Three BlackRock portfolio managers' views on international equities

• Propelled by the Fed’s aggressive tightening campaign, the U.S. dollar reached its highest level in 20 years in 2022.¹ This has started to reverse, removing a key headwind and creating more support for ex-U.S. equities.
• As 2023 gets underway, supply chain challenges that held back international equities are abating, in large part due to the re-opening of China post-COVID and supply chain normalization.
• Emerging market (EM) equities are reflecting already higher interest rates in many markets, as well as inflation that is within normal bounds for these markets. On average, international equities are still trading at valuation discounts to the U.S.,² while we think there is potential for relatively stronger earnings and profit margins for international relative to U.S. equities.
• Based on the above, BlackRock Fundamental Equities portfolio managers see opportunities in developed ex-U.S. and emerging markets.

The banking-related events in the U.S. and Europe in March have created some headwinds and exposed some additional vulnerabilities associated with rate rises. Regardless of the mid- to long-term implications, advisors remain significantly underweight international equities. Once the dust settles around current risks to the financial system, BlackRock Fundamental Equities portfolio managers see reasons for offshore markets to continue their outperformance. 

Recently, institutional investors have been migrating more capital overseas, based on our proprietary analysis. The chart below shows where investors report themselves to be overweight and underweight (x-axis) versus the 3-month average normalized ETF flows in those same sectors (y-axis).

Strong inflows at the start of this year into U.S.-listed ETFs that target ex-U.S. markets showed a similar trend, with more than $6 billion of net inflows into broad emerging market ETFs, $9 billion into international developed ETFs and another $1 billion into single country ETFs.³

International stocks have historically outperformed in periods of lower U.S. stock returns when we analyze 10-year rolling periods from March 1986 to December 2022. Historically, international stocks outperformed 96% of the time when U.S. stocks returned less than 6% and 100% of the time when U.S. stocks returned less than 4%.⁴

International stocks could benefit from a confluence of conditions that investors have not seen in some time.

While the U.S. dollar could strengthen in the near-term, given the current more cautious outlook, we do not think the greenback will get back to its peak, as we believe we are close to the end of this hiking cycle. Any pause in the Fed’s rate hikes, alongside ongoing China re-opening – which we see reducing demand for perceived safe-haven assets – would likely spur a further U.S. dollar retreat.

Historically, a weak dollar has been associated with strong international equity performance (See chart below). We see three key reasons for this:

• strengthened local currency typically rewards dollar-based investors with direct current returns;
• a weaker U.S dollar relieves pressure on EM economies, many of which have high external debt obligations denominated in USD; and
• a weaker dollar means more purchasing power, and therefore spending, from local consumers around the world. In fact, in each of the last five times the dollar reached its peaked, international investors were rewarded with outsized returns in the following period (see chart below).

U.S. dollar peaks historically coincide with international rallies

After hitting a 20-year high in 2022, recent U.S. dollar weakness is fueling optimism for international stocks5

According to the International Energy Agency, “the preeminent driver of [global] 2023 GDP and oil demand growth will be the timing and pace of China’s post-lockdown recovery.”⁶ The lifting of activity restrictions, coupled with supportive monetary, fiscal, and regulatory policy, creates a potential opportunity for positive real GDP growth above 6% in the world’s second-largest economy in 2023, a significant jump from 3% in 2022.⁷ BlackRock Fundamental Equities portfolio managers believe China’s longer-term growth could be slower than before the pandemic, largely owing to heightened geopolitical risks and falling demand for Chinese exports, But, we saw the MSCI China Index return 19% from October 2022 to March 2023⁸ – and we think this rally not only has room to run but could ignite a broader rally in ex-U.S. equities. Chinese oil consumption is also rising sharply in response to reopening (see chart below on Chinese Oil Demand).⁹

Prior to the pandemic, China was the world’s third-largest consumer of liquified natural gas, second-largest oil-consumer, and largest electricity user.¹⁰ As China reopens and demand rises, EM exporters with strong ties to China are likely to benefit.

