US Versus EAFE: Where to Invest for the Future?

EATON VANCE TOPIC PAPER • OCTOBER 2016

US versus EAFE: Where to invest for the future?

Jean-Pierre Couture, M.Sc. A number of our clients have recently asked us our Chief Economist & Strategist, Emerging Markets Hexavest opinion on the long-term benefits of investing in Robert Brunelle Senior Vice President European and Asian shares (EAFE mandates). Business Development & Client Services Hexavest Given the challenging political landscape in Europe post-Brexit vote and the muddle-through economy in Japan, should investors focus on U.S. shares that could benefit from a stronger, more stable economy? EATON VANCE TOPIC PAPER • OCTOBER 2016 • US VERSUS EAFE: WHERE TO INVEST FOR THE FUTURE? • 2

The recent performance of the U.S. stock market relative to shown in Exhibit A, in 500 moving 5-year periods since developed international equities, especially expressed in U.S. 1970, the MSCI EAFE Index has outperformed the MSCI dollar terms, might also influence asset allocators in this line U.S. Index 50% of the time. Furthermore, the table below of questioning. While the MSCI US Index has outperformed shows that although the U.S. stock market has marginally the MSCI EAFE Index by close to 10% on a 5-year outperformed developed international equities with lower annualized basis at the end of June 2016 (closer to 5% in volatility over that period, a simple rule of diversification local currency terms), historical performance shows that (50/50) has brought higher returns and lower volatility. there is no clear consistent winner in this battle. In fact, as

Exhibit A Annualized returns in USD, 5-year moving periods.

50%

40%

30%

20%

MSCI US 10%

MSCI EAFE 0%

-10% 11/1/74 11/1/75 11/1/76 11/1/77 11/1/78 11/1/79 11/1/80 11/1/81 11/1/82 11/1/83 11/1/84 11/1/85 11/1/86 11/1/87 11/1/88 11/1/89 11/1/90 11/1/91 11/1/92 11/1/93 11/1/94 11/1/95 11/1/96 11/1/97 11/1/98 11/1/99 11/1/00 11/1/01 11/1/02 11/1/03 11/1/04 11/1/05 11/1/06 11/1/07 11/1/08 11/1/09 11/1/10 11/1/11 11/1/12 11/1/13 11/1/14 11/1/15

MSCI EAFE MSCI US 50/50 portfolio Annualized returns (in USD) 8.59% 8.95% 9.03% Standard deviation 17.01% 15.26% 14.56% Start date 12/31/1969.

But, is this recent outperformance of the U.S. stock market a have the upper hand. As shown below, for many years, new trend that will persist in coming years? We believe forecasted growth for the U.S. economy has been higher analyzing the question through the lens of our three pillars than growth in Europe and Asia. But that growth differential may shed some light on the question. has narrowed in recent years as expectations for future growth in the U.S. have come down, while expectations for Macroeconomic environment: US holds edge, Europe have improved following the eurozone crisis of but EAFE improving 2011-2012 and expectations for Japan have stabilized at a We do agree with the argument that, over the coming years, very low level. the U.S. economy will most likely continue to outperform It is also interesting to note that consensus expectations for both the European and Japanese economies in absolute GDP growth in emerging economies have been revised down terms. That being said, markets often trade on relative terms in recent years as forecasters adjusted to the new growth and, on that basis, both the European and Asian economies regime in these countries. While some emerging economies EATON VANCE TOPIC PAPER • OCTOBER 2016 • US VERSUS EAFE: WHERE TO INVEST FOR THE FUTURE? • 3

Exhibit B Reginal forecasted growth. Exhibit C EAFE versus US forecasted growth differential. 12-month growth, Consensus Economics 12-month growth, Consensus Economics 8 0.5 EAFE stronger 6 0.0 +++ 4 -0.5 ++

2 -1.0 + Average N 0 -1.5 - -- -2 EM -2.0 World US stronger --- US -4 Euro area -2.5 Japan -6 -3.0 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 Sources: Hexavest, Consensus Economics, Datastream. Sources: Hexavest, Consensus Economics, Datastream. will face significant challenges in coming years, we anticipate preferred option given their lower valuations) or invest in that GDP growth in emerging economies, in aggregate, will developed-market shares that have a strong exposure to remain stronger than developed economies given their emerging economies. The latter strategy might lead investors generally favorable demographic profile, lower consumer debt to rethink their exposure to U.S. shares versus European or burden, higher productivity growth, etc. To benefit from that Asian shares: Corporate revenues from emerging economies favorable environment, investors may decide to invest directly are significantly higher for shares of companies listed on the in local shares of emerging markets (which would be our European and Japanese markets (Exhibit D).

