Be Selective When Weighing Overseas Opportunities

OCEAN CITY — U.S. equities continue to hit all-time highs, causing some investors to become increasingly uneasy. International developed markets, on the other hand, still stand roughly 20% below their pre-crisis high.

We favor European and Japanese equities, as relatively attractive valuations and accommodative money policies should provide tailwinds going forward. Investors should position themselves more carefully, however, given our outlook for uncertain economic growth.

Europe and Japan have lagged in the post-recession recovery. Roughly 64% of investors in the BofAML Global Fund Manager Survey expect quantitative easing in Europe, with a consensus that it will come before the end of the year.

Similarly, the BOJ recently confirmed that it will maintain its current stimulus in an effort to move Japan from an era of deflation to inflation. For the month of June, annual Consumer Price Index (CPI) inflation in Japan came in above 3% for the third consecutive month. However this has been exaggerated by the effects of a consumption tax levied in April, and adjusted for the tax, headline CPI was 1.5%. Prime Minister Shinzo Abe recently released the “third arrow” of his reform program, calling for reductions in corporate taxes, strengthened corporate governance and improved labor market conditions. As BofAML Global Research has pointed out, these moves should incentivize corporations to use their cash stockpiles to buy back shares, make capital expenditures or fund acquisitions.

Bottom-up fundamentals also support our positive outlook. While profit margins are at a 50-year high in the U.S., they are near the current cycle lows in Europe and even lower in Japan. This leaves opportunity for improvement, which would be additive to earnings growth and valuation expansion. In fact, our colleagues in BofAML Global Research note that Japanese and European equities are still trading at a valuation discount to the U.S.

In addition, Japanese and European companies traditionally have the world’s highest operating leverage —the ratio of fixed to variable costs. Relatively low variable costs mean earnings should get a boost if sales pick up.

Our positive outlook for these markets is not without risks. While growth has improved, it remains volatile. In Europe, the recovery has been constrained by a lack of global competitiveness in some areas, a sizeable debt overhang, and bank restructuring. In Japan, the consumption tax increase caused an economic contraction in the second quarter.

Fragile growth means investors should favor certain sectors over others. Defensive equity sectors have outperformed cyclicals in Europe by roughly 7% this year, and BofAML European Equity Strategist Obe Ejikeme believes this will continue. His team favors companies in the healthcare and food and beverage sectors. In both regions, higher-quality companies should prove more resilient in an uncertain economy, given their steadier earnings and cash flows. Ejikeme notes that domestically oriented companies in Europe have higher earnings expectations built in, and tend to fare poorly in maturing business cycles. On the other hand, those exposed to U.S. and Emerging Market consumers currently have lower expectations and typically outperform in a weak macro environment.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)