Overseas Stocks Should Outpace US

07/11/2007 12:00 am EST

Focus: GLOBAL

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, Standard & Poor’s International Equity Strategist, says foreign markets have the wind at their backs and will likely continue to outperform US stocks.

Global economic growth shows no signs of deteriorating—a surprise to some and a concern to many. The fear is that more aggressive central bank tightening will be required to stave off inflation, which could have dire consequences for future profit growth.

Standard & Poor’s continues to believe inflation fears are overblown. We still expect benign core inflation, and not much action from the Federal Reserve, over the rest of the year, with an interest-rate cut possible in early 2008.

Globally, inflation does not appear to be a worry. Europe continues to experience improving productivity, and Japan continues to flirt with deflation, not inflation. As for emerging markets, inflation has fallen dramatically in recent years.

In sum, we think recent volatility represents a long-term buying opportunity, particularly for international equities. Despite five years of torrid outperformance, international equities remain more attractively valued than US shares.

The MSCI EAFE (Europe, Australasia, and the Far East) index, the leading developed international benchmark, trades at [around 15x] 2007 earnings estimates. Earnings are expected to rise 9.8% in 2007, resulting in a P/E-to-growth (PEG) ratio of only 1.5.

In comparison, the S&P 500 index trades at 16.2 x 2007 earnings, which are expected to improve 7.4% in 2007, equating to a 2.2 PEG ratio. In addition, international stocks have higher dividend yields than their US counterparts. The MSCI EAFE currently yields 2.8% vs. only 1.8% for the S&P 500.

In terms of global mergers and acquisitions, momentum may slow, but we think the game is far from over. According to data from Thomson Financial, worldwide announced M&A transaction volume recently passed the $2 trillion mark, putting 2007 on a pace to easily surpass the record 2006 total of $3.67 trillion. Non- US markets accounted for about 55% of the announced total.

While higher borrowing costs may prove a modest drag on foreign M&A, we do not believe deal flow is about to grind to a halt. Among the world’s leading economies, ten-year government bond yields remain well below the earnings yields of their respective benchmark equity indexes. Hence, the potential return on equity for future deals remains higher than the cost of capital.

In addition, global liquidity remains abundant thanks to record foreign-exchange reserves in China, OPEC countries, and other emerging economies. Another factor is ongoing carry trade-driven funding, amid relatively low global capital market volatility and wide interest-rate disparities between global currencies. And strategically, international multinationals are increasingly capitalizing on faster Asian, Eastern European, and Latin American revenue growth, while simultaneously taking advantage of those regions’ lower labor costs.

Given that S&P believes current volatility represents a healthy pause and not the beginning of a new bear market, we maintain our 65% equity allocation, divided between 40% domestic and 25% foreign.

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