Investment returns from international markets have lagged the U.S. market by a wide margin over multiple time frames during the past decade. As a result, valuations of non-U.S. stocks continue to fall well short of richer U.S. stock valuations. In other words, international equities appear cheap.
Does that signal a buying opportunity for international equities, or are there still some compelling reasons why U.S. investors should remain cautious of increasing their international equity allocation?
Let’s look at the recent performance of the international market. The MSCI All Country World Index, ex US market, which is a very broad benchmark for stock markets outside of the U.S., has posted annual returns of 4.45%, 2.75%, and 5.06% over recent three-, five-, and 10-year time frames as of late August.
By comparison, the S&P Total Market Index, which is a comparably broad index for the U.S. stock market, has posted significantly better returns of 13.61%, 11.99%, and 12.90% over the same three-, five-, and 10-year time frames. Clearly, having any meaningful allocation outside of the U.S. equity market proved to be a significant drag on overall portfolio performance during those time periods.
There are a number of reasons for the disappointing returns from international markets, including structural differences in country and regional economics, tax policies, and political realities. Cultural differences, such as entrepreneurial dynamism, or societal attitudes around work relative to leisure, have also been relevant factors affecting economic activity and, thus, international capital market returns.
After such dramatic underperformance over an extended time frame, and with comparatively cheap valuations in the non-U.S. market, this would be a good time to take a deeper look at this very large, yet confounding sector of the global capital markets.
The total value of all global equity markets is currently approximately $125 trillion. The U.S. stock market represents about 40% of this total. With 60% of equity market opportunities lying outside of the U.S., investors who are diversification purists would advocate a substantial allocation to non-U.S. markets in order to approximate exposure to the global equity opportunity set. However, as noted, this approach would have led to significantly lower returns relative to a U.S.-centric approach over the past decade.
In considering a long-term allocation to international markets, it is important to be aware of some key differences in characteristics between the domestic and international markets. There are also critical currency, market structure, and geo-political issues to consider. Finally, there are secular dimensions which have been evolving for a number of years which have diminished the benefits of international diversification from a country-specific perspective.
Equity market composition – U.S. vs. international
Differing economic environments for the U.S. compared with the rest of the world have led to dramatically different business environments. In short, key U.S. sectors have grown more rapidly than the rest of the world, with the driving force being innovation in industries such as Information Technology and Health Care.
Information Technology and Health Care companies make up 26% and 15% respectively of the total U.S. equity market. Not only have these sectors experienced higher revenue growth rates, but profitability is also meaningfully higher for these sectors. International equity markets have significantly less exposure to these two vibrant sectors, with Information Technology and Health Care sectors making up just 11% and 10% of international equity markets, respectively.
In contrast, international markets have much larger exposure to the slower growth, heavily regulated Financials sector. Financials make up 20% of international markets, double the exposure found in the U.S. market. Furthermore, the Financials sector in international markets, and especially in Europe, experienced much more prolonged devastation from the Great Financial Crisis of 2008 than did the Financials sector in the U.S.
Finally, international markets have much greater exposure to the Materials, Energy, and Industrials sectors of the market. These sectors are cyclical and do not have anywhere near the level of profitability as the Information Technology and Health Care sectors, which have driven the U.S. market. Furthermore, these industries are more capital intensive and have had to deal with serious challenges related to sustainability and environmental issues.
Key secular, cyclical, and valuation considerations
How should you determine international asset allocations in your portfolio? There are several critical areas to consider, including secular, cyclical, and valuation factors:
In addition to the cultural and environmental factors that have inhibited relative economic and long-term market performance, key international markets are facing the headwinds of demographics.
China and Europe are both facing imminent demographic challenges, as birth rates move from being barely positive to modestly negative in the coming decades. This demographic shift has extremely problematic ramifications as populations age due to declines in potential economic growth, productivity, and corporate profitability. A template for this dynamic already can be observed in Japan, where declining birth rates and an aging population have led to economic stagnation for nearly 20 years.
Globalization, which provided immense benefits for international economies, especially China and other emerging countries, has been dramatically altered by Covid-19. The supply challenges and weakness in global trading that resulted from the pandemic, not to mention geo-political tensions, have caused developed countries and companies to shift from offshoring operations to onshoring more, with economic activity returning to the U.S. – even in some of the less productive market segments.
Political, legal, and structural issues will continue to inhibit international markets relative to the U.S. China’s heavy-handed insinuation of the state’s political priorities into corporate decision making and the structure of markets remains a major concern. Meanwhile, the economic fissures caused by Russia and its invasion of Ukraine, a growing energy crisis, and the many uncertainties of Brexit, create major long-term challenges for Europe.
In the near term, the economic cycle remains heavily impacted by Covid-19. China has suffered the economic consequences of its zero-covid policy, as recent lockdowns have impacted not only China, but also its trading partners around the world. China also remains in the early stages of dealing with a serious real estate problem caused by the cyclical overbuilding of the past decade.
The cyclical problem of inflation, which the entire world is facing, is significantly more troublesome in Europe and, to a lesser degree, Asia. Like the U.S., foreign central banks are in the early stages of raising interest rates and tightening policy to combat inflation. Given that foreign economies, especially emerging markets, have more financial leverage than the U.S., rising interest rates will likely act as more of a cyclical drag on corporate profitability.
The tragic war in Europe, and the growing energy crisis it has created, will remain a serious impediment to economies and markets. This energy crisis is contributing to a surge in inflation. Inflation is now over 10% in Europe and shows little sign of receding. Producer prices – the cost of inputs – have risen close to 40% in some countries due to surging energy costs. Persistent inflation will be a serious drag on real economic growth in Europe as consumers and businesses deal with extreme price pressures. The European Central Bank is already anticipating a recession.
Given their very different economic and market characteristics, foreign markets have consistently traded at valuation levels that are lower than the U.S. Currently, foreign markets trade at a price/earnings ratio (P/E) of approximately 13 times earnings. This is a 25% discount to the valuation of the U.S. market, which recently had a market valuation of about 17 times earnings. Since 2005, international equities have only been this cheap relative to the U.S. market about 5% of the time.
Furthermore, the dividend yield of foreign markets, at about 2.5%, is much higher than the U.S. dividend yield of approximately 1.5%. However, U.S. companies have used stock buy-back strategies as the preferred approach to returning capital to shareholders.
Secular and cyclical issues have also contributed to a surging value of the U.S. dollar relative to global currencies. In fact, global currency depreciation relative to the U.S. dollar has been a significant contributor to disappointing returns from international equities.
The dollar has appreciated by over 50% relative to a broad basket of global currencies over the past decade. Currency translations are an extremely important factor in returns generated from foreign investing. The dollar has recently been hovering around the highest level in 20 years relative to global currencies.
International equity allocation conclusions
A number of market structure, legal, political, secular, and cyclical issues in the international equity market could continue to hinder its returns relative to the U.S. market. However, current valuation metrics from an historical standpoint are quite cheap.
Although international economies and capital markets are very large and cannot be ignored, an allocation in proportion to the percentage that international markets contribute to global equity indices (60%) would be excessive for a U.S. investor. Given these factors, what is a thoughtful approach to making an allocation to international equities?
An allocation to international equities could be considered alongside an investor’s allocation to the domestic value sector. International equities and the U.S. domestic value sector have many common characteristics. They have a high concentration of stocks in the Financial, Energy and Industrials sectors, sport low valuations, and have relatively high dividend yields. However, unlike the U.S. value sector, international equities have a major complicating issue of potential currency translation, which can greatly affect returns.
Incorporating objective historic returns, volatility, and correlation data for both international and U.