Improving economic growth in Europe and Japan, coupled with attractive valuations and a weak dollar, have produced the most encouraging outlook for international investing in years. Investor sentiment has soared as political uncertainty diminished.
International equities are outpacing U.S. equities for the first time in nearly a decade. That trend may continue as Europe and Japan have taken longer to recover from the global financial crisis and, therefore, potentially have more room to run.
The European Central Bank and Bank of Japan continue to inject massive amounts of stimulus into their respective economies, priming the pump for additional growth and inflation in the years ahead.
Europe has enjoyed a remarkable recovery in recent months, driven by a powerful combination of central bank stimulus, ultra-low interest rates and improving growth. But perhaps the most important influence on investor sentiment is what didn’t happen in 2017: the European Union didn’t collapse under the weight of nationalist, anti-EU movements that had posed a significant threat during a year that featured pivotal elections in France and Germany.
If anything, the future of the 28-nation economic union looks stronger now than it has in years, despite the U.K.’s expected departure in 2019. Fears that France, Italy and Greece might follow the U.K.’s Brexit path have dissipated as continental Europe has essentially lined up in support of the EU’s governing authority. As a result, the euro has strengthened against the dollar and Europe has enjoyed a surge of financial asset inflows.
Meanwhile, euro-zone economic growth is gradually catching up to the U.S. Third-quarter GDP in the 19-member euro zone grew at an annualized rate of 2.6%, and the unemployment rate has fallen to 8.7%, its lowest level since 2009. Moreover, corporate earnings are up across the board, led by a strong rebound in the energy, mining and banking sectors, thanks in part to the strengthening global economy.
Europe’s manufacturing activity — previously a weak point on the region’s path to recovery — has increased dramatically, supported by rising orders for everything from new aircraft to highly sophisticated technology components. In fact, many euro-zone factories have reported labor shortages amid the surging demand. Factory activity has expanded in all major European nations, led by manufacturing powerhouse Germany and the neighboring Netherlands.
Despite these encouraging signs, however, the European economy continues to struggle with deflationary pressures. Core inflation, excluding volatile food and energy prices, was just 0.9% in November, matching its lowest level since March and far below the European Central Bank’s 2% target. This persistently weak trend prompted the ECB to extend its massive bond-buying stimulus program through September 2018 in an attempt to boost lending and support further economic growth.
Currency trends have formed a nice tailwind for dollar-based investors in international equities. After the dollar peaked in early 2017, the currency effect on overseas investments reversed from previous years, when a strong dollar hurt returns. With the dollar slipping in 2017, European equities have far outpaced U.S. stocks in dollar terms. The dollar also has declined against many other currencies, including the yen, producing a similar tailwind for Japanese equities.
Investors should keep a close eye on this trend, however. Improving U.S. economic growth, gradually rising U.S. interest rates and the European Central Bank’s stimulus-program extension combined to push the dollar higher in September and October. Capital Group currencies analyst Jens Sondergaard believes this near-term dollar strength will fade, and that the dollar will continue its decline through 2018 and into 2019.