What’s Behind the Strength in Foreign Developed Equities?

by:
Director, Product Management, New York Life/MainStay Investments

Foreign developed equities, as measured by the MSCI EAFE Index, are off to a strong start in 2017, returning close to 14% through the end of May. After trailing the S&P 500 Index for four consecutive years (2013 – 2016)1, the resurgence in foreign equities has generated tremendous investor interest – with good reason.

To gain perspective on the recent strength in foreign equities and to assess the outlook for the asset class, we spoke with J. Christian Kirtley, CFA, Portfolio Manager, and Senior Research Analyst with the International Choice Team at Epoch Investment Partners (“Epoch”). Epoch serves as sub-advisor for multiple mutual funds offered by New York Life/MainStay Investments.

Improving Fundamentals Driven by Organic Growth

So far in 2017, earnings throughout much of the developed world, Europe in particular, have generally been high quality and driven by top-line growth, beating estimates much more often than not. Leaders have primarily been from cyclical areas of the market, including information technology, consumer services, capital goods, and materials.

According to UBS, earnings revisions in Europe have been positive for the last six months (fourth quarter 2016 and first quarter 2017) and are the most positive they have been since 2010, thus adding to the body of evidence for a turn in the European profit cycle. European earnings are on track to be up approximately 15% year-over-year in 2017, and the amount of full-year guidance upgrades has outnumbered downgrades.

Figure 1 – European Earnings Momentum Continues to Trend Higher

Source: Thomson Reuters Datastream, UBS European Equity Strategy, as of 4/30/17. Past performance is no guarantee of future results. The MSCI Europe Index represents the performance of large- and mid-cap equities across 15 developed countries in Europe. The Index covers approximately 85% of the free float-adjusted market capitalization in each country. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. *Aggregate Number is the difference between the # of monthly sell-side analyst upgrades versus downgrades. **Index Level is denominated in local currency (euro).

Free Cash Flow Growth as a Measure of Corporate Strength

Although earnings growth is an important driver of equity returns, it does not, by itself, provide sufficient information to form a panoramic view of a company’s health. Free cash flow (FCF) analysis, on the other hand, is a more transparent and reliable measure of corporate strength.

Given lower equity valuations, lower leverage, and lower investment-grade borrowing costs, Epoch believes share repurchase activity makes more sense for European companies. With the unwind of quantitative easing, multiple expansion will likely have less of an influence on equity returns in the current market cycle. Given this, a free cash flow investment approach is especially timely.

Epoch believes European firms may experience an uptick in both share repurchase and mergers and acquisitions (M&A) activity. With the U.S. dollar strengthening considerably in recent years, relative to other major currencies (i.e., British pound and euro), we may see more U.S.-based firms attempting to buy European and U.K.-based companies.

Risk Management

Epoch evaluates fundamentals and continues to monitor the impact of geopolitical risk on portfolio holdings. Elections in Europe, tensions in North Korea and the Middle East, as well as proposed tax and regulatory reforms by the Trump administration bear watching. While it is difficult to predict major market events, a high conviction strategy, built on a collection of fundamentally strong businesses compounding at attractive rates of return, may help navigate market volatility.

Portfolio Positioning

Epoch remains focused on the long-term drivers of equity returns. With the unwind of quantitative easing, we are entering a new equity regime that will likely be dominated by earnings growth (captured through a cash flow lens) and dividends. Careful stock selection will become increasingly important. The International Choice Team is constructive on a select group of quality companies with strong balance sheets and diversified drivers of free cash flow.

Conclusion

We believe the growth potential for foreign equities remains very attractive. A cyclical upswing appears to be taking place across most of the globe that will be supportive of profits. Identifying companies that can create excess free cash flow, researching the risks to those cash flows, and then constructing portfolios that diversify risks will be key to generating attractive risk-adjusted returns for investors over the medium and long terms.

1. Source: Morningstar.

The opinions expressed are those of Epoch Investment Partners, Inc. as of the date of this report and are subject to change. There is no guarantee that any forecast made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment.

All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market.

Foreign securities may be subject to greater risk than domestic investing. These may include securities markets that are less efficient, less liquid, and more volatile than those in the United States, as well as foreign currency fluctuations and different governmental regulatory concerns.

The MSCI EAFE Index consists of international stocks representing the developed world outside of North America.

The S&P 500 Index is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Past performance is no guarantee of future results. An investment cannot be made in an index.

New York Life Investment Management LLC engages the services of federally registered advisors. Epoch Investment Partners, Inc. is unaffiliated with New York Life Investments. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Kevin Kloski, CFA

Director, Product Management, New York Life/MainStay Investments

Kevin recently worked as a Portfolio Specialist at Voya Investment Management where he served as a subject matter expert on fundamental and quantitative equity strategies.

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