Schwab's Kleintop: Time to Add Global Stocks

After a long outperformance by U.S. equities, the time appears to be right for investors to make a shift and add a broad exposure to international stocks to their portfolios, according to Jeffrey Kleintop, managing director and chief global investment strategist for Charles Schwab & Co.

Most investors are probably underweight international stocks in their portfolios, which is natural after a decade of underperformance, he said in an interview with ThinkAdvisor on Wednesday, suggesting they’d be mistaken to hold on or add positions in former equities leaders in hopes those stocks will be the first to rebound.

“When markets are difficult, challenging, volatile, they want to retreat back to what’s been working,” Kleintop said. “I think that’s the wrong thinking this time. I think we’ve started a new environment where international stocks are where we want to focus.”

Moving to new leaders in an environment with higher inflation and rising interest rates should benefit portfolios, Kleintop added. A broad exposure to international stocks should present an appealing opportunity in the second half of this year, he said.

“There’s a lot of focus on whether we’re going to get a recession or not globally and the market’s been obsessed with that in the first half of the year,” he said. “What it may have overlooked is that earnings are actually improving,” 

Economists have lowered their growth outlook for most countries around the world — the Organization for Economic Cooperation and Development cut global projections Wednesday — “but at the same time we’re seeing analysts raise earnings forecasts for this year and next year,” he said. 

That divergence between economic and earnings forecasts is atypical but may make sense in the current environment, Kleintop noted. “Some of what’s causing concern about the economy, high inflation, is actually good for the private sector and profits,” he said.

In his 2022 midyear outlook, released Monday, Kleintop explained that rising energy prices can pressure the economy while boosting energy company earnings. In addition, the increased business investment happening now contributes more to profits than to economic activity, he noted.

Forecasts Up, Valuations Down

Despite concerns about the economic effects of high inflation and the war in Ukraine, analysts now expect European earnings to grow by more than 13% this year, an eight percentage point boost from the start of 2022 and a faster climb than forecasts for U.S. companies, according to Kleintop, who wrote that profits may be more important than gross domestic product for share prices in this year’s second half.

“If we continue to see solid earnings growth in the second half of the year, stocks may find their footing,” he said in the interview.

Stock valuations in non-U.S. developed countries are well below average, at previous-recession levels, suggesting that “investors are much more pessimistic about the earnings picture than analysts are,” he said. “Something will have to give in the second half of the year,” with either analysts saying they were wrong or markets acknowledging they underappreciated these companies’ earnings potential, he added.

“The real question is how much more aggressive will central banks be in trying to tame inflation,” and how that will affect the economy and earnings, Kleintop said.

U.S. Stock Risks

Kleintop sees more risk now in U.S. stocks, which continue to trade above their 20-year average, face a less favorable fiscal and monetary policy backdrop than European and Asian equities, and are less sensitive to inflation than global and especially European equities, he said.

“I see a relatively brighter picture in international stocks in the second half of the year,” he said, adding that equities from global developed markets may outperform U.S. stocks this year for the first time in a long while. Global stocks, like European energy, materials and financial equities, tend to benefit more from rising inflation, he said, and “that’s really helping to drive stronger growth in Europe than in the U.S.”

Rather than focusing on specific sectors, Kleintop recommends a broad international exposure within a diverse portfolio. “We’ve started to see a shift in the cycle back to an environment that favors international stocks,” he said. 

Risks and Opportunities

Kleintop favors broad holdings across Asia, Europe, Latin America and parts of the Middle East, rather than limiting investments to certain industries, given that correlations across stock markets have fallen to 20-year lows and diversification benefits portfolios when sectors and markets shift more independently from each other.

“I think a broad index is the way to do it,” Kleintop said, noting that a broad international ETF is a way to add exposure and benefit from low correlations and a strong earnings picture. “If I had to pick a region I probably like Europe the best given valuations and stimulus and earnings growth. I don’t think this is an environment where we should be making big bets.”

Economic uncertainty over inflation, war in Europe, central bank rate policies and China’s COVID-19 lockdowns may have eased modestly from earlier in the year, Kleintop said, but ongoing risks could cause continued stock market volatility in the second half.

Excess Inventory

One of the biggest risks is the possible move from product shortages to gluts, he said. 

“We might start to see a lot of these shortages that have really been part of the inflation problem may begin to melt away and we may be replacing them with another problem, which is gluts,” he said, noting that several major retailers recently reported excess inventories that may prompt them to cut prices. Demand for semiconductors also appears to be easing, he said, citing comments this week from an Intel executive. (Semiconductor stocks fell Wednesday in response, Bloomberg reported.)

Gluts can be worse than shortages and can pressure earnings, Kleintop said, calling them an underappreciated risk. “It’s a problem to companies that have been reliant on pricing power to help them sustain their earnings picture,” he said, expressing hope that gluts will remain limited rather than developing more broadly.

Other key risks include the possibility, especially closer to winter, that natural gas supplies from Russia to Europe will be cut off, which “would pull Europe into a recession,” he said.

Further COVID-19 breakouts in China also pose a risk. China’s doing a fairly good job trying to keep production and ports open but its population isn’t adequately vaccinated, so “we’re still at risk of supply chain shutdowns” and potential recession in the world’s second largest economy, Kleintop said.

Buybacks and Short-Duration Stocks

The second half also brings opportunities, he said, citing short-duration stocks and companies engaging in share buybacks in addition to diversification in international equities.

Short-duration stocks, which offer more immediate cash flows, tend to outperform when interest rates rise, he noted. These low price-to-cash-flow stocks have been consistent outperformers globally this year and that may continue as a theme in the second half, Kleintop said. Short-duration stocks are more dominant in international markets, he noted in his outlook.

Companies that have announced or increased share buybacks present another opportunity. They appear to be benefiting from more price support than others as they have outperformed this year, with results fairly pronounced in Europe, he said, citing another potential ongoing theme for the second half.