Weekly Market Commentary
INTERNATIONAL STOCKS WE LOOK EAST TO JAPAN
Burt White Chief Investment Officer, LPL Financial
Matthew E. Peterson, Chief Wealth Strategist, LPL Financial
After years of earnings recession, improving corporate earnings and relatively low valuations are making overseas investments more attractive. For the all consternation over and discussion of geopolitical and macro-economic issues, what ultimately drives stocks everywhere are corporate earnings, and earnings almost everywhere are increasing. Furthermore, analysts’ estimates of future earnings have also been increasing, despite lingering uncertainties around the impact of the Brexit vote and the U.S. election. We have already seen a dramatic increase in earnings for emerging markets (EM) in 2016, while 2017 expectations for both EM and developed market stocks, as measured by the MSCI EAFE Index, continue to improve. The biggest positive surprise may be coming from Japan as its market climate restructures. Valuations are generally attractive on both an absolute and relative basis across most markets. We have been relatively constructive on EM for most of 2016 and are now looking at other international markets.
END OF THE DROUGHT
Before something can go up, it must stop going down. Corporate earnings have been declining since Q2 2011 for both the MSCI EAFE Index and MSCI Emerging Markets Index [Figure 1]. Note that what gets referred to as the earnings recession for the S&P 500 was very shallow by comparison, and only began in Q3 2014. Only a handful of companies in the MSCI EAFE Index have reported Q4 2016 earnings as of January 20, 2017. However, expectations are for a strong quarter and for calendar year 2016 earnings to end with just over 1% growth. While hardly inspiring, if the year should show positive growth as expected, it would be the first annual growth since 2011. Some of this growth will come from the energy and energy-related industrial sectors, in which earnings have been declining along with oil prices in 2015 and early 2016. The positive impact of oil over $45/barrel will be evident in Q4 2016 earnings, but it will not be until 2017 that the effect is more fully apparent.
The drought in EM earnings growth turned in Q1 2016. Though less than 3% of EM countries have reported earnings yet for Q1 2017, market expectations are for over 17% earnings growth for the index for 2016. As in developed markets, earnings for energy, but also materials stocks have been rebounding with higher prices globally.
WHEN IT RAINS, IT POURS
We often say it’s earnings that determine stock market performance in the long run. However, we are also very interested in the shorter-term impact of estimate changes for future earnings. For almost all international markets, earnings forecasts for 2017 have increased since September 30, 2016 [Figure 2]. A number of major geopolitical events have occurred since then, including the likelihood the U.K.’s departure from the European Union will happen with more substantive changes (the so-called “hard Brexit”), an anti-European vote in Italy, and the election of Donald Trump, who has promised a more protectionist U.S. trade policy. Each of these events could have dampened earnings forecasts and they still may diminish earnings as the year unfolds. Yet despite these events, and others looming on the horizon, analysts have been increasing their 2017 estimates.
Valuations continue to be attractive in overseas markets [Figure 3]. Typically, we look at this sort of data over a shorter time frame. This longer perspective shows how harmonized global equity markets (including the S&P 500) have become.
Market movements are more synchronous now than they used to be, which is a negative for investors looking for increased diversification overseas. However, if markets are indeed more correlated to each other, that implies that buying when markets are attractively valued may be even more important. The earnings acceleration overseas, combined with lower valuations, strengthen our conviction on emerging markets, despite the heightened risks, and suggest that developed markets may be looking more attractive as well.
THE EAST LOOKING MORE WESTERN
The Japanese economy, and for the most part its stock market, has been waning for so long it’s hard to remember that Japan used to matter to global investors. However, even after years of stagnation Japan is still the world’s third-largest economy and second-largest stock market by overall capitalization at approximately 8% of global stock markets combined. Japan may finally represent a long-term investment opportunity. Why? First, there is earnings growth potential, likely to be 4.5% for 2016 and expectations for 11.7% growth for 2017.
The bigger issue for Japan is the potential change in how investors view the country and its stocks as a result of a significant change in how the country and the companies in it operate. This shift usually only happens in emerging markets. Japan has seen major changes since its equity market peaked in 1989. Historically, the Japanese market had features that made the market relatively unattractive. Many of these attributes have evolved [Figure 4] in some ways making the Japanese market more conventional, and therefore perhaps more attractive to foreign investors.
