5 Reasons International Stocks May Underperform in 2017

Key Points

  • Developed market international stocks may underperform U.S. stocks in 2017 for five reasons: rising political risk, fading economic surprises, slower relative growth, currency drag, and sector leadership.

International diversification is important to managing risk and return over the long-term, but developed market international stocks may underperform U.S. stocks in 2017 for five reasons: rising political risk, fading economic surprises, slower relative growth, currency drag and sector leadership.

1. Rising political risk

The U.S. election is now in the past, but Europe’s are coming in 2017—shifting the focus of political risk outside the United States. European equities may lag U.S. equities in response to upcoming votes in Europe, including the French election in April/May 2017 and German elections later in the year. The populist outcomes of the Brexit vote and U.S. election have given rise to fears that similar anti-establishment outcomes in Europe would be more damaging than those in the United Kingdom or United States. Investors may avoid European stocks leading up to the votes only to buy them as the outcome becomes known and the uncertainty fades, as they have around this year’s key votes shown in the chart below.

Post-vote rallies were preceded by pre-vote slumps

Post-vote rallies were preceded by pre-vote slumps

Source: Charles Schwab, Bloomberg data as of 12/11/2016.

2. Fading economic surprises

Economic growth in Europe (which makes up more than 60% of the international developed markets per the MSCI EAFE index) has been exceeding economist expectations, but the momentum of upward surprises may begin to fade as we head into 2017. The Citigroup Economic Surprise Index for the Eurozone, which rises when data exceeds economists’ expectations, has moved up to the level that marked past peaks, as you can see from the chart below. While growth is unlikely to stall, the pace of growth is unlikely to be a positive surprise. Stock markets tend to move on the direction of surprises (positive or negative).

Europe’s positive economic surprises may be peaking

Europe’s positive economic surprises may be peaking

Source: Charles Schwab, Bloomberg data as of 12/11/2016.

3. Slowing relative growth

In 2017, Europe may post a solid 1.6% pace of GDP growth, according to post-U.S. election forecasts from the Organization for Economic Cooperation and Development (OECD). That pace was fast enough to exceed U.S. growth of 1.5% in 2016. But Europe may lag the U.S. economy in 2017 as growth in the U.S. is forecast to accelerate to 2.3%, as you can see in the chart below. The connection from GDP to earnings and market performance isn’t always strong given many variables, but on the margin this favors U.S. stocks.

OECD sees better 2017 world economic growth led by the U.S

OECD sees better 2017 world economic growth led by the U.S.

Organization for Economic Cooperation and Development (OECD) forecasts for Gross Domestic Product (GDP) as of 11/28/2016
http://www.oecd.org/eco/outlook/Escaping-the-low-growth-trap-press-handout-summary-of-projections-oecd-economic-outlook-november-2016.pdf

Source: Charles Schwab, Organization for Economic Cooperation and Development data as of 11/28/2016.

4. Currency drag

A rise in the value of the U.S. dollar acts a drag on international developed market returns for U.S.-based investors. If the dollar continues the fourth quarter rise relative to the currencies of major trading partners (see chart below) as the market anticipated Fed interest rate increases, it may erode returns on non-dollar investments. In addition, the corresponding drop in the value of the euro and yen, along with a rise in inflation expectations, have prompted the European Central Bank (ECB) to slow their quantitative easing (QE) asset purchase program that may have helped to support Europe’s markets. Alternatively, a return to dollar weakness would act as a boost to international stock returns for U.S.-based investors.

U.S. dollar has rebounded to where it started 2016

U.S. dollar has rebounded to where it started 2016

Source: Charles Schwab, Bloomberg data as of 12/11/2016.

5. Sector leadership

Outperformance by technology stocks has historically favored U.S. stocks over developed international stocks, as you can see in the chart below. The tech sector may continue to lead the markets in 2017, boosted by the spending of global business leaders as confidence returns along with sales growth for the first time in several years.  Alternatively, a sustained shift to leadership by financials would favor developed international stocks over U.S. stocks, given the relative stock market weightings in those sectors.

Technology sector outperformance usually means U.S. outperformance

Technology sector outperformance usually means U.S. outperformance

*Relative year-over-year total return measured in US dollars.

Source: Charles Schwab, Bloomberg data as of 12/11/2016.

Staying home

Although there may be some bright spots, the overall developed international stock market may lag the U.S. stock market again in 2017. Although it may be tempting to only invest in the U.S., keep in mind that most investors greatly overweight their home country in their portfolio (for some eye-opening insights read our recent commentary: Your portfolio may be less diversified than you think). While this can sometimes mean better short-term performance, it can significantly limit sector diversification, the ability to manage volatility and the achievement of investment objectives over the long-term.

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