EFA - EFA: Why U.S. Stocks May Be Left In The Dust

2023-04-25 15:06:09 ET

Summary

• The Macro environment suggests that international equities could outperform US ones going forward.
• The EFA is a good way of getting exposure to developed economies outside the US.
• Select international stocks could perform even better moving forward.

Thesis Summary

The last few decades have been characterized by low inflation/deflation and a strong dollar. In this regime, investors have found good returns in risky "growth" stocks, while commodities, value and international equities have lagged behind.

However, I believe we could be setting ourselves up for a decade of higher overall inflation and a weakening dollar, where the laggards of yesterday will be the leaders of tomorrow.

For this reason, I believe investors would be well advised to diversify into international stocks, something that can be done easily by investing in the iShares MSCI EAFE ETF ( EFA )

The Dollar Is No Longer Unchallenged

Over the last few years, investors have benefitted from a very accommodative monetary policy, with a regime of lowering interest rates and an increasing Fed Balance Sheet.

The US was able to do this since it was coming from a prolonged period of high-interest rates, and the dollar was unrivalled as the world's reserve currency.

The situation today is much different, with interest rates near zero for some years now, a bloated Fed balance sheet, and a dollar that is no longer unchallenged.

As we can see in the image above, over the last 20 years, a lot more transactions have been carried out using emerging market currencies, with the Chinese RMB leading the pack.

The world is undergoing a certain degree of de-globalization and even long-time US partners. like Saudi Arabia is choosing to trade their oil in Yuan.

A Change Of Regime

Don't get me wrong, I'm in no way saying the US dollar or its economy is on the brink of collapse. However, there is a clear trend emerging, a trend which, in my opinion, is reminiscent of the 1970s. This was a time characterized by the abandonment of the gold standard, high inflation and numerous recessions, including inflationary recessions. And this is exactly what could be in store moving forward.

The dollar is slowly being abandoned. Inflation is starting to pick up domestically, and the Fed is going to struggle to reign it in.

We are already seeing this happen. The fast pace of interest rate increases has already shaken the financial system . And how do we combat this? Bail-outs, emergency loans and what appears to be an impending Fed pivot.

The red dot shows that rate cuts are already expected to take place at some point this year.

And while disinflation is currently trending down, once this genie is out of the bottle, it's hard to get it back in.

The next 10 years of inflation could look something like this:

As we can see, inflation gave us three distinct peaks, each higher than the previous, starting in 1970, and each accompanied by a recession.

What Assets Will outperform?

Given this inflation and macro outlook, it's likely that we could see a repeat off the situation below in the coming decade.

As we can see, from 1971 to 1981, the SPX ( SPX ) gave investors mild gains, while Gold ( GLD ) and Oil ( USO ) appreciated very significantly.

The stocks that did perform better, however, were those from foreign countries.

The chart below compares the returns between US equities and the MSCI EAFE, which are international equities from developed countries excluding Canada and the US.

When the line is going down, it shows outperformance in the EAFE. As we can see, this is what happened at the beginning of the chart, which starts around 1970, and all the way until 1985.

Time To Buy EAFE

US stocks have been very good to investors since 2010, but this trend is reversing. For this reason, I'd advise investors to gain exposure to international equities through the EAFE.

The EFA is a very well-diversified ETF, with over 823 holdings giving exposure to Europe, Australia, Asia, and the Far East.

In terms of sector distribution, Financials, Industrials and Health Care combined makeup almost half of the holding distribution. The top holding is Nestle S.A. ( OTCPK:NSRGY ), followed by Novo Nordisk ( NVO ) a healthcare company focusing on diabetes and obesity.

Overall, I like the heavy exposure to healthcare and industries, though, financials could be an underperformer moving forward.

With an aggregate P/B ratio of 1.77 and a P/E ratio of 14.15, according to the fund's website , the fund is reasonably valued.

Over the last year, the EFA has actually been one of the best performers out of its peers, second only to the iShares ESG Aware MSCI EAFE ETF ( ESGD ), which invests in similar regions, but only in companies that are deemed socially conscious.

Final Thoughts

In conclusion, I believe the stage is set for a prolonged period of underperformance in US equities. International equities in Europe, Asia and the Far East can offer a lot better value, and this can be easily captured through the EFA ETF. However, I also advise looking into select stocks in these areas, which is what I do in my marketplace.

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