Japan used to be an expensive market with price-to-earnings (PE) ratios regularly above 70, and at times in the hundreds, during some of the market peaks, such as 2002 and 2008. Valuations in Japan were high for two reasons. First, Japan had extraordinary low interest rates for years, but Japan is no longer alone in having low or negative interest rates. Second, for all their success in gaining market share and creating major global brands, Japanese companies were not as efficient, as measured by statistics like return on equity (ROE) and were not as profitable as similar companies based in other countries.
There were many reasons for why the Japanese market was different from western markets, and many of these reasons are changing. Japanese companies often offered lifetime employment; firing or laying off workers was a rare concept in Japan, even during periods of recession or changing business conditions. Today, fewer than 10% of Japanese companies still use lifetime contracts. Being able to lay off workers has had several impacts on business in Japan; they are now more profitable because they are able to react to economic changes. But also, Japanese companies are more inclined to hire and Japan’s workforce is growing, despite an overall aging population. This increase in workforce has increased consumer spending, and therefore boosted Japanese consumer stocks.
The final structural component in the potential Japanese equity revival is the undoing of the system of cross holdings across Japanese companies, known as the keiretsu. Under the keiretsu system, Japanese companies often own shares of each other. This suggests that sometimes corporate decisions are made for the benefit of other companies under the umbrella, rather than profit maximization or shareholder return. The number of shares held within the keiretsu system has declined dramatically. As a result, the percentage of Japanese shares held by foreigners has increased, as investors gain condfidence that corporate managers are working for them, not for themselves, their employees or other companies within the keiretsu.
Improved earnings oversees are motivating global investors to examine areas that have been out of favor, either for the past few years, like emerging markets, or the past few decades, like Japan. What they are finding are improving expectations for future earnings, more attractive valuations, and in the case of Japan, positive structural changes in the way companies operate. LPL Research has been positive on emerging markets for some time, and are now looking to the more developed markets for opportunities.* — —
*As noted in our Outlook 2017: Gauging Market Milestones, we expect mid-single-digit returns for the S&P 500 in 2017 and the continuation of the nearly eight-year-old bull market, consistent with historical mid-to-late economic cycle performance. We expect S&P 500 gains to be driven by: 1) a pickup in U.S. economic growth partly due to fiscal stimulus; 2) mid- to high-single-digit earnings gains; 3) an expansion in bank lending; and 4) a stable price-to-earnings ratio (PE) of 18–19. Gains will likely come with increased volatility as the economic cycle ages.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
Because of their narrow focus, specialty sector investing, such as healthcare, financials, or energy, will be subject to greater volatility than investing more broadly across many sectors and companies.
Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio.
All investing involves risk including loss of principal.
The Standard & Poor's 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The MSCI EAFE Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises the MSCI country indexes that represent developed markets outside of North America: Europe, Australasia, and the Far East.
The MSCI Emerging Markets Index captures large and mid cap representation across 23 emerging markets (EM) countries. With 822 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI Japan Index is a free float-adjusted, market capitalization-weighted index that is designed to track the equity market performance of Japanese securities listed on Tokyo Stock Exchange, Osaka Stock Exchange, JASDAQ, and Nagoya Stock Exchange.
This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
RES 5757 0117 | Tracking #1-574747 (Exp. 01/18)
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Prior Weekly Market Commentaries:
- December 11 2017: CORPORATE BEIGE BOOK: UPBEAT AS EXPECTED
- December 4 2017: 2018 STOCK MARKET OUTLOOK: DOUBLE-DIGIT RETURNS?
