Global Equity Strategy

Weekly discussion of recent equity market action with equity sector highlights and what it may mean for investors.

January 11, 2017

Sean Lynch, CFA, Co-Head of Global Equity Strategy

International Equities—Should I Stay or Should I Go?

  • While all major equity markets gained in 2016, the S&P 500 Index’s total return exceeded those of international equities for the fourth year in a row.
  • Fundamentals appear to be improving in international equity markets, supporting their future potential.

What it may mean for investors

  • Some investors recently have questioned the value of international equity exposure. Yet, this exposure offers important portfolio advantages.
  • We advise investors to retain their international equity allocations and to remain well diversified across domestic and international equity classes in 2017.
speedometer reading of equities: large cap, mid cap, developed markets, small cap, and emerging-market.

Keeping investors committed to their equity investments was a challenge last year. This was the case for U.S. equities but especially so for international equities. U.S. large-cap stocks bested international developed and emerging-market equities in 2016, making it the fourth year in a row that the S&P 500 Index beat the MSCI EAFE Index and the MSCI Emerging Markets Index.

Table 1: The S&P 500 Index Has Outperformed International Equity Indices for Four Years Table 1: The S&P 500 Index Has Outperformed International Equity Indices for Four YearsSource: Bloomberg, 1/9/17. Each index represents total returns.

Wells Fargo Investment Institute (WFII) maintained an overweight in U.S. Large Cap Equities throughout 2016 before our recent downgrade to evenweight on January 3, 2017. WFII also moved from underweight to evenweight for Emerging-Market Equities last month.

As we now hold all three of these equity classes at a tactical evenweight position, investors are asking for any delineation among our preference for these groups. We still favor U.S. large-cap equities over international developed and emerging-market stocks, but we do not believe that investors should abandon their international exposure. That exposure provides diversification to an equity portfolio in a year that is likely to feature some significant volatility. In this week’s report, we take a brief look back at international markets and outline the factors that we will be watching this year.

Reviewing Relative Country Performance Abroad (the “BRICs” and Other Markets)

The disparity between individual country returns was wider in emerging markets than it was in developed markets. Some investors have forgotten the BRIC (Brazil, Russia, India, and China) acronym that describes the four fastest-growing emerging economies. Last year, many investors left Brazilian and Russian equities aside, only to see these two countries deliver the strongest global equity performance in 2016 (by a wide margin). At the start of 2016, investing in these countries’ equities may have required an investor to believe that the leaders of these countries; Mr. Putin of Russia and Ms. Rousseff of Brazil, would inject some stability into their economies. Yet both economies benefited from the rise in oil prices (despite the impeachment of former Brazilian President Dilma Rousseff last year). The MSCI Brazil Index rose by 66.7 percent last year, while the MSCI Russia Index was up 55.9 percent.

Table 2: Selected 2016 Performance: Emerging Markets Table 2: Selected 2016 Performance: Emerging MarketsSource: Bloomberg, 1/9/17. Each index represents total returns in USD. Past performance is no guarantee of future results.

Two important pieces of the BRIC puzzle, India and China, both showed modest gains in 2016 and remain key markets to watch for 2017. The emerging-market laggard was Mexico, whose losses picked up steam following President-elect Trump’s victory (this was true both from an equity-market and currency standpoint). The wide range of performance within emerging markets highlights why we would rather be broadly diversified across emerging markets today, rather than seeking to select individual countries for investment. Yet, we do evaluate international equity investments by region and favor emerging equity markets in Asia over those in Latin America, Europe, and Africa.

Table 3: Selected 2016 Performance: Developed Markets Table 3: Selected 2016 Performance: Developed MarketsSource: Bloomberg, 1/9/17. Each index represents total returns in USD. Past performance is no guarantee of future results.

Developed markets did not have the wide-ranging returns that we saw in emerging markets last year. Canada and Australia were the strongest performers, while Italy and Sweden were the laggards. Germany, Japan, and France all had modest gains for the year. In 2017, we favor developed equity markets in the Pacific region (such as Australia and Japan) over European developed markets.

Chart 1. Earnings Expectations Have Risen for Developed Markets Chart 1. Earnings Expectations Have Risen for Developed MarketsSource: Bloomberg, 1/9/17. Past performance is no guarantee of future results.

