Owning US equities has been one of this column’s key themes in the past two years. This author was bullish on US shares in early 2012 and suggested taking some profits in August 2013 and building an allocation in troubled European equity markets.

The iShares Core S&P 500 ETF, the preferred vehicle for US equities exposure, returned 28 per cent in the year to January 2015, and 30 per cent annualised over three years. Those who bought US equities in 2012 have enjoyed excellent returns.

The iShares European ETF has returned 9.4 per cent over one year (most of it in the last few months), and 22 per cent annualised over three. It started to rally (in Australian dollar terms) in early 2013. For all its problems, Europe still looks the most attractive stgeloped market for contrarian investors who can withstand short-term volatility.

I still favour a higher allocation to international equities in 2015. Offshore markets have become the “new black” in investing for Australians in the past six months, as fund managers and brokers strongly argue the case for a bigger portfolio allocation to international equities.

The best time to buy international equities was a few years ago when the Australian dollar traded above parity with the US dollar and was clearly overvalued, and when US equities were cheaper. But international equities will still outperform Australian equities this year.

This week’s cut in the official cash rate and accompanying Reserve Bank commentary suggests our economy will continue to grow below its trend rate for some time, requiring more rate cuts in 2015. It is hard to see Australian equities outperform in this context.

Further falls in the Australian dollar, albeit at a slower pace in 2015, will provide impetus for international equities returns, for local investors with unhedged currency exposure.

Don’t get me wrong: I still like the long-term prospects for US equities, given that economy’s high exposure to information technology, lifesciences and consumer staples companies.  It just looks increasingly overvalued and ripe for a correction later this year.

Chart 1: iShares Core S&P 500 ETF

Source: ASX

Further reducing exposure to US equities, and having an underweight allocation, is prudent. They have had a stellar run: an 18 per cent annualised gain over five years, as reflected in the iShares Core S&P 500 ETF. But no bull market last forever and buying into the late stages of a spectacular rally is dangerous.

The US bull market’s big drivers, quantitative easing (QE), falling US interest rates and a lower US dollar, have been turned off. Rates are expected to rise, the Greenback should head higher and the US is done with its five-year QE program. Its economic recovery also looks a little patchier lately.

European equities have the reverse situation: a massive QE program announced this year; the likelihood of further falls in the euro helping big European exporters; and low or even lower interest rates. They are tailwinds for European equities, but will take time to flow through as the Eurozone equity markets grapple with ongoing volatility.

A rising threat of deflation and Greece’s potential exit from the European Union highlight the risks facing European equities. But the prospect of deflation, an insidious economic problem, should fire up policymakers to do much more to stimulate the Eurozone economies. And Greece’s possible exit is less concerning than it was a few years ago, provided it does not encourage other peripheral European countries to do the same or relax much-needed fiscal austerity programs.

As such, a higher allocation to European equities in 2015 is warranted. It’s not easy buying when most investment commentators do not have a good word to say about European economies or equity markets. But nobody makes money hugging the consensus view.

Chart 2: iShares European ETF

Source: ASX

Long-term contrarian investors might increase European equities allocations now. Others could capitalise on an expected pullback in global equities this year to build a position. Offshore markets are primed for a correction or shakeout later this year, perhaps led by a bond market default or a sharper slowdown in global growth than expected.

After returning 4.5 per cent annually for the past 10 years, based on the iShares European ETF, the region has woefully underperformed most other offshore markets. The long-term underperformance of European equities, and those in Japan for that matter, will eventually reverse, providing solid long-term gains for contrarians who buy when the news is bad.

The recovery will not be quick. But in relative terms, European equities have better prospects in the next few years than the overvalued US market.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis are at Feb 5, 2015.