- November 20 2017: HIGHLIGHTS FROM ANOTHER STRONG EARNINGS SEASON
- November 12 2017: TRUMP’S FIRST YEAR
- November 6 2017: MLP WEAKNESS APPEARS OVERDONEETS
- October 30 2017: WHAT MIGHT SCARE MARKETS
- October 23 2017: FIVE REASONS TO TAKE A LOOK AT JAPAN
- October 16 2017: THE 1987 CRASH: A NOT SO HAPPY ANNIVERSARY
- October 9 2017: THIRD QUARTER 2017 EARNINGS PREVIEW: SLOWER BUT STILL SOLID
- October 2 2017: MARKETS BUYING INTO TAX REFORM
- September 25 2017: THE BULL MARKET APPEARS ALIVE AND WELL
- September 18 2017: UPDATE ON GROWTH AND VALUE STOCKS
- September 11 2017: STRONG EUROPEAN EARNINGS ARE KEEPING EUROPE CHEAP
- September 5 2017: PUTTING THE NORTH KOREAN THREAT INTO PERSPECTIVE
- August 28 2017: CORPORATE BEIGE BOOK: UPBEAT AS EXPECTED
- August 21 2017: TAKING A LITTLE RISK OFF THE TABLE
- August 14 2017: BOTTOM LINE: IMPRESSIVE EARNINGS SEASON
- August 7 2017: BUY THE DIP? WHAT DIP?
- July 31 2017: IS POLICY SKEPTICISM CREATING A SMALL CAP OPPORTUNITY?
- July 24 2017: TAX REFORM PIVOT?
- July 17 2017: GLOBAL SUMMER EARNINGS: SIZZLE OR FIZZLE?
- July 10 2017: SECOND QUARTER 2017 EARNINGS PREVIEW: Q1 A TOUGH ACT TO FOLLOW
- June 26 2017: A TECHNICAL CHECK-IN: THE GLOBAL BULL LOOKS STRONG
- June 19 2017: MIDYEAR OUTLOOK 2017: BUSINESS FUNDAMENTALS BACK AT THE CONTROLS
- June 12 2017: HURDLING OVERSEAS EARNINGS-WHAT DO THE FORECASTS TELL US?
- June 5 2017: MASTER LIMITED PARTNERSHIP MORE GOING ON THAN OIL PRICE
- May 30 2017: CORPORATE BEIGE BOOK: IT KEEPS GETTING BETTER
- May 22 2017: FOCUS ON FUNDAMENTALS
- May 15 2017: EARNINGS UPDATE: RAISING THE BAR
- May 8 2017: FIVE REASONS NOT TO SELL IN MAY
- May 1 2017: REFLECTING ON NASDAQ 6,000
- April 24 2017: EUROPE ENTERS THE TOUR DE FRANCE
- April 17 2017: WHICH BREAKS FIRST, STOCK PRICES OR UNCERTAINTY?
- April 10 2017: FIRST QUARTER 2017 EARNINGS PREVIEW: DOUBLE DIGITS?
- April 3 2017: CHECKING IN ON SOME TRUMP TRADES
- March 27 2017: THE STOCK MARKET’S FINAL FOUR FACTORS
- March 20 2017: WILL THIS SIXTEEN BE SWEET?
- March 13 2017: HOW MUCH IS LEFT IN THE TANK?
- March 6 2017: CORPORATE BEIGE BOOK: BETTER SENTIMENT AND LOTS OF TAX TALK
- February 27 2017: TIPTOE THROUGH THE TULIPS AND OTHER EUROPEAN OFFERINGS
- February 21 2017: EARNINGS UPDATE: FIVE OBSERVATIONS
- February 13 2017: REAL ESTATE OVERVIEW: ALL ABOUT THE CYCLES
- February 6 2017: TAKING STOCK OF TECHNICALS AND SENTIMENT
- January 30 2017: IS THERE STILL VALUE IN VALUE?
- January 23 2017: INTERNATIONAL STOCKS WE LOOK EAST TO JAPAN
- January 17 2017: IS SMALL CAP STRENGTH SUSTAINABLE?
- January 9 2017: FOURTH QUARTER 2016 EARNINGS PREVIEW: LOOKS LIKE ANOTHER GOOD ONE
- January 3 2017: 2017 STOCK MARKET OUTLOOK: GEARS ARE TURNING, BUT PARTS MAY NEED GREASE
- December 19 2016: A LOOK BACK AT 2016 HITS AND MISSES
- December 12 2016: CAN’T STOCKS AND BOND YIELDS JUST GET ALONG?
- December 5 2016: IRRATIONAL EXUBERANCE PART TWO?