What We are Watching

This year, we are watching several key factors in international markets, including earnings estimates, currencies, and leading economic indicators (such as Purchasing Managers’ Index, or PMI, data). We have seen a gradual improvement in analysts’ 2017 earnings expectations for both developed and emerging-market equities. Over the past few years, analysts have placed lofty projections on international earnings, only to be disappointed. We are retaining our current earnings estimates and year-end price targets for international equity markets. Yet, we believe that it is important to closely follow the outlook coming from individual companies, and to watch key leading economic indicators, and to consider the impact of currencies on companies’ earnings. As an example, a weaker yen makes Japanese manufacturers’ exports more competitive from a cost standpoint. The recent strength of the U.S. dollar versus other major currencies may result in some of these foreign-based global manufacturers seeing an uptick in export activity. However, we would caution that some of this earnings tailwind stemming from a weaker currency may be offset by continued talk of tariffs and protectionism coming from the United States.

Chart 2. Earnings Expectations Also Have Risen for Emerging Markets Chart 2. Earnings Expectations Also Have Risen for Emerging MarketsSource: Bloomberg, 1/9/17. Past performance is no guarantee of future results.

Investment Recommendations

The S&P 500 Index has outperformed both emerging-market and developed market (ex-U.S.) equity-market index performance over the past four consecutive years. Some investors may be questioning why they should keep their international-equity exposure. Our view is that international equities add a key diversification benefit to equity exposure and an investor’s entire portfolio. We also are starting to see signs of gradual improvement in the economies and earnings of international markets. While it is too early to call for these markets to outperform U.S. equity markets this year, we remain evenweight on all three of these major equity classes (as we are on all equity classes but U.S. Small Cap Equities). We would have to get more comfortable with the fundamentals improving before upgrading our international equity tactical weightings. Additionally, volatility in 2017 may provide opportunities to reevaluate (or adjust) tactical positioning in the equity space. As we head into 2017, we advise investors to stay the course, and to remain exposed at their targeted levels for international equities.

Weekly Wrap and Look Ahead

All major domestic and international indices were positive for the week and year to date.

Index Last Week’s Performance1 2016 YTD Performance
S&P 500 +1.7% +1.7%
DJIA +1.0% +1.0%
NASDAQ +2.6% +2.6%
Russell 2000 +0.7% +0.7%
MSCI EAFE +2.3% +1.8%
MSCI Emerging Markets +2.7% +2.2%
1. For the week of January 3 – January 6, 2017.
Source: Wells Fargo Investment Institute, Bloomberg, 1/9/17.

Five of 11 S&P 500 Index sectors outperformed the index, while 10 of 11 gained ground on the week.

Best-Performing Sectors
Sector Last Week’s Performance2
Health Care +2.9%
Information Technology +2.4%
Consumer Discretionary +2.3%
Worst-Performing Sectors
Sector Last Week’s Performance2
Telecom Services -1.2%
Utilities +0.5%
Energy +0.6%
2. For the week of January 3 – January 6, 2017.
Source: Wells Fargo Investment Institute, Bloomberg, 1/9/17.
Past performance is no guarantee of future results.

This week, we believe that the stock market is looking ahead and just wants to get through the January 20 inauguration. Investors are in a “wait and see” mode, even though the major indices crawled to new all-time highs in recent sessions. Trading volume remains light thus far in the New Year.

We are looking forward to trying to gauge the level of congressional cooperation with the president-elect once he takes office. On a day-to-day basis, this seems rather challenging based on the comments from various politicians on both sides of the aisle. The overall consensus view on the “Street” is that all of the new administration’s nominees will eventually be approved by Congress but not without some contentious hearings and political grandstanding. In the coming weeks, we expect that both Democrats and some Republicans may seek to grill a number of the nominees. The hearings start this week (as will the fireworks).

From a fundamental standpoint, we believe that the S&P 500 Index is trading at what we would consider to be “fair value.” We are not looking for much out of the major indices this year, and we see more of a “stall pattern” for stocks in 2017. We are not calling for an end to the current cycle. Yet, we do believe that the new administration may have very little influence over economic and earnings growth this year. The numerous pro-growth proposals, if implemented (and in a great enough magnitude) will likely start showing up in the economic statistics in 2018 and 2019.

