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5 Reasons to Consider Investing in Europe and Japan

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International stocks have trailed U.S. stocks for much of the past decade, with only brief periods of outperformance. Consequently, many investors have wavered in their commitment to global diversification.

Within the international investment universe, European and Japanese stocks face skepticism, given tepid economic growth, demographic challenges, and often-questionable economic policy choices.

However, it may be time to take a fresh look at European and Japanese stocks as the global economy begins to heal from the economic shutdowns caused by the COVID-19 pandemic.

The following five factors boost the outlook for Europe and Japan:

1. Promising signs of containment of COVID-19.

Europe is ahead of the U.S. in containing COVID-19 infections, with activity and mobility measures signaling positive economic momentum. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns.

In contrast, parts of the U.S. are experiencing a worsening first wave of infections or the start of a troubling second wave of infections. The U.K. also has daunting challenges, with still-high infection and hospitalization rates, a stumbling economy, and many unanswered questions about Brexit.

2. Government and central bank efforts to offset the economic damage caused by COVID-19.

Monetary policy remains loose in Europe and Japan, with the European Central Bank (ECB) notably expanding its bond-buying efforts to provide additional liquidity to countries such as Italy and Spain. Forward guidance signals that policy will remain easy for the foreseeable future.

European stocks trailed U.S. stocks in the initial recovery from the March lows, in part because of a slower fiscal policy response. There are promising signs on the policy front, in contrast to the experience of the past decade. Germany is breaking with its frugal past by providing significant fiscal support, as is Japan. Both countries are providing support that totals more than 10% of GDP.

The European Union’s budget includes funds earmarked to help member states rebound from the economic damage associated with the COVID-19 pandemic. The most noteworthy aspect of the plan is that it is funded by the issuance of hundreds of billions of euros in bonds that will be obligations of the EU rather than member states. The recovery plan is a symbolic leap toward fiscal union.

Stimulus from China is also likely to help global industrial production, boosting exports from Europe and Japan.

3. European and Japanese stocks are cheap and would benefit from a cyclical rebound.

European and Japanese equities trade at a larger valuation discount to U.S. stocks than is typically the case. European and Japanese equities are highly levered to both the global business cycle and China’s economic fluctuations.

Consequently, if global activity recovers and China’s credit and fiscal impulse continue to improve, the more-cyclical European and Japanese markets are likely to benefit.

Banks may also offer interesting opportunities, though selectivity will be important given the likelihood of significant differences between winners and losers. Banks have sold off sharply as investors expect a rapid rise in non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nearly a century. However, NPLs may not expand by as much as anticipated given substantial support by global monetary and fiscal authorities.

4. The dollar may continue to fall, boosting the U.S. dollar returns of foreign stocks.

Many investors expect the long-term trend of U.S. dollar leadership to come to an end within the next year. Measures such as purchasing power parity indicate that the euro may be undervalued relative to the dollar. In addition, the steep reduction in U.S. rates narrows the rate advantage relative to euro and yen-denominated assets, while balance-of-payment dynamics are increasingly bearish for the U.S. dollar.

5. Investing internationally (still) provides diversification benefits.

Over multi-decade periods, portfolios with international exposure of at least 20% offered similar returns and lower volatility than U.S. equities. In addition, the U.S. represents only about 15% of global GDP and less than half of global market capitalization.

A portfolio without international stocks excludes many of the world’s leading companies. A sampling of the most prominent companies domiciled in Europe and Japan includes pharmaceutical leaders Roche, Sanofi, Novo Nordisk, Novartis and Takeda; automakers BMW, Daimler, Toyota and Honda; insurance titans Allianz, Munich Re and Zurich Insurance Group, technology companies ASML Holdings, SAP and Keyence; industrial leaders Siemens, ABB and Airbus; and consumer giants Unilever, Nestle, L’Oreal and Inditex (Zara).

Despite recent challenges, European and Japanese equities should be included in investor portfolios. European and Japanese stocks may reduce risk in an unpredictable world, while offering the potential to participate in the recovery of global growth as economic activity resumes after protracted lockdowns.

Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.

Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.

Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.