Oil demand rising as China reopens

Barrels of oil per day (millions)

At the same time as China’s re-opening is easing the last major COVID strain on global supply chains, countries around the world, especially in Europe, have spent the past year adapting their economies to the economic fallout of the ongoing war in Ukraine. According to Global Supply Chain Pressure Index data from January 2023, supply chain pressure has declined 66% since April 2022, when supply chains were first disrupted due to the conflict in Ukraine, and nearly 80% since December 2021, the peak of disruption from COVID-19.¹¹ The resulting easing of prices and greater availability of goods is likely to drive local consumption across Europe and Japan, which could be a major boon to developed market equities.

“While inflation is certainly elevated in emerging markets, it is still within the normal long-term range,” notes Gordon Fraser, portfolio manager of the BlackRock Emerging Markets Fund (MADCX). “Moreover, emerging market countries, broadly speaking, have been ahead of the curve in tightening efforts, particularly in Latin America and Eastern Europe. This is a fundamentally different situation compared to the U.S. where the Fed is earlier in its tightening cycle relative to emerging market central banks and excess broad money creation has yet to be absorbed.”

As mentioned previously, China’s reopening brightens the view on international equities broadly – but especially for emerging markets – where valuations make this an attractive entry point. In 2022, EM stocks, as measured by the MSCI Emerging Markets Index, traded close to price-to-book and price-to-earnings levels seen during the 2008-2009 Global Financial Crisis.¹²

Emerging markets are still cheaper than the U.S.

Price-to-book ratios of the MSCI Emerging Markets Index and the MSCI USA Index 

Price-to-earnings ratios of the MSCI Emerging Markets Index and the MSCI USA Index 

International markets are trading at a significant discount to U.S. counterparts even after strong year-to-date performance. As of March month-end, the P/E ratio of the MSCI ACWI ex USA Index was 47% lower than that of the S&P 500 Index.¹³ But today, the story has moved beyond valuations. While there is generally a discount between DM ex-U.S. and U.S. equities, today’s earnings story is novel.

Company earnings in Europe have been better than feared, as lower energy prices and renewed demand from China boost the economy. Europe is actually the only region globally where 2024 earnings revisions are back in positive territory. We see many opportunities for investors in the region, although it is important to be selective as tighter financial conditions and profit-margin pressure may bring dispersion across sectors and within industries.

“Luxury goods in particular look like an interesting opportunity abroad,” according to Olivia Treharne, manager of the BlackRock International Dividend Fund (BISIX) “These are companies with strong irreplicable brands that can pass on high costs to their customers. Their customers are therefore less likely to be impacted by the inflationary environment and more likely to continue spending. China’s reopening may also provide a boost to some of the more discretionary areas of consumer spending.”

Overseas companies are keeping more from their earnings… 

Profitability margins of U.S. versus international equities

…and forecast higher corporate earnings growth

Corporate earnings estimates of U.S. versus international equities

Another key factor contributing to positive international performance relative to U.S. performance is sector composition. We would argue that, likewise, sector composition has been the driver of outsized U.S. returns the last few years. But this is changing. In the U.S., technology companies have the largest weight in the S&P 500 Index, and many are beginning to see earnings downgrades. Meanwhile, European equities have a stronger value-bias than U.S. equities and could stand to benefit in an environment of higher inflation and interest rates.

James Bristow, who manages the BlackRock International Fund (MAILX), comments that, “despite an uncertain environment, we continue to find opportunities across sectors and markets, but uncovering and assessing these ideas requires being nimble and selective. We see active stock selection and precision exposures with ETFs as the best ways to capture alpha in this environment.”

While risks and uncertainties remain, BlackRock Fundamental Equities portfolio managers continue to believe there is ample opportunity abroad, with the potential for shifting market conditions favoring international equities going forward. Investors looking for exposure have a wide range of tools to choose from across active mutual funds and index ETFs targeting broad international equities, developed markets, emerging markets and even individual countries.