Lara Castleton: Hello and thank you for joining this episode of Global Perspectives, a Janus Henderson podcast created to share insights from our investment professionals and the implications they have for investors. I’m your host for the day, Lara Castleton, U.S. Head of Portfolio Construction and Strategy, and today we’re venturing outside of the U.S. markets to talk about the international space.

For years, the U.S. markets have outperformed most of the ex-U.S. environment. But with a recent rotation out of some mega-cap tech names and still-record levels of cash sitting on the sidelines, a lot of investors are wondering where to diversify their assets. In our consultations globally, we frequently hear the question, is now the time for ex-U.S. equities?

So, to dig into that space, I’m joined by Julian McManus and Chris O’Malley, Co-Portfolio Managers on our Global Alpha Equity Team. Today, we’ll discuss the macro backdrop behind ex-U.S. markets, talk about why the tech trade is not just a Magnificent Seven (Mag 7) story, and dig into some of the implications for investors as they think about allocating to the space.

Gentlemen, thank you for being here.

So, Julian, I want to start with you. Just to set up the macro backdrop, I mentioned how U.S. markets have been outperforming ex-U.S. for quite some time. What’s the best explanation in terms of that divergence?

Julian McManus: Well, I think it has been driven primarily by the Magnificent Seven in the U.S., and for good reason because the U.S. has an environment that’s conducive to business models like scaled platforms, such as Amazon, Google, and Meta platforms. And I think that a lot of innovation has been going on in the U.S. in a way that’s been difficult for Europe or perhaps Asia to emulate.

Castleton: Chris, if I look to the markets this year, there actually have been some pockets of outperformance outside the U.S. Can you talk about where some of those have been?

Christopher O’Malley: Yes, sure. European banks have outperformed as those companies’ valuations were depressed. Their net interest income should continue to see growth, driven by a higher interest rate environment, and those companies continue to return cash to shareholders.

Within technology, there are also selectively tech companies outside of the U.S. who are seeing revenue growth as they are benefiting from many of the same trends that the Magnificent Seven here in the U.S. are exposed to.

McManus: Obviously, also, Japan has been a very strong market of late, and a lot of that’s being driven by fundamental changes happening at the corporate governance level and where we’re seeing significant improvements in capital efficiency by really large companies like Toyota but also the banks and the insurance sector.

Castleton: Okay, great. So, I’m excited to dig into tech a little bit later, mentioning that Mag 7, which you just talked about, has been such a big driver of the outperformance in the U.S. markets. We’re going to talk about some of the ex-U.S. tech trade, as well.

But I guess as we set up looking forward, one of the biggest dynamics over the last decade, too, has just been extremely low interest rates, low inflation. As we look forward, is there any backdrop in the macro environment that could set up international to potentially outperform U.S., or at least do better than the last decade? What would you be looking at?

McManus: I think one of the things that are likely to drive international markets is cuts in interest rates. And so, as the ECB is actually now — the European Central Bank (ECB) — is now ahead of the Fed (Federal Reserve) in starting its cutting cycle, you could see more rapid interest rate cuts in Europe. And that could spur some fairly large moves in more of the cyclical parts of the European market that tend to be more represented in Europe than in the U.S.

Castleton: And then more recently we saw some positive economic growth coming out of Europe. So, does that add to the story as well?

O’Malley: Yes, I think some of the things that you’re seeing in Europe are you’re seeing inflation come down at a faster pace than it is in the U.S., and you’re also seeing PMIs (Purchasing Managers’ Indices) in Europe start to inflect positively.

The other thing that’s interesting about Europe is the spread between the U.S. and European valuations are at their widest point, the widest point that we’ve seen in 20 years. So, we are very constructive on the European market going forward.

Castleton: And so, valuations are also a really big topic. Again, interest rates used to be 0%. They are no longer 0%, and so, that has big implications for valuations. I think international has a little bit more attractive valuations than the U.S. Is that fair?