Sector S&P Weighting* Wells Fargo Investment Institute Guidance
Consumer Discretionary 12.1% Overweight 14.9%
Consumer Staples 9.2% Underweight 5.5%
Energy 7.4% Underweight 4.0%
Financials 14.7% Overweight 16.4%
Health Care 13.8% Overweight 17.2%
Industrials 10.2% Overweight 11.6%
Information Technoloy 21.0% Overweight 21.8%
Materials 2.9% Evenweight 3.0%
Real Estate 2.9% Evenweight 3.1%
Telecom Services 2.6% Evenweight 2.5%
Utilities 3.1% Underweight 0.0%
S&P 500 Earnings Estimate for 2016 $119.00
S&P 500 Earnings Estimate for 2017 $127.00
S&P 500 Year-end 2017 Target Range 2,230-2,330
*Sector weightings may not add to 100% due to rounding. Weightings as of 1/9/17. Targets are not guaranteed and may change.
Source: : Wells Fargo Investment Institute, Bloomberg, 1/9/17.
Valuations and Fundamentals for Five Primary Equity Asset Classes Valuations and Fundamentals for Five Primary Equity Asset Classes*Enterprise Value.
Source: Wells Fargo Investment Institute, Bloomberg, 1/9/17. Developed Markets: MSCI EAFE Developed Market Index (Europe, Australasia, Far East). Emerging Markets: MSCI Emerging Markets Index.

Risk Factors

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Investments that concentrate in certain countries or regions are subject to greater risk of adverse economic conditions than one that is more geographically diversified, thereby increasing its vulnerability to any single economic, political or regulatory development that may occur in that country or region. This may result in greater price volatility.

Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market.

There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change.

Definitions

An index is unmanaged and not available for direct investment.

DJIA is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

Developed Markets: MSCI EAFE Developed Market Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. It is unmanaged and unavailable for investment. Statistics are shown in U.S. dollars and local currency.

Emerging Markets: The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

MSCI Australia Index is designed to measure the performance of the large and mid-cap segments of the Australia market. With 71 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Australia.

MSCI Brazil Index is designed to measure the performance of the large and mid-cap segments of the Brazilian market. With 75 constituents, the index covers about 85% of the Brazilian equity universe.

MSCI Canada Index is designed to measure the performance of the large and mid-cap segments of the Canada market. With 94 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Canada.

MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

MSCI France Index is designed to measure the performance of the large and mid-cap segments of the French market. With 77 constituents, the index covers about 85% of the equity universe in France.

MSCI Israel Index is designed to measure the performance of the large and mid-cap segments of the Israeli equity market. With 13 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Israel.

MSCI Italy Index is designed to measure the performance of the large and mid-cap segments of the Italian market. With 23 constituents, the index covers about 85% of the equity universe in Italy.

MSCI Mexico Index is designed to measure the performance of the large and mid-cap segments of the Mexican market. With 30 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Mexico.

MSCI Russia Index is a free-float adjusted market capitalization weighted index that is designed to track the equity market performance of Russian securities listed on MICEX Stock Exchange. The MSCI Russia Total Return Index takes into account both price performance and income from dividend payments. The MSCI Russia Index is constructed based on the MSCI Global Investable Market Indexes Methodology, targeting a free-float market capitalization coverage of 85%.

MSCI Spain Index is designed to measure the performance of the large and mid-cap segments of the Spanish market. With 25 constituents, the index covers about 85% of the equity universe in Spain.

MSCI Switzerland Index is designed to measure the performance of the large and mid-cap segments of the Swiss market. With 38 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Switzerland.

MSCI Taiwan Index is a free-float adjusted market capitalization weighted index that is designed to track the equity market performance of Taiwanese securities listed on Taiwan Stock Exchange and GreTai Securities Market.

MSCI Turkey Index is designed to measure the performance of the large and mid-cap segments of the Turkish market. With 25 constituents, the index covers about 85% of the equity universe in Turkey.

NASDAQ is an unmanaged group of the 100 biggest companies listed on the NASDAQ Composite Index. The list is updated quarterly and companies on this Index are typically representative of technology-related industries, such as computer hardware and software products, telecommunications, biotechnology and retail/wholesale trade.

Nikkei 225 Index is the leading and most-respected index of Japanese stocks. It is a price-weighted index comprised of Japan’s top 225 blue-chip companies on the Tokyo Stock Exchange. The Nikkei is equivalent to the Dow Jones Industrial Average Index in the U.S.

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

PMI Surveys track sentiment among purchasing managers at manufacturing, construction and/or services firms. An overall sentiment index is generally calculated from the results of queries on production, orders, inventories, employment, prices, etc.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately eight percent of the total market capitalization of the Russell 3000 Index.

Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25 percent of the total market capitalization of the Russell 1000® Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. The Index is unmanaged and not available for direct investment.

Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the GIS division of Wells Fargo Investment Institute. Opinions represent GIS’ opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC (WFCS) and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.

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