Exhibit D Exposure to emerging markets. Exports to EM in % of GDP and revenues from EM in % of total revenues

20% Exports to EM ex-China Revenues from EM (MSCI Indices) Exports to China 15% Exports to EM ex-China

Revenues from EM (MSCI Indices)

Exports to China 10%

0% Japan Eurozone* U.S.

Sources: Hexavest, Credit Suisse, MSCI. *MSCI Europe ex-U.K. EATON VANCE TOPIC PAPER • OCTOBER 2016 • US VERSUS EAFE: WHERE TO INVEST FOR THE FUTURE? • 4

That is the economic argument, but what about other factors resilient since the Great Recession. For example, take GDP such as political risks and demography? When we look growth, which comes from two sources, labor force growth ahead to the next 5-10 years, isn’t the U.S. in better shape and productivity growth: It is well-known that productivity when it comes to these other factors? growth in Japan has tracked that in the U.S. over the last few years, at around 1%, so Japan is not underperforming In Europe, the vote by U.K. citizens to exit the European on this front. On the labor force side, the result of Union has certainly renewed doubts over the future of the Abenomics has been a rise in the female participation ratio European project. It will take months before formal talks (above U.S. levels), combined with a fall in the start and years before we have a clear picture of the working unemployment rate to record lows. This has allowed the relationship between the EU and the U.K. In the meantime, labor force to grow by about 0.5% since 2013, putting real the eurozone is working to address concerns over its banking GDP growth around 1%-1.15%. From the standpoint of an system, but is facing regulatory hurdles designed during the economy with a potential of only around 0.5%, this is an crisis to avoid future bank troubles. Moreover, the political impressive development. landscape is at risk of changing significantly in the next quarters with elections in Germany, France, the Netherlands, Valuation: EAFE at 16-year low relative to US Austria and a possible third round in Spain after two inconclusive elections. In that environment of uncertainty, it is The political risks in Europe and structural issues in Japan difficult to envision a significant pickup in economic activity are certainly nothing new to investors. They explain, to a beyond the current 12-month forecasted growth of 1.4%. large extent, the historical discount of the MSCI EAFE Index to the MSCI US Index. One might argue that the historical As for Japan, most critics point to its deflationary bias, discount should, in fact, be higher going forward given that entrenched during the bursting of the asset bubble in the the risk of a breakup of the eurozone is now significantly 1990s, and sustained for over 20 years. Combined with an higher post-Brexit vote and that the modest growth in Japan aging population that has a strong preference for saving, the has come with a large price tag on the balance sheet of the tendency in Japan has been for price falls. On the positive Bank of Japan and the ever growing debt burden of the front, policies from the Abe government are finally government. That being said, the current valuation spread in attempting to address these issues. Although the jury is Exhibit E stands at two standard deviations below the certainly still out on the success of these measures, the historical average and close to the lows seen during the tech reality is that the Japanese economy has been surprisingly bubble. Surely, these risks are, to a large extent, already

Exhibit E MSCI EAFE Relative Valuation vs. MSCI US Exhibit F Cyclically adjusted P/E ratio. Relative price-to-book Price to 10-year real earnings -10% 60