O’Malley: That is fair. In Europe, we’re seeing P/E (price-to-earnings) ratios at around 12, whereas in the U.S., we’re closer to 20. And so, as the ECB continues to lower rates, we should see valuations increase and those multiples come up, especially as we see economic activity increase in Europe and earnings accelerate.

McManus: And I would just add on that Japan also still has very low valuations, not quite as low as Europe, but 14x,15x earnings is quite common. And in addition to that, Japan…a lot of Japanese corporates have very overcapitalized balance sheets. So, as they buy back shares and deploy capital more efficiently and unwind their crossholdings, they’re cheaper than they look when you strip out all of the cash. And so, there’s a lot of upside to valuation multiples in not only Europe, but Japan as well.

Castleton: Great, and so for investors who are, as I mentioned, recently rotating out of maybe more expensive mega-cap tech names, there are definitely places abroad, ex-U.S., where those valuations are more attractive.

One question I do just want to address, though, is we get questions on geopolitical conflicts. Just what’s the environment that you’re seeing in terms of geopolitical conflict? How do you factor that in?

McManus: So, it’s something that we think about a lot when we put the portfolio together. I think in the past, geopolitical risk has focused primarily on Taiwan. We happen to think that China is not in a position to take military action against Taiwan, at least for the next few years. What worries us more, I think, is what’s happening in Europe, particularly in Ukraine. And that’s something that definitely factors into the way that we put the portfolio together. Defense companies are an obvious example of something that…an industry that’s been neglected for many years and now actually is becoming increasingly important.

Castleton: Right, and just one thing we always talk about is, do correct me if I’m wrong, but ex-U.S. markets tend to be a lot more multinational as well. So, while there is the thought that geopolitical conflict, particularly in Europe, is going to really hurt all of those companies like they would here in the U.S., it is a different backdrop in those markets because they get their revenues much more globally. Is that right?

McManus: Yes, I think that’s fair to say.

Castleton: So, geopolitical conflict, something that’s definitely on the radar. The other one that I get questions on quite frequently is just the [U.S.] dollar. And for a very long time, we’ve been waiting for the U.S. dollar to weaken versus international markets. Just, how do you think about the dollar going forward?

McManus: So, I think that predicting currencies is about the hardest thing you can do in financial markets. And so, for that reason, we deliberately minimize currency risk. But currency is really not an area where we want to spend our risk budget.

Castleton: Okay, so, that makes sense. It looks like we’re really looking at bottom-up fundamental stories. We’re factoring in the macro environment, which is set up to potentially look good with valuations where they’re at, with interest rates coming down, inflation coming down.

So, let’s dig into some of those more exciting areas, and innovation is not something you have historically paired with international developed markets, but that’s one I want to talk about, especially in the technology space. So, technology’s been a very popular sector as of late. It’s typically been dominated in the U.S. markets, but what are you most excited about or cautious on in technology ex-U.S.?

McManus: I would say that I’m particularly excited about the enabling technologies behind AI (artificial intelligence) and behind what we’re seeing in the U.S. So, Nvidia actually has TSMC, Taiwan Semiconductor, make their chips mostly in Taiwan, and the enabling technology behind Taiwan Semiconductor actually comes from the Netherlands, in large part, so ASML and originally their parent company, ASM International. There’s a massive ecosystem of equipment and technology and process technology companies that provide the lithography equipment and the packaging technologies that enable TSMC to make those Nvidia chips. So, it’s not well recognized, but a lot of that key technology is outside the U.S.

Castleton: Okay.

O’Malley: And given where some of these companies sit on the technology curve and where their niches are within the semiconductor process…so, we believe some of these companies could grow even faster than semiconductor capex (capital expenditure) spend.

Castleton: Okay, interesting. And so, AI is a big topic this year, starting at the beginning of last year, actually, as well. I don’t know if it’s going to continue the trend recently of some of this AI scrutiny in those mega-cap tech names. But how do you view the landscape globally with AI?

