The Spotlight Blog

A Bottom For International Markets?

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With light positioning for international shares relative to U.S., more positive headlines regarding U.S. – China trade relations and an exit to Brexit, it is not surprising that international equities have bounced back relative to U.S. equities over the last month.

While this renewed sense of optimism for international markets reflects positively on the overall risk environment, we do not believe that the current rotation has lasting legs causing us to fade this rally, and stick to a U.S. overweight.

INTERNATIONALS PLAYING CATCH UP. GLOBAL PMIS BOTTOM.

  • While international markets have found some footing of late, they have considerably underperformed over the last    year, three years, and beyond as investors have favored the higher growth sectors that U.S. markets offer and shunned the value sectors that are prominent overseas. Differences in sector-level exposures have been the key driver of U.S. outperformance, especially as the U.S. has nearly 9% lower exposure to financials and over 13% more exposure to IT.
  • With the aforementioned headlines boosting sentiment, another less discussed driver of improvement from international shares has been investor belief that global manufacturing data may have bottomed as illustrated in the below figure. While manufacturing remains in contraction territory, it has steadily ticked up over the last two months, which directly boosts international markets to a greater extent than the U.S.

Manufacturing PMI Showing Signs Of Improvement

Source: FTSE Russell, as of October 30, 2019. U.S. represented by the Russell 1000 Index and International represented by the FTSE All-World ex US Index. One cannot invest directly in an index.

FOLLOW THE MONEY?

  • Like performance, international equity ETF flows have been more inspiring of late with investors adding $2.08 billion to the group in October while redeeming $3.22 billion across U.S. focused ETFs. However, this is on the back of September, a month that brought a whopping $14.65 billion into U.S. ETFs compared to only $1.27 billion in net inflows for international ETFs.
  • Taking a longer-term view of flows does little to change the narrative of ETF investors favoring U.S. exposures relative to International, as trailing flows over the last 12 months show a nearly $17 billion advantage for the U.S. even when taking into months like January ($13.87 billion of outflows) and May ($16.14 billion of outflows). Short-term flows into and out of the U.S. have been more volatile in the recent past, while international flows have been relatively stable.

Flows Continue To Favor Large Caps

Source: Bloomberg Finance, L.P., as of November 1, 2018 to October 30, 2019. Data represents the net flows of U.S.- listed U.S. Equity ETFs and International Equity ETFs, specifically targeting exposure to U.S. and International markets, respectively. For example, when the blue or orange bars are positive, net flows were positive. On the other hand, when the blue or orange bars are negative, net flows were negative.

STRETCHED VALUATIONS AS EARNINGS SEASON UNFOLDS

While clarity on a path forward for trade negotiations seems positive, fundamentals for international equities remain poor. Outside of dovish monetary policy, the spillover of manufacturing weakness appears to have affected the services side of the economy as the global services PMI has drifted lower in recent months.

  • Massive outperformance from the U.S. has caused valuations to be stretched with the cyclically adjusted price to  earnings ratio for the U.S. hitting 27.53x versus its 10-year median of 21.18x, while the same measure for international markets reads 18.45x compared to 15.89x. This certainly makes the long-time potential for mean reversion to be robust, but its forecasting ability over shorter time periods is mixed.
  • Finally, the earnings picture for international markets does not offer a compelling case to take near-term action on the valuation argument, especially in the context of an uncertain economic environment as U.S. earnings are expected to see relatively better in the current quarter. In addition, U.S. firms (as measured by the S&P 500) are beating earnings estimates by 4.5%, while international companies (as measured by the MSCI EAFE) are managing only 0.1% beat.

While still early in the revisions cycle, current expectations for 2020 see the U.S. generating better results than their international peers as well.

International Shares Have Slumped Along With Commodities

Source: Credit Suisse, as of October 30, 2019. U.S. represented by the S&P 500 Index and International represented by the MSCI EAFE Index. One cannot invest directly in an index.

IMPLEMENTATION IDEAS

  • With an overweight to U.S. companies and an underweight to international firms, the Direxion FTSE Russell US Over International ETF [RWUI] allows investors to increase their weight to U.S. equities relative to their international peers in one ETF thanks to its capital efficient 150/50 structure.
  • The Direxion FTSE Russell International Over US ETF [RWIU] allows investors to increase their weight to U.S. equities relative to their International peers in one ETF thanks to its capital efficient 150/50 structure.  

 


DEFINITIONS

  • Russell 1000® Index: The Russell 1000 Index consists of the largest 1,000 companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. companies.
  • FTSE All-World ex US Index: The FTSE All-World Excluding United States Index is a free float market capitalization weighted index. FTSE All-World Indices include constituents of the Large and Mid-capitalization universe for Developed and Emerging Market segments.

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