Matt Orton: A lot has changed over the past decade, but one constant theme in the investing world has been the underperformance of developed international equities relative to the U.S. As a result of this historically long drought in performance, many investors are under-allocated to the space and may not fully appreciate the diversification benefits from looking abroad. But international markets are doing well this year, and Europe in particular is off to a great start in 2021. Fund flows have also started to move higher, perhaps pointing finally to some investor enthusiasm. So I think it's worth spending some time diving into the drivers of international performance, and discussing how to assess where we go from here.

Matt Orton: This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights.

Matt Orton: Today I'm joined by Angel Lupercio, portfolio co-manager at Scout Investments, who focuses specifically on international investing. Angel, thanks for joining us today.

Angel Lupercio: Great to be here.

Matt Orton: And I think it makes sense to start by looking at some of the reasons why international equities have largely underperformed in the U.S. for so long. I know there's some structural headwinds that have challenged the space, and Angel, maybe you can dive into that a little bit deeper.

Angel Lupercio: Sure. So I guess the first thing I would point to is the fact that there's a large difference in sector weightings for international developed markets versus U.S. markets. The MSCI EAFE is skewed more towards what people refer to as value, whereas U.S. markets over the past decade, and even further back than that, have tended to skew more and more towards growth. In fact, it's important to note that just 10 stocks in the S&P 500 make up around 25% of the index's total market value. And I would actually classify eight of those 10 as growth stocks.

Angel Lupercio: And if we look at the indices sector by sector, industrials, financials, materials, and consumer staples, all of which most people would classify as value sectors, make up notably heavier weights in the EAFE versus S&P 500. And in fact, combined, they make up about 50% of the index weight versus just around 28% in the S&P. And then in contrast, information technology, which is the growth-iest of the growth sectors of course, makes up around 27% of the S&P and only 9% of the EAFE. So when you look at it from that perspective, it's a little more understandable as to why U.S. markets have outperformed international over the past decade or so.

Angel Lupercio: I would say let's not forget that value versus growth tends to move in cycles, and it has done so since well before my career began. And if you look at just the past four decades or so, globally, you find that the average cycle works out to around seven or eight years. And the current growth cycle has gone way beyond that.

Angel Lupercio: So finally, I think it's worth pointing out that going forth, some of those sectors that are considered value sectors are in all likelihood, you're going to see a pickup in growth over the coming decade or so. Industrials, materials, energies should see a pickup as we continue to transition to a green economy. So I'm not saying those are going to become growth sectors, just that they may see a little pickup. And I believe that would be to the benefit of international equities. And I'm not attempting to make a call on growth versus value over the next few years or next decade, but I think all the right variables are in place for what people consider value sectors to perform.

Matt Orton: And I think those are really good points, Angel, that might be underappreciated by a lot of investors, especially just thinking about the composition of the indices and sector weightings. Is there anything else that you think outside of sector weights and the structural issues that have contributed to the relative underperformance between the two areas?

Angel Lupercio: Yeah, there are definitely a number of things you can point to. Populist politics, I would say is a big one. The people in the UK, for example, they didn't do themselves any favor[s] by following populist politicians' advice and voting to leave the EU. And since that vote took place, UK markets drastically underperformed in both the U.S. and international markets as a whole. And given that the UK makes up 10% of the EAFE, when UK underperforms, it can have a material negative impact on the Amex overall.

Angel Lupercio: A more recent example would be Peru. When it became evident that a far leftist was likely to win the presidency, the markets panicked. And that market has underperformed ever since. Not that we haven't suffered our own bout of populism, but we've been fortunate enough to have a stock market that's loaded with new economy growth stocks, whereas the UK and Peru really don't.

Angel Lupercio: And then certainly the pandemic has had an effect on relative performance because international indices are far heavier weighted towards cyclical stocks versus the U.S. So any recession has a larger negative effect on most indices outside the U.S. And I think maybe people here are sort of starting to forget that the pandemic is still ravaging some countries, and lockdowns and travel restrictions are ongoing, and that's hurt those markets' performance relative to the U.S. That said, as these countries get COVID under control, it would not be surprising to see those markets do well.