McManus: So, I think that the software side of things is likely to continue to be dominated by headlines and innovation out of the U.S. But I think a lot of the hardware and the process technology and the materials that enable it are going to continue to be dominated outside of the U.S.

So, think Europe, in the Netherlands particularly, that ecosystem has a very long history and is difficult to replicate, but also in Japan. And a lot of semiconductor capex is actually going into Japan, both in Kyushu in the south and Hokkaido in the north, and the amount of innovation that’s going on there is really impressive.

Castleton: Great, so, AI and technology may still be a U.S. story going forward, but there’s a lot of these underpinnings behind the scenes that are concentrated…

McManus: Correct.

Castleton: …outside the U.S.

McManus: Exactly.

Castleton: So, technology also investable there, ex-U.S.

Let’s turn to other sectors, then, because U.S. markets do have different sector concentrations than non-U.S. So, I’m just wondering, what are investors potentially missing out on if they are too narrowly focused on the U.S. markets going forward?

McManus: So, I think that in the past, markets like the UK have been criticized for being very heavily dominated in terms of banks and mining companies. In the past, those were businesses that were considered unattractive. We would point out that there are actually some really interesting things happening right now.

In the case of financials across Europe, capital bases have been rebuilt and now, very strong management teams are creating a lot of value by returning capital to shareholders and repurchasing their shares at massive discounts to their intrinsic value, which creates a lot of value for shareholders.

And also, an unappreciated or we think underrated aspect of mining companies, is the way that they are going to be actually enabling the energy transition in future. So, as we transition from a carbon-based economy to using more electric vehicles and so on, we’re going to need a lot more copper across grids and in our cars. And so, that’s where mining companies come in.

Castleton: Chris, anything you’d want to add there?

O’Malley: Yes, specifically on European banks, these companies had traded at depressed valuations for a decade. And what we’re seeing now is the companies are benefiting from a higher interest rate environment. Even as we’re seeing interest rates come down, the companies’ balance sheets will continue to benefit for years to come.

These companies also operate in markets that are much less competitive to the U.S., and they’re earning returns that are much higher than they have over the last 10 years. And so, we still see plenty of room for valuations to improve there.

Castleton: Great, that makes sense. Thank you both for that. So, let’s dig in then to implementations for investors because again, my team consults on portfolios, but just for any investor there’s a plethora of opportunities to get access to these non-U.S. markets. There’s dedicated emerging market strategies or just single-stock companies. So, how do you see the opportunity for investors to get access to a potential ex-U.S. outperformance or strong performance going forward?

O’Malley: So, I think there are two main ways you can do it. Obviously, international strategies give exposure to everything ex-U.S., including emerging markets.

The other aspect is the possibility of not dividing the U.S. and international, but if you actually allocate to a global product then you can leave that decision of where best to allocate capital, whether in the U.S. or whether outside the U.S., to the manager. And one of the added advantages is that that one manager can have a holistic view of the risk around the world when they put the portfolio together. If you split your allocations into a domestic and an international manager, then you could end up doubling up on the same types of risks. We obviously spend a lot of time thinking through the risks that we’re taking on a global basis, and so, we find that that leads to better risk-adjusted returns over time.

Castleton: That’s absolutely something that my team does a lot of work on, as well, consulting with portfolios. A lot of heavy U.S. allocations, you want to make sure that anything outside of the U.S. is actually providing that diversification benefit that you’re looking for. So, that makes sense.

Something that we consistently hear, even deeper than just that type of implementation, is the free-cash-flow word thrown around. I think you teased it a little bit earlier. Why is free cash flow so important when you’re specifically looking outside the U.S.?

