Value and Small Caps Could Drive International Equities
23 JAN, 2025
By Justin Thomson, Head of International Equity, T. Rowe Price
As the inflation and interest rate shocks of 2022 continue to reshape the dynamics of international equities(excluding the US), a positive outlook for this asset class should become more apparent in 2025. We expect further evidence of a widening opportunity set benefiting international equity markets—particularly value and small caps, as well as equities in countries like Japan and South Korea.
We are emerging from a highly unusual period where a single market (the US) and a single sector (technology)dominated returns. Within this sector, a small group of exceptional companies drove most of the performance. This dominance has skewed investor positioning and valuations: many portfolios are heavily weighted towards US equities, while nearly all non-US equity sectors are currently cheaper than their US counterparts.
Small Caps Are Positioned for Strong Earnings Growth
Valuations alone are not a compelling reason to invest in a specific market or asset class, but they provide a useful starting point for assessing long-term return potential. In international markets, value stocks have been trading at a discount relative to growth stocks. This is likely to change as we anticipate a strong rebound in non-tech investments, driven by widespread factory automation and the reshoring of supply chains.
The companies that thrived in the aftermath of the global financial crisis were US tech firms with business models reliant on intangible assets. In our view, the near future will likely see above-trend demand for tangible assets, boosting sectors such as industrials, energy, and materials, which are traditionally value-oriented.
International small caps (as represented by the MSCI All Country World ex-USA Small and Mid Cap Index) historically traded at a premium to large caps. However, by 2024, this premium had disappeared following several years of disruption and supply chain challenges linked to COVID-19.
In our opinion, these stocks are now well-positioned to deliver stronger earnings-per-share (EPS) growth than their large-cap counterparts in the coming years as economic conditions improve. Historically, after periods of weakened corporate performance, small companies tend to outperform larger ones in terms of earnings growth. We expect this trend to repeat, with the additional tailwind of extremely low valuations in the small-cap segment enhancing returns for investors.
Structural Shifts in China and New Opportunities
Globally, we may need to adjust to a structural shift in China, where economic growth is unlikely to return to the 5–6% levels of recent decades. Growth could be further hindered if US President-elect Donald Trump follows through on promises to increase tariffs on Chinese imports.
However, the extent of these measures and the scope for negotiating a new trade agreement between the two countries remain uncertain. Meanwhile, a combination of rock-bottom valuations, rising innovation, and the potential for strong countercyclical rebounds will continue to present new investment opportunities in China.
Japan and South Korea: Mid-Term Strength and Governance Improvements
In Japan, we believe the medium-term bullish case remains intact, as Japanese companies shift their focus from market share to profit maximisation.
Despite recent political instability, South Korea is striving to replicate Japan’s success in enhancing shareholder valueby promoting good corporate governance practices. Tax incentives are being offered to companies prioritising shareholder returns, while the newly introduced "Korea Value-up" index will include firms that have improved capital efficiency.
These changes provide ample structural opportunities at attractive valuations.
Key Takeaway
In our view, the expanding opportunity set will favour international markets, particularly value and small-cap stocks.
