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Investors Might Find Better Returns Abroad In 2023. Here’s Why.

With the brutal returns of 2022 almost behind investors, those looking to make up lost ground might do better to look abroad next year.

Some strategists see a better set-up for foreign stocks than their U.S. peers, a change from the recent past, when investors were rewarded for staying close to home. Over the past five years, the iShares MSCI ACWI ex U.S. (ACWX) exchange-traded fund lost an average annual 1.8%, compared with the average 7% gain for the SPDR S&P 500 ETF (SPY).

In a tough year for many assets, global stocks have fallen 18% so far this year, compared with 20% for the S&P 500. Some strategists think global stocks are poised to extend their lead.

Stocks in Europe and emerging markets are cheap compared to those in the U.S., but that’s not the only draw. Diverging monetary policy and economic backdrops, as well as investors having little allocated abroad, could set up international stocks relatively well for 2023, especially if the dollar’s strength wanes in coming months.

Strategists at mutual fund firm Vanguard estimate annualized returns for the next 10 years for developed markets of 7.2% to 9.2% and emerging markets of 7% to 9%, compared with just under 5% to 6.7% for U.S. stocks. Among the reasons behind the rosier view for global stocks are expectations for a harder road for U.S. stocks with stretched valuations, the risk that higher labor costs eat into cyclically high profit margins, and rising odds of a recession.

The strategists see more value, even if it comes with less growth, abroad after U.S. stock returns have trounced global stocks over the past decade. A portfolio of U.S. stocks bought in 2012 is worth double that on a cumulative return basis than an international stock portfolio over the same period.

That outperformance feeds into Vanguard’s rosier outlook for international stocks, especially if the U.S. dollar weakens. Vanguard’s strategists see emerging markets as attractively valued for the first time since the pandemic. They note the 30% decline for emerging market stocks over the past 12 months, as central bankers in these countries aggressively raised rates to help control inflation and geopolitical risks led investors to demand a higher risk premium to invest in these countries.

Near-term risks persist, including the dollar’s strength, the prospect of a global recession, and geopolitical tensions. But Vanguard’s strategists say the narrative against foreign stocks appears overdone. Plus, interest rate increases in the emerging world have slowed and U.S. rates are rising faster.

China’s economy is poised for a cyclical recovery as authorities ease strict Covid restrictions and provide more stimulus to stabilize its troubled property market. At the same time, Vanguard cautions that the rebound could be restrained given the longer-term structural issues facing China—and its property market—including an aging population and too much supply of apartments.

The dollar is a major factor for international stocks. The relative health of the U.S. economy as Europe and China flailed and the Federal Reserve raised rates more than any other major central bank underpinned strength in the dollar this year. But that’s changing as the U.S. economy slows and China’s economy is expected to get a much-needed boost in the first quarter after it navigates what is expected to be a bumpy transition to living with Covid. Monetary policy could also diverge as some of the emerging markets that had raised rates ahead of the Fed could even start easing before the U.S.

In its latest survey of global fund managers, Bank of America found the highest expectation of the dollar weakening since May 2006. Investors are also becoming more bullish about China’s reopening, with managers the most overweight the asset class in 18 months.

Gavekal Research’s Louis Gave and Anatole Kaletsky see the next bull market playing out in Asia and emerging markets. The duo expects the Fed to pause interest rate increases in 2023, though inflation may be more intractable than anticipated. Once the Fed blinks on interest rates, Gave sees the dollar weakening—opening the door for international markets just as China begins to see a boost from its reopening.

The next couple of weeks will be critical to see how China fares as it abruptly transitions to a living with Covid approach after years of zero-Covid. UBS Wealth Management’s Mark Haefele sees China’s opening path as one of the critical variables for the market and recommends investors stay nimble.

In a note to clients, he suggests investors stay defensive for now, tilting toward global healthcare and staple companies with relatively resilient earnings. He also recommends that investors be ready to shift toward riskier bets into the new year.

German stocks could be an early winner, with attractive valuations and companies that stand to benefit as China reopens, Haefele says. Also worth considering: Opportunities in pharma and medical equipment stocks that could get a boost as China deals with further waves of Covid.

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