McManus: Free cash flow, as far as we’re concerned, is the most important source of value creation because at the end of the day, that’s what investors get to eat. Whether that free cash flow is deployed by management teams productively in new investments, whether it’s M&A (mergers and acquisitions) or organic investments in their existing business, or whether it’s return to shareholders in accretive ways, such as buying back shares at a discount to intrinsic value, both have their place. But if you don’t start out with that free cash flow that’s undervalued by the market in the first place, then you’re on shaky ground. And of course, we like free cash flow rather than just earnings because earnings are always open to manipulation. Free cash flow strips out the manipulations and the distortions that some management teams are incentivized to perpetuate.

O’Malley: The only thing I would add is that valuing a company based on its longer-term free-cash-flow generation potential gives us the confidence and allows us to take advantage of volatility in stocks, based on near-term uncertainty.

Castleton: I’ll add in that there has been some near-term uncertainty with international markets, so, by focusing on those metrics, it seems like you can maybe avoid some of those unforeseen circumstances to the best of your ability.

McManus: Yes.

Castleton: Well, before we wrap up, I think we would be remiss to not talk about elections. This has been a very big year for elections across the entire globe. I would love to just get your takes on the elections that have happened and what to expect going forward. How should investors think about them?

McManus: Yes, there have been a lot of interesting elections recently, with unexpected results. People were very nervous going into the French election. In fact, legislative gridlock has been the result in France, which is actually a positive for equity markets and risk assets, in our opinion, because some of the more extreme tail risk policies have been taken off the table there.

Elsewhere in the world, in emerging markets, Mexico delivered a surprise in a greater-than-expected majority for the socialist party. And so, markets are still trying to digest exactly what that means for equities.

And then in India, the BJP party, led by Mr. [Narendra] Modi, delivered a smaller-than-expected majority, which we don’t see as necessarily being negative. We think it means a continuation of the same policies.

And then finally, in the UK, I think we’re now starting to learn that a Labor government may not be quite as business friendly as they had led us to believe going into the election since they found supposed budget shortfalls that may necessitate raising corporate tax rates, which they had promised they wouldn’t touch for five years.

So, all to say every region is different and comes with its own risks, but we still find a lot of opportunity where the market is overpricing risk in some areas, like in France, and possibly underpricing risk in other areas, such as perhaps Mexico and the UK. And then finally, of course — and I can hand this over to Chris — but we have the big election coming up in the U.S. in November, and that comes with its own set of risks.

O’Malley: Certainly, the negative headlines around tariffs that might accompany a [Donald] Trump presidency will be negative for many non-U.S. companies. We believe defense holdings would actually perform quite well, as the pressure for European companies to increase defense budgets would increase.

Castleton: Makes sense. So, obviously a lot of uncertainty still on what’s going to happen here in the U.S. But in these previous elections, as you’ve noted, there’s been quite a few surprises. So, just adds to the story, from what I’m hearing, on a blanket passive allocation to international markets, especially around a year where so many elections, can come with some risk. It sounds like active management is important. Is there anything else you want to add on that?

McManus: Yes, I think when you’re investing internationally, active management’s really important because it’s important to be selective about which areas, which regions and countries you’re invested in. Corporate governance is a really important part, and it’s really important to be able to select companies in countries where the rule of law and shareholder protections are robust. And so, that selectivity is much more powerful and really important in terms of differentiating versus just scattergun index approaches.

Castleton: Well, thank you both for being here to walk through all things ex-U.S. today.

And we hope you found the conversation useful and came away with a framework to think about how to implement an allocation outside the U.S. by focusing on free cash flow and active management in the space.

For more insights from Janus Henderson, you can download other podcasts wherever you find them, or visit janushenderson.com.

I’ve been your host for the day, Lara Castleton. Thanks, see you next time.

Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.

Free cash flow (FCF) yield is a financial ratio that measures how much cash flow a company has in case of its liquidation or other obligations by comparing the free cash flow per share with the market price per share and indicates the level of cash flow the company will earn against its share market value.

Monetary Policy refers to the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.

Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.

Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors, based on a survey of private sector companies.

Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.

Volatility measures risk using the dispersion of returns for a given investment.