-20 S&P 500 CAPE 50 Average 1980- MSCI Eurozone CAPE -30 +1 std dev Average 1980- 40 MSCI Asia-Pacific CAPE Average 2009- -40 average 30 -50 -1 std dev 20 -60 10 -70 0 -80 1980 1990 2000 2010 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 Sources: Hexavest, Datastream. As of date 8/31/2016. Sources: Hexavest, Datastream. As of date 8/31/2016. EATON VANCE TOPIC PAPER • OCTOBER 2016 • US VERSUS EAFE: WHERE TO INVEST FOR THE FUTURE? • 5

priced in and a reversal to the mean (albeit lower than the might favor European shares that provide a higher dividend historical average) could provide a significant lift to yield, as shown in Exhibit G. Also, we are seeing an European and Asian shares. increased focus on shareholder-friendly measures in Japan in Exhibit H, which is leading to a meaningful rise in share Other positives for European and Asian shares include the buybacks. appetite for yield, which, in a prolonged low rate environment,

Exhibit G Dividend yield (%). Exhibit H TOPIX stock buybacks. Japan, Trillions of JPY

8 12 11.27 140% YoY growth, 7 UK 10 assuming similar performance in latter Eurozone 6 half of the calendar year 8 World 5 6 4 4.58 4.70 Japanese Corporate 4.41 4 3 3.21 Governance Reform 2.43 2 2 1.47 1.47

1 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2010 2011 2012 2013 2014 2015 2016 2016 YTD Exp.

Sources: Hexavest, Datastream, IBES. Sources: Hexavest, Bloomberg.

Sentiment: Extended US outperformance warrants caution European shares and, to a lesser extent, Japanese shares, We take a contrarian stance on sentiment. From that while emerging market shares have clearly been the laggard perspective, the significant outperformance of the U.S. on this metric. Combining relative performance and flows, market vs the rest of the world in recent years would we would give our highest rating to emerging markets and certainly lead to a negative assessment for U.S. shares. lowest to U.S. shares. Our assessment for European and However, flow of funds in recent years have certainly favored Japanese shares would be neutral.

Exhibit I Cumulative returns since the Great Recession.

350

300

250

200

150

100

50 '09 '10 '11 '12 '13 '14 '15 '16 Source: MSCI. MSCI US U$ - NET RETURN MSCI EUROPE U$ - NET RETURN MSCI JAPAN U$ - NET RETURN EATON VANCE TOPIC PAPER • OCTOBER 2016 • US VERSUS EAFE: WHERE TO INVEST FOR THE FUTURE? • 6

Conclusion Economies and markets will certainly evolve greatly in The dramatic outperformance of U.S. shares combined with coming years. While we acknowledge longer-term secular the relatively more stable economic outlook understandably factors such as demography, which may be more favorable has investors questioning the benefit of investing in other to some regions (U.S. and emerging markets), no region/ developed markets via EAFE mandates. While it’s important country is immune to political shocks, wars, natural to understand and respect the past, we are investing for the disasters, recessions, market corrections, etc. Therefore, we future. When we look forward, through the lens of our believe that broader mandates such as global or ACWI macroeconomic environment, valuation and sentiment versus regional mandates (U.S. and EAFE for example) allow pillars, we see at least as favorable an outlook for EAFE for greater flexibility to benefit from such changing shares. Couple that outlook with the proven diversification environments. Our regional positioning in these global benefits, and we believe that EAFE shares should continue portfolios is driven from our summary regional assessments to have a prominent place in investors’ portfolios. in the table below:

Regional outlook* Macroeconomic Valuation Sentiment Regional rating environment North America + ------Europe + - Neutral Neutral Asia Pacific - ++ Neutral + Emerging Markets - ++ +++ ++++

*note that this assessment is done with an investment horizon of 12 to 18 months. EATON VANCE TOPIC PAPER • OCTOBER 2016 • US VERSUS EAFE: WHERE TO INVEST FOR THE FUTURE? • 7

About Eaton Vance Eaton Vance is a leading global asset manager whose history dates to 1924. With offices in North America, Europe, Asia and Australia, Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of providing exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information about Eaton Vance, visit eatonvance.com.

About Hexavest Hexavest is an independent investment management firm in Montreal, Canada, and is 49%-owned by Eaton Vance. Founded in 2004, the firm provides discretionary investment management of equities and tactical asset allocation for institutional clients. For more information about Hexavest, visit hexavest.com.

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