To EAFE Or Not to EAFE, That Is the Question.
While we within Burrows Capital Investment Strategy Group ponder many things, most are less weighty than the question posed by Hamlet in the Shakespeare play of the same name.Instead, we use this, the (possibly) most quoted line in English literature to frame the question we have been asking ourselves –is it time to increase exposure to developed international equity markets.
The MSCI EAFE Index (“EAFE”), meaning Europe, Australasia, and Far East, is an equity index which captures large and mid-cap representation across 21 developed countries around the world, excluding the US and Canada. With 783 constituents or companies, the index covers approximately 85 percent of the free float-adjusted market capitalization in each country. It is also the oldest international stock index, dating back to 1986.
When viewed through the lens of the MSCI All Country World Index (“ACWI”), foreign markets (also known as the ACWI Ex-US) comprise 38.5 percent of the global equity opportunity set. EAFE is the largest segment of foreign equities, comprising 63% of the non-US market (and over 24 percent of the global market), so in short, investors cannot ignore the EAFE market, or they do so at the risk of their potential returns.
Whilst investors can choose to simply allocate their equity risk to the ACWI (the “set it and forget it” strategy), we believe investors should have a more tactical approach to investing and look at foreign markets and US markets independently. Note this does not mean a trading approach, moving in and out of asset classes, regions, sectors, etc. and hoping to capture the highs and lows within markets (which works for some, but it is not our approach). Rather, we believe that investors should have a longer-term view (strategic allocation) and a shorter-term view (tactical allocation), which changes strategic allocations to best capture near-term opportunities. It is through this lens which we ask the question: to EAFE or not to EAFE?
As the following chart shows, investors have been rewarded for an overweight to the MSCI USA Index (“US”).
While this may be the case, the US still has not consistently outperformed its EAFE counterpart; looking at rolling returns, we can see there are periods where the EAFE has outperformed the US.
Perhaps best shown through relative returns:
The EAFE outperformed the US from the middle of October 2023, until the end of December 2023 as seen above. This outperformance was then curtailed by the resurgence of the largest of US large caps to start 2024, particularly led by NVIDIA. This then leads to the question – is the EAFE going to resume its period of outperformance?
By many measures, the EAFE looks cheap relative to the US. On a price to earnings basis (“P/E”), the EAFE typically trades at a discount to the US, but that discount is now near its widest level in 20 years (see chart below):
A look at the historical price to earnings ratio through a standard deviation lens, which measures variance around an average, also reveals the EAFE is also “cheap” relative to other equity indices.
Like the price earnings ratio, the price to book ratio (the amount the company is valued by markets versus its accounting value) is trading near its average, but significantly below its average relative to the US equity market (the US historically trades at a premium versus EAFE but is well above its average value).
Finally, the dividend yield of both markets is also historically low (in a relative sense), as the US is below average and EAFE is above average. Historically, the EAFE has had a higher dividend yield than the US due to more of its members being in slower growth businesses, which return more in the form of dividends to shareholders.
What accounts for many of these disparities is the industry sector composition of the indices. As the chart and table below show, the US has a far larger allocation to the faster growing information technology and communication services sectors.
These sectors typically have higher earnings growth, hence the higher price to earnings, price to book multiples and lower dividend yields. This helps explain the outperformance in years when technology and related sectors are up as well as underperformance when they are down (2022, for example). Due to this dynamic, EAFE can not only stand on its own merits, but can serve as a “hedge” against a drawdown in mega-cap tech stocks.
There are, of course, other considerations which will help shape relative returns like economic growth. The chart and tables below show the estimated growth of the US versus the larger EAFE blocs.
There is also the currency effect; a positive correlation exists between US dollar strength and major US equity indices. In other words, a strong dollar tends to lead to US market outperformance against the EAFE whilst a weak US dollar helps EAFE relative to the US market. One explanation for this can be that foreign investors convert their home currency into US dollars to buy stocks, further increasing prices; however, correlation does not imply causation.
We think investors have become very “US centric” and biased in their equity portfolio construction and outlook. It is important to continually review the universe of options to help increase the probability of outperformance against a benchmark. That said, whilst we believe that the EAFE is “cheap” relative to US markets, we have not identified the catalyst that will cause it to revalue higher relative to the US.
Should the US see a (relative) resurgence in inflation or a drop in economic growth (and the knock-on currency effect), it could be the catalyst for EAFE outperformance. We are, however, watching the largest cap names in the US for signs of stress in both growth rates and valuations (the “Magnificent Seven” trade at a P/E of 38 as a group), as a drop in information technology or communication services could also serve as a catalyst for outperformance.
As a result, we remain underweight developed international equity, but will be looking for signs that it is time to move to neutral or overweight.