Australian equities are richly priced. Trading 8% above fair value, our market ranks amongst the most expensive across Morningstar’s global coverage [Exhibit 1]. In fairness, this premium isn’t extreme by historical standards—we’ve seen valuations at these levels roughly 40% of the time during the past ten years. And opportunities remain, including stocks on our January 2025 Best Ideas list (see page 4). But the market looks more expensive than usual, particularly across the large caps, and paying more today means lower future returns.

Exhibit 1: Australia ranks amongst the most-expensive markets we cover

Premium/Discount-to-Fair-Value by region

Source: Morningstar. Data as of 6 Jan. 2025. Europe inc. UK data as of 14 Jan. 2025. Fortunately, investors are not constrained to our shores. The ASX is home to $121 billion of global equity exchange-traded products, roughly twice the size of domestic strategies. Despite this, Australian portfolios are still heavily skewed to the local market. State Street found domestic shares account for 44% of the average superannuation portfolio, even though Australia accounts for less than 2% of the global equity market. A familiarity with the local investing landscape, and the allure of franking credits, doubtless contributes to the home bias. There’s no definitive answer on how much exposure an investor should have to the local market. But the average allocation seems high, and this comes into sharper focus when our market looks overpriced. So where might investors turn for diversification and better value?

The US

The world’s largest stock market is first to mind. Trading 4% above fair value, the premium is not as steep as Australia. But we’re in unusual territory for US equities. Since the end of 2010, the market has traded at a premium of 4% or more less than 10% of the time. The most recent example occurred in early 2021—right before the disruptive technology bubble popped. [Exhibit 2]

Exhibit 2: 2024 rally pushed the US stock market above fair value

Composite of Price/Fair-Value ratios for US stocks under Morningstar coverage.

Source: Morningstar. Data as of Jan. 6, 2025. That’s not to say devaluation is imminent. Markets can stay expensive for a while, and we might just be in for a period of lower returns until earnings catch up. But the tailwinds that propelled the market higher last year appear to be receding. Spending on artificial intelligence hardware is now increasing at a decreasing rate as opposed to increasing at an increasing rate. And as our US technology strategist points out, as the market comes to better understand the AI megatrend, the big, positive surprises like those of 2024 are less likely to repeat. The US market trades at rich valuations despite significant macroeconomic and political uncertainty. Inflation is proving stubbornly persistent, the Fed has tempered the outlook for rate cuts, and while we’re not calling a recession, growth is slowing. We’re not so concerned about the upcoming fourth-quarter earnings season, as the US economy appears to have held up into year-end. But the management teams of companies we cover may lower the bar on expectations for earnings growth in 2025. This could unsettle markets, but bouts of volatility around earnings can create attractive entry points. Trump is the big wild card. It remains to be seen how much of the tariff talk was just campaign trail rhetoric. We still don’t know when potential tariffs might be implemented, how big they might be, and what countries and products will be taxed. Our Chief US Economist thinks Trump’s two main tariff proposals—the 60% tariff on China, and the 10% universal tariff—are unlikely to come to pass, but the outlook is highly uncertain. So where do we see value in US equities? Small and mid-cap stocks trade below fair value, while large caps generally look expensive. US growth stocks, particularly in the technology sector, have run hard. Ten stocks, including the Magnificent Seven, accounted for almost 60% of US equity market returns in 2024. But these stocks only account for 30% of US market capitalization. We think the outperformance is mostly behind us, and only two of the Magnificent 7—Alphabet, parent of Google, and Microsoft—screen as undervalued. But ‘value’ stocks—stable, mature businesses, with low debt levels and solid cash flows—remain attractively priced in general.

Asia

Value abounds across Asia’s equity markets, with stocks we cover at a discount of around 6%. China looks particularly undervalued, at a 22% discount, though this market has its challenges. Aging demographics, deleveraging, and weak consumer spending are core. Equity performance has been unimpressive in recent years, notwithstanding an ebullient reaction to stimulus measures announced in September 2024. Investors considering exposure to China should keep in mind the heightened regulatory, geopolitical, and economic risks. Nonetheless, we are optimistic about the medium-term prospects for Chinese equities. We are encouraged by signs that the authorities are prioritizing policy support to shore up the economy and expect stimulus measures to continue evolving in the year ahead. A more benign regulatory backdrop compared with a few years ago is also constructive. As a cyclical recovery takes shape, we anticipate moderate earnings growth from Chinese companies—but it could take time. Several Asia-focused ETFs on the ASX receive medalist ratings from our manager research team. Medalist ratings are on a scale of Gold, Silver, Bronze, Neutral, and Negative. Funds awarded Bronze ratings or above are expected to provide better risk-adjusted returns than their relevant indexes, after accounting for fees. Key statistics for these funds, including the geographic weighting to China, are in Table 1. This list might serve as a starting point, but investors should consider their individual objectives.

Table 1: ASX-listed Asia & emerging markets exchange-traded funds (Bronze Rating or higher)

Source: Morningstar.

Europe

European equities trade at a 5% discount to fair value. This isn’t particularly cheap compared to the bargain territory of the past two years, but excluding Asia, it’s the most attractive region we cover. Value is particularly pronounced in the UK: at a 10% discount, it’s the cheapest developed market globally. The macroeconomic environment is improving in Europe, which should support corporate profitability in the region. Inflation has cooled to roughly 2%, the ECB’s target level; GDP growth is picking up; and monetary easing has commenced. Two risks we see for early 2025 are (i) political disruption, with German elections planned for February and France still working to establish a stable government, and (ii) US trade policies. As the largest trade partner with the US, it’s unlikely Europe will escape unscathed. But these risks look priced. Almost half the stocks we cover trade in 4- or 5-star territory, and across all categories, European stocks trade at a discount to US peers. For investors considering European exposure, there are a handful of dedicated ETFs on the ASX. Table 2 shows key statistics. The iShares Europe ETF is the only fund we cover and receives a Neutral medallist rating.

Table 2: ASX-listed Europe & UK exchange-traded funds

Source: Morningstar.