. side at the moment is tariffs will be a drag on GDP growth. And so that earnings story in the US, I would argue, is cloudier now than it was last year. And I actually think the earnings story for non-U.S. equities, especially Europe on the continent, actually looks better than it did this time last year given the spending commitments from Brussels that we were just discussing a few moments ago.
We’ve gotten so used to thinking about Europe as this laggard economy over the past 10 years or whatever. And I’m wondering, do you think that was always a bit of an overstated case how far behind Europe is to the United States? I mean, the way people sometimes talk about it is almost like it’s a backwater. And yet if you go to Europe, you see it’s a fairly high standard of living over here. Is it really that far behind? Was it really ever that far behind the U.S.?
I mean, I think there’s a difference between European standards of living, their economic growth, and then what’s happening in their financial markets. Those things, they’re related, they’re correlated, but they’re not exactly the same things.
I think it is objectively true that European financial markets naturally underperformed by quite a bit U.S. markets.
And I think that’s actually more a U.S. growth story than it is a European stock underperformance story. Our technology sector growth stocks in the United States, especially after the global financial crisis from ’08 to ’09 really blew the doors off. They actually outperformed very handsomely. Josh, we had two years of 20%-plus growth in the S&P 500 index. That is not normal. And by any objective measure, any other global financial markets can have a really hard time catching its breath and being able to keep up when the U.S. market is growing at 20%-plus 2 years in a row.
And so I think the past decade-plus is more a U.S. story in terms of our just phenomenal outperformance. European stocks were a bit of a laggard. I think that argument was overplayed. And I think there’s probably also a little bit of a political tint or an ideological tint to some of those characterizations of what was happening in Europe.
What is true is Europe, the United States, China, we are all beginning to struggle with a very significant demographic contraction, where we are now having more deaths than we are births. And so that’s less true in the United States. It’s very true in Europe, especially places like Germany. It’s certainly true in China now and in places like Japan. And so this is something that is going to impact financial markets for the rest of our lives in terms of really what’s happening demographically.
What do you think is the lesson about diversification from all of this? We’ve had these moments where we were so excited about the seven tech companies, the Magnificent Seven in the U.S., that people said, why am I investing in all this other stuff, right? But what’s been the lesson here so far? It really didn’t just start the last two months. You could really go back to last summer when we started to see this great rotation take effect. But what’s been your takeaway about diversification, the value of it during this period?
The lesson around diversification is something that has been reinforced time and time again, Josh, throughout my now 30-year career. And that is that we diversify not because of what we expect to happen in markets. That’s easy. If everything we expected to happen in markets came to fruition, then there would be no need to diversify. If we knew with certainty which stocks were going to outperform, there would be no need to diversify. But we diversify not because of what we expect to happen, but to protect against what we don’t expect to happen. And that’s really the lesson of diversification.
I don’t care how smart you think you are. I don’t care if you could have an army of PhDs working for you. Predicting the future is impossible. Nobody can predict the future. We started our conversation, Josh, with a very simple question that you asked around was I surprised by the outperformance of European stocks. And I said, yeah, because it underperformed for so long.
Now, with the benefit of hindsight, I can look at the data and say, oh, OK, this seems to make sense now. But that’s only clear after the fact. It’s never that clear before the fact. And that’s why we diversify, is to protect against what we don’t expect to happen.
So I think that’s the real lesson, to diversify broadly across different types of investments, across different asset classes, but also within those asset classes. Josh, I call diversification the humility factor in portfolios. It’s our way of admitting that, look, yes, we may have a view on certain companies, or countries, or asset classes, but you really want to be humble and temper that view and diversify broadly, because if you get it wrong, it could be catastrophic.
Think of all those investors that owned internet stocks in the late ’90s. Think of all those investors that owned real estate stocks in the mid-2000s. Think of all those investors that owned, perhaps, Enron or WorldCom, for those of us who are old enough to remember those debacles. And so my comments here aren’t meant to be apocalyptic. It’s just to be humble. Build a diversified portfolio and prepare for the unexpected. That’s the key lesson in investing, is to always prepare for the unexpected.
When we were talking about this earlier, getting ready for this, you also mentioned a really important point about humility, which is that even if you knew all these trends were in place, you wouldn’t necessarily know when the market was going to flip and it was going to start — you wouldn’t know exactly when the sentiment was going to turn and this was going to start to reflect.
It can be the case that U.S. stocks have high valuations relative to European stocks. And you might expect that to compress. But you don’t know when it’s going to start doing that. So there’s also the humility of timing when these changes actually take effect.
And I would say that, Josh, everything you think you know about the economy, about the market, about a specific company or country, everything you think you know, millions of other market participants know the same exact thing. They have the same earnings information that we have. They have all the same information on economic growth, all the same information on currencies and valuations. There is no edge when it comes to global publicly-traded financial markets. And so that’s why humility is the most important factor in any portfolio.
Well, Don, this has been a great discussion. I think the takeaway for everybody is this is exactly why you stay diversified, is you never know when suddenly European stocks are going to be saving your entire portfolio. It hasn’t been the case in a number of years. And then all of a sudden, if you hadn’t been in Europe, you’d be down 5% or almost 10% at certain points this year. And if you had a good split between US and international, your portfolio might be flat or even up a little bit. It’s a remarkable experience. And, Don, thank you so much for being here today to talk about it.
Great. Thank you, Josh. It was fun.
If you’re already a Mercer Advisors client, don’t hesitate to reach out to your advisor for more information. And if you’re not a client but would like more information, visit our website, merceradvisors.com. It starts by setting up a phone call. Thanks so much for being with us here today. This has been Market Perspectives.
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