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Market Update

Can the Great Rotation Abroad Persist?

European and emerging-markets stocks have sprung back to life as investors shift away from overpriced U.S. equities--but will it last?

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Europe and emerging markets are experiencing a revival this year.

The S&P 500 is up 5.5% as of this writing while the MSCI emerging-markets index is up more than 11% and the MSCI Europe has gained 6.5%.

That's quite a change from late 2016. The S&P 500 rose 3.3% in the fourth quarter, while emerging markets fell 6.5% and Europe shed 0.6% in the same period.

Why the shift? For starters, the U.S. economy has been slowing for the past six months, leading some investors to look abroad. U.S. economic growth decelerated in the fourth quarter of 2016 to 2.1% from 3.5% the previous quarter, and economists expect a drop below 2% in the first quarter of 2017.

"Over the last three or four months we've seen the growth expectations for Europe, even Japan and emerging markets (…) going up," said Morningstar director of economic analysis Robert Johnson in a recent video. A stabilization of commodity prices has allowed export-led emerging economies to recover from the 2014-2015 price collapse.

"In the meantime, the outlook for the U.S. economic performance has gotten a little bit worse," says Johnson.

As Morningstar senior analyst Gregg Wolper noted in a recent article, a declining U.S. dollar this year has boosted returns for U.S.-based investors dabbling in foreign stocks who don't hedge their currencies.

In addition, many argue that U.S. stocks are overpriced relative to their foreign counterparts, which is also driving bargain hunters overseas.

"Europe and emerging markets are doing better due to the cascading impact of valuations going up in the U.S. and people looking elsewhere for cheaper valuations," said David Samra, portfolio manager of the closed Artisan International Value (ARTKX), which earns a Gold rating from Morningstar.

Can emerging markets and Europe continue to thrive this year?

Emerging Markets
In 2014, commodities prices--led by crude oil--plunged amid global overproduction and China's decrease in appetite. As such, commodity exporting countries, mostly emerging-markets economies, experienced a sharp deceleration and in some cases recession.

Russia and Brazil, two major emerging-markets commodity-exporting economies, have been in a recession since 2015 yet they are expected to climb back to positive growth in 2017. In early April, flows into Brazil, Russia, India, and China equity funds hit a level last seen in the fourth quarter of 2015, according to EPFR Global.

"Most of the economies are expanding or recovering in emerging markets," said Andrew Clifton, a portfolio specialist at T. Rowe Price European Stock (PRESX), which earns a Bronze rating from Morningstar.

Growth is improving relative to developed markets in terms of the macro and corporate earnings. Moreover, "real interest rates at the moment are at a reasonably high levels," Clifton said, adding that a lot of the external imbalances have been addressed while some countries have improved their levels of reserves.

In addition, the majority of emerging-markets currencies are stronger against the U.S. dollar since the turn of the year, according to an April 4 Capital Economics research note. Although the U.S. dollar remains at its highest level in a decade, it has fallen 3% year-to-date as of this writing, according to WSJ Dollar Index.

"What's happened now is the dollar gets a little weaker or at least stabilizes, that makes U.S. goods a little bit more competitive again or at least it doesn't worsen the situation," Johnson said.

As the U.S. dollar and valuations of U.S. equities remain at high levels, investors are shifting their attention to other horizons looking for better deals.

According to Bank of America Merrill Lynch's March Global Fund Manager Survey of 165 managers with a total of $505 billion in assets under management, 81% of respondents said the U.S. market is overvalued--with the dollar at its highest since June 2006--and thus see a rotation away from U.S. stocks to emerging market equities.

"Margins in emerging markets are below average in certain areas, so they have (more room) to improve, similar to the position in Europe," Clifton said.

Et Tu, Europe?
In Europe, business and consumer confidence rose in March, equity valuations are inexpensive relative to the U.S., and political uncertainty should wind down by early June after the U.K.'s general election.

"The geopolitical risks have been in everybody's mind with election worries and also high levels of debt and the need for austerity," said Baxter Hines, a portfolio manager of AllianzGI NFJ International Value (ANJIX), which earns a Bronze rating from Morningstar.

Even as Europe has been going through a protracted debt crisis since 2009 as many Eurozone member states were unable to pay their government debt or bail out their banks, the region is showing signs of greenshoots and money has been flowing in.

"That has been on people's minds for a long time and that's why investors have had this gloom and doom kind of attitude, but there are definitely some glimmers of hope in Europe," Hines said.

The Euro area is forecast to grow 1.6% this year compared to 1.7% last year, according to the International Monetary Fund. The unemployment rate has continuously improved since 2013, while the euro currency, once trading at $1.39 per euro in 2014 is at near par with the U.S. dollar, with one euro buying $1.09, and making goods more competitive.

In addition, Europe's current cheap valuations make up for previous years' weakness in earnings. In early April, European equity funds posted its biggest inflow since February 2016, according to EPFR Global.

"Each year for the past four to five years for different reasons earnings growth have been disappointing in Europe," said Clifton. "But what has changed for Europe is improving expectation about corporate performance, with earnings growth finally looking as it's making very good progress this year."

So far, the geopolitical situation has been benign to the markets and investors may be waiting for political resolution in the U.K. and France.

In mid April U.K. Prime Minister Theresa May called for a snap general election on June 8, which no doubt injected some uncertainty into the market and could lead to some market volatility. That said, the move is considered positive by many.

"The election is seen as a chance for more time to be put in the Brexit negotiations and more predictability and transparency around those negotiations to take place," Hines said. "So it will lead to a cleaner break rather than one that is more hasty and emotional, and it gives the Britons another chance to reinforce their convictions."

Clifton said that if anything "it lessens the chance of a very negative outcome. It is always best when people are negotiating to have as much strength as possible," and added he doesn’t see the election call as a "material market event."

French elections, however, are another matter.

France went to the polls on April 23 and will go once more for the run-off on May 7 to elect its president. Investors are concerned that if the far-right candidate, Marine Le Pen, wins, the unity of Europe could be in danger and markets can become extremely volatile.

"A Le Pen win would be an outlier event, and that would give the market most concern. Absent that, the market relative to return history is reasonably valued," Clifton said.  

"What the markets in Europe will need to have in order for the sentiment to get better is for the news flow to get less bad and we definitely have seen that in the last few months," Hines said.

Investing Ideas
Investors looking to tilt their portfolios toward either Europe or emerging markets have many Morningstar Medalist funds to choose from.

Passive options among Europe-focused stock mutual funds and ETFs include the Gold-rated  iShares Core MSCI Europe (IEUR).  Vanguard European Stock Index (VEURX) and  Vanguard FTSE Europe ETF (VGK) both earn Silver ratings. Other passive options include Bronze-rated  iShares Currency Hedged MSCI Eurozone (HEZU) and  iShares MSCI Eurozone (EZU). Actively managed options include Silver-rated  Invesco European Growth (AEDAX) and Bronze-rated  T. Rowe Price European Stock (PRESX).

Among diversified emerging-markets funds, there are more than two-dozen Morningstar Medalists. The actively managed  American Funds New World (NEWFX) earns a Gold rating while emerging-markets funds from Fidelity, T. Rowe Price, Vanguard, iShares and Schwab also earn medals.

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Manuela Badawy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.