Angel Lupercio: And then third, and finally, we have to keep in mind, I think, that it was in the early part of the last decade that the Eurozone sovereign debt crisis became particularly acute, and the Eurozone of course makes up a huge portion of the EAFE. So when it underperforms, as it did drastically in the first few years of last decade, it's certainly going to cause underperformance in international markets overall.

Angel Lupercio: And it's definitely worth noting that in the first two years of the last decade, the Eurozone market as measured by the EURO STOXX 50 index, had already underperformed the S&P by almost 43 percentage points. So it got off to a really rough start.

Matt Orton: Those are all really good points, especially about the impact of countries' regions within the index on performance. And you saw that even play out last year and so far this year. Last year, Asian equities outperformed, given their ability to avoid some of the worst COVID-induced shutdowns. And this year, European equities are outperforming as their economies start to reopen. So it's encouraging to see that different regions can outperform, but I would think that we need them broadly to start working together. What do you think it might take to see international equities more broadly start to outperform?

Angel Lupercio: So, first things first, all countries around the world need to do a better job of getting the pandemic under control. At this point, that's the main thing. U.S. equities are priced so high right now that I think as long as COVID gets under control, there's a fair probability that non-U.S. stocks are going to outperform. And as economies continue to reopen, cyclical stocks should, in theory anyway, do better, which certainly argues in favor of international indices versus U.S.

Angel Lupercio: And we also need the nationalist and populist politics that I mentioned earlier to settle down. And it's already slowly fading, and you can see that in election results, but we need it to continue. The new Peruvian president that I mentioned earlier, for example, he only won by a razor thin margin. It was something like 44,000 votes. But when countries cooperate internally, externally, it's always going to be good for equities.

Angel Lupercio: So basically I think we just need the current trends that are in place economically, politically, and pandemic-wise to just continue down their current path. International equities should perform nicely.

Matt Orton: And building on that Angel, are there any particular geographies or regions that you favor right now, or conversely, might try to avoid?

Angel Lupercio: Yeah, sure. Latin America is one I really like right now, particularly Columbia and Peru. Latin American nations, unfortunately overall have been hit harder by the pandemic than most, if not all developed nations. As a result over the past year, almost all of the most important Latin American markets have underperformed with the S&P 500 and the EAFE. And they've drastically underperformed on a year-to-date basis. So there are certainly opportunities there.

Angel Lupercio: Canada is another one to keep an eye on. That market has already performed well over the past year and year-to-date. But the country has really rich natural resources, so as economies around the world opened back up, much of what Canada has to offer, the hydrocarbons in particular, are going to see continued increase in demand.

Angel Lupercio: And then overseas, I would look to Japan. I think you can find some value there. They're still struggling a bit with the pandemic right now, and that's in part why the market hasn't performed particularly well this year. Nevertheless, exports continue to pick up, and Japan's another market that's leveraged to cyclical companies, industrials in particular. And then in Europe, I point to Spain. That market's still well below its pre-pandemic peak.

Matt Orton: And a similar follow-up, taking it from country to sectors, are there any sectors where you're finding good opportunities right now?

Angel Lupercio: Yeah. Coincidentally, the two sectors where I think you could find the best opportunities just happened to be the sectors I cover in my analyst role. And those are energy and financials. As long as they have well-structured balance sheet, you can find opportunities in energy space. In my estimation, there's been massive underinvestment in energy over the past few years. So I think an energy shortage at this point is almost inevitable, and that in all likelihood would drive up the price of the products these companies produce. And I think that sector is the only sector that's still down versus the end of 2019, in both the S&P 500 and the EAFE. All other sectors have recovered and they're in positive territory over that period.

Angel Lupercio: And then financials is the other sector that's underperformed over the period. So you can find some opportunities there as well, particularly in countries hardest hit by the pandemic. I mentioned Latin America earlier, and that's one to look at.

Matt Orton: And within that, just to follow up, within the energy space, you've seen a lot of headlines in the U.S. with pensions, divesting from the space, and potential headwinds coming from ESG. Do you think that's going to be a concern longer term, or do you think the underinvestment and the reopening themes are going to outweigh that?

Angel Lupercio: Oh, I think the underinvestment is definitely going to outweigh that. There's a certain irony in the transition of energy from brown to green. And that irony is that in all likelihood, we're going to have to pollute more so that we can pollute less in the future. So you're going to have just an unimaginable demand for hydrocarbons and materials that these companies produce, and that should benefit the energy sector.

