There’s a scene in Peter Jackson’s adaptation of Tolkien’s Fellowship of the Rings where Frodo and the Gang are deep in the Mines of Moria and under attack from all sides. In the movie, the actor portraying Boromir says in a sardonic tone, “They have a Cave Troll.” No big deal, the hits just keep coming. So, what does this have to do with stocks? Well, for investors in stocks outside of the United States, it’s easy to feel a little bit like Boromir. We were positive on international stocks as we entered 2022, but just when it appeared that the late 2021 Omicron scare would be less a threat than initially considered, the three bogeymen of rising energy prices, a stronger dollar, and war appeared in short succession. It might be easy to see all these headlines and lose hope. But, somewhat curiously, markets haven’t seemed to throw in the towel.
The S&P 500, a bellwether index of US stocks is down 18.7% this year, largely on concerns around inflation and rising interest rates. We’ve discussed at length the fact that earnings have grown this year in the US. What’s driven markets lower is the price people are willing to pay for those earnings. Outside of the US, however, markets are doing better. With the litany of headwinds facing international markets this comes as a welcome surprise.
The MSCI EAFE Index, an index that measures the performance of stocks in developed countries in Europe, Australasia, and the Far East, is down 14.9% this year. Down double digits is perhaps cold comfort, but what’s more interesting is when we look at the performance of an ETF that tracks the EAFE while hedging the effects of currency movements, we see an even better number, with a hedged EAFE index down just 7.39% this year. An easy way to think about this is that when the dollar is up, foreign stocks are worth less when measured in dollars. When the dollar is down, foreign stocks are worth more. When we compare the movements of EAFE stocks in their own currencies (think big international companies) to the S&P 500 we see outperformance of over 10%, with war, inflation, and rising energy prices all front-page news!
All this discussion might provoke a couple of questions. One may be, “Why are international stocks behaving this way?” The other may be, “What will it take to see international stocks go up?” On the first question, our view goes back to one of our reasons we were positive on international stocks going into the year – investor expectations. A great way to measure investor expectations is to look at valuations. As the chart below illustrates, we ended 2021 with foreign stocks trading at a 33% discount to US stocks, one of the largest discounts in history. When valuations are this low, stocks tend not to overreact to negative news as its mostly priced in.
As to the second question, we think the near-term landscape is rocky. It will take time and statecraft to resolve the conflict in Ukraine. If and when that occurs, energy prices would likely settle down. This would then allow the European Central Bank to respond to inflation by tightening monetary policy, and buoying the Euro against the US Dollar. Markets feel like a slog right now. But the only way around a slog is through it. Reversal in any or all of these factors could be the turning of the tide for international stocks.
Written by Alex Durbin, Portfolio Manager