Despite bouts of volatility this year, U.S. equities, led by high growth firms have dominated global markets. Concerns over a global trade war and rising U.S. interest rates were headwinds for international equities. Looking beyond the macro headlines, the fundamental strength of international firms remains intact and is supported by attractive relative valuations. For further insight, we spoke with Carlos Garcia-Tunon, CFA, who serves as Portfolio Manager and Head of Fundamental Equity at MacKay Shields.

International equities have lagged, but are well positioned for future growth

So far this year, domestic equities have outpaced international and emerging markets equities by a wide margin. Much of the relative weakness outside of the U.S. has been exacerbated by a strengthening U.S. dollar and not necessarily corporate results. U.S. companies have also been the prime beneficiaries of a strengthening U.S. economy, tax cuts, and robust earnings.

The preliminary estimate for second-quarter annualized GDP growth in the U.S. was 4.1%—the strongest economic reading in nearly four years.1 Conversely, foreign economies are in an earlier phase of an expansionary cycle. Expectations for more interest rate hikes by the U.S. Federal Reserve have overshadowed strong fundamentals, thus putting downward pressure on foreign and emerging market securities.

More attractive valuations overseas

Economic and earnings growth outside of the U.S. has moderated, but remains healthy and is supported by attractive valuations based on several different accounting and financial metrics. According to Bloomberg estimates, international equity valuations are approximately 4% percent above their 10-year average whereas U.S. stocks are roughly 16% above.

Disciplined investing with a focus on fundamental and secular growth trends

As is typically the case, there are issues that could impact global markets. An overly aggressive Fed rate policy, trade wars or slowing growth in China could crimp earnings, particularly within more cyclically sensitive industries. Against this backdrop, we believe individual stock selection will take on added importance. This includes not only identifying quality, secular growth companies that can withstand challenging conditions, but also entails avoiding companies with weak fundamentals that could be vulnerable if volatility increases.

Staying the course with sustainable growth companies

In our view, an appropriate investment strategy—especially in today’s market—is to focus on competitively advantaged companies with a history of sustainable growth backed by secular trends. We favor international companies with diversified business models and above-average earnings growth. These include demographic trends, such as a rapidly growing middle class in many developing countries, technological shifts, including the proliferation of online commerce and advertising, and business dynamics, such as outsourcing. Companies with these tailwinds at their back tend to be more resilient in challenging economic environments.

Actively diversify across the market capitalization spectrum

Investors can also exploit greater market inefficiencies by diversifying across international small- and mid-cap stocks which are often overlooked and underowned. Several smaller-sized companies derive a bulk of their revenues from domestic demand and as a result are less influenced by trade barriers and other macroeconomic headlines. Moreover, the number of sell-side research analysts covering smaller capitalization firms has been on the decline, thus providing a compelling opportunity to enhance risk-adjusted performance through disciplined stock selection.

1. Source: U.S. Department of Commerce

MSCI ACWI ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries. With 2,154 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.

MSCI ACWI ex USA Small Cap Index captures small cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries. With 4,315 constituents, the index covers approximately 14% of the global equity opportunity set outside the US.

MSCI ACWI ex USA Mid Cap Index captures mid cap representation across 22 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 960 constituents, the index covers approximately 15% of the free float-adjusted market capitalization in each country.

MSCI EAFE Index consists of international stocks representing the developed world outside of North America.

MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) designed to measure equity market performance in global emerging markets.

S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.

Price/Book Ratio, or P/B ratio, is a financial ratio used to compare a company’s current market price to its book value.

Price/Cash Flow Ratio (also called price-to-cash flow ratio or P/CF), is a ratio used to compare a company’s market value to its cash flow.

Price/Earnings Ratio (price‐to‐earnings or P/E Ratio) denotes the weighted average of all the P/Es of the securities in the fund’s portfolio.

Price/Sales Ratio, P/S ratio, or PSR, is a valuation metric for stocks. It is calculated by dividing the company’s market cap by the revenue in the most recent year; or, equivalently, divide the per-share stock price by the per-share revenue.