Matt Orton: And within financials as well. European financials in particular have done very, very well so far this year. But what about other countries where there might be some headwinds with respect to rates or yield curve, say like Japan? Is your preference for financials a little bit more regional?

Angel Lupercio: Yeah, Japan, you mentioned, and that's generally a market where we avoid the banks because the banks have just been so poorly run over the years. It's been going on for decades, and I think a lot of people would still classify them as zombie banks. Financials, as I said, Latin America, I think is really one of the places that you look, particularly Columbia, Peru, even Mexico. You have some banks there that just have some unbelievably strong balance sheets relative to what we see in developed markets. So even compared to developed markets, I think you still look there if you're looking at the financial space.

Matt Orton: Thank you for that color. And let's transition now to the vaccine rollout because I know you hit on that before as perhaps helping to drive some of the reopenings of these overseas economies. And the vaccine rollout in the US has definitely been far and above the rest of the world so far. And it's going to take some of these other countries probably years to achieve the same vaccination rates that the U.S. has achieved over the past several months. So what might be some specific ways that the continued recovery from the pandemic will impact international equities differently than the U.S.?

Angel Lupercio: I think the recovery is going to continue to be uneven. The healthcare systems in most of the lesser developed nations around the world, they're far less advanced than they are here in the U.S. or Europe. So they've really struggled with the pandemic. That said, that does create opportunities in some of those markets. So emerging markets tend to be more leveraged to old-school sectors like energy and materials, which I spoke a little bit about earlier.

Angel Lupercio: So assuming the global economy does well as vaccinations can be rolled out, and economies continue to reopen, these cyclical sectors should perform well in places like Columbia, which I've already mentioned, for example, has an economy that's highly leveraged to petroleum products and coal. That should benefit. Here in the U.S., our markets are more leveraged to technology in healthcare and consumer discretionary. Yet, sure, consumer discretionary can be highly cyclical in some cases, but not as much so as energy and materials.

Angel Lupercio: And then when you look at the MSCI EAFE, you find that its highest weighted sector is financials. They should all show benefit as the economy continues to reopen, and we get a better picture of what kind of damage the pandemic has really done to basic asset quality.

Angel Lupercio: Right now, in my view, it's difficult to get a grasp on how strong banks in certain countries, balance sheets are because there's been so much temporary loan forbearance around the world. So the question then becomes, what percentage of particularly banks' loans are going to go into default when people have to start paying those loans back that were under moratorium? For most of the world's largest banks, this isn't going to be an issue because the global banking system in general is just so well-capitalized, particularly U.S. banks, but they're likely to be a few scares that make the headlines, I think, and hopefully this will open up in more investment opportunities.

Angel Lupercio: And then also, keep in mind the Federal Reserve and federal and local governments responded to the economic devastation caused by the pandemic with levels of stimulus that aren't like anything we've ever experienced here in the U.S., certainly in our lifetimes. And as those stimulus packages run off this year, there is a possibility we'll actually see temporary slowdowns in economic activity, and perhaps investor nervousness in the U.S. And additionally, if the Fed feels obligated to raise interest rates later this year or next, to combat increased inflation we've seen in recent months, this is only going to pile on to negative sentiment.

Angel Lupercio: So this situation really argues for exposure to emerging markets, as those governments and central banks aren't going to let up on the stimulus gas pedal any time soon, as well as developed international markets, because most of them didn't use fiscal stimulus to the extent the U.S. did. And many of them already have huge welfare states versus the United States. So the governments really didn't feel as obligated, I think.

Matt Orton: And one potential risk maybe that you can just touch on it as you look at your companies and sectors, are the variants that are coming out and whether or not the vaccines are effective against them. How do you assess the risks of that uneven recovery you mentioned versus the longer term benefits that you see playing out as economies continue to reopen?

Angel Lupercio: Yeah, so I think the best thing to do right now is to just keep in mind that so far we've seen that the vaccinations actually work well against the various mutations as well. So, right now I'm not really giving a whole heck of a lot of weight to vaccinations potentially turning into disaster and no longer defending against COVID-19. When there's actually more evidence out there or any evidence that the vaccinations aren't as effective as they need to be against these variants, then maybe I'll give it a little more concern.

Matt Orton: Great. And one other area I do want to touch on that you'd mentioned before, was the levels of unprecedented fiscal and monetary stimulus. And you're already starting to see fits and starts of rising rates in the US, questions about inflation. They're all big topics right now. And given that you cover financials and energy, perhaps with that expertise, you can discuss how you're thinking about the impact of rates and inflation, and how they can drive markets over the next several years.

Angel Lupercio: Yeah, sure. First off, I point out the price increases have really been apparent in practically all segments of the global economy. And in fact, some commodities hit multi-year highs earlier this year. The pandemic created supply chain disruptions, production bottlenecks, resulted in a shortage of shipping containers, which is a big one across parts of the globe, as the economy started reopened. And they've all contributed to inflation. And another driver of inflation that at least for now, seems to be affecting the US more than most other countries around the world, is wage inflation.

Angel Lupercio: All that said in most cases, I think these things are probably short-term, including wage inflation, particularly in parts of the economy like service and hospitality, as an example. As governments shut off the evermore unnecessary financial assistance, people are going to go back to work, and that should drive down in most industries, most industries, the labor shortage, and should relieve a little wage pressure. Again, that's most industries.

Angel Lupercio: There seems to really be a consensus among the world's most important central banks anyway, that the inflation we're going through right now is transitional. And for the most part, I think I would agree with that. That said, there are other inflationary pressures that are likely going to last for a number of years, I think.

Angel Lupercio: I mentioned earlier that I personally believe there is a coming energy shortage due to lack of investment by companies in sector all around the world. And that's not an easy fix. Drilling new wells and enough new wells and opening up old wells to make up for the shortage, that takes time. It doesn't happen overnight. Building a new refinery, that's easy either. There's certainly been a lack of investment in new refineries for many years. Those are large multi-billion dollar, multi-year projects.

Angel Lupercio: And then another multi-year issue is the semiconductor chip shortage we've all read about. Building foundries as with a finery is multi-billion dollar, multi-year project. And with regard to labor, there are some industries where wage pressures will likely last for a number of years. IT in particular is one where demand continues to grow. And shortages of people with the right background were lingering even pre-pandemic. And it's only gotten worse.

Angel Lupercio: We're also likely to see if it's not happening already, frankly, a labor shortage and wage pressure in the developing green economy. If we're going to complete the energy transition at the ambitious rate that many people are expecting, hundreds of thousands, if not millions of people are going to have to be educated and trained to build out that new infrastructure, another multi-year process.

Angel Lupercio: And then as far as rates are concerned, if inflation is more persistent than central bankers expect, they will, of course, be forced to react. That said, I don't really think they're going to be in any hurry. We have to keep in mind that inflation on average, undershot the Fed's 2% target for years. So they may not mind letting it play a little catch-up before acting.

Angel Lupercio: And then while the European Central Bank doesn't have an official target, it's generally presumed by many that its de facto target is around 2%, same as the Fed. So they've been undershooting as well. In fact, it's actually been undershooting even more so than the Fed. Average inflation in the Eurozone over the past decade has only been about 1.2% versus here in the U.S. where it's been around 1.8%. So the ECB may be even more inclined to maintain a dovish stance than the Federal Reserve. And again, that speaks well for international equities.

Matt Orton: Those are all great points, and ones that I think everyone should keep in mind as we think long-term about where we can potentially go. And perhaps just for some closing thoughts, maybe you can touch on one or two key risks to the thesis of international potentially outperforming US as we look forward.

Angel Lupercio: Yeah. I think the real risk right now does have to do with the pandemic. If countries have to re-shut down and travel restrictions have to be put back in place in all likelihood, those are going to happen in international markets. I don't see it happening in the U.S. We're just way too far along and way too head of the curve in this thing relative to international equities. So I think that's the first one that I would point to that would be disastrous, I think, for Europe, if it happened across the board, and the economy didn't start to reopen. That said, I don't see any reason that that's going to happen. I don't think it's very likely.

Matt Orton: Excellent. Well, Angel, this has been very, very insightful, and I definitely appreciate your time here today. Thank you very much and thanks to our listeners for tuning in. And take care. Thanks.

Angel Lupercio: Thanks.

Matt Orton: Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.

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Definitions

The EURO STOXX 50® Index covers 50 stocks from eight Eurozone countries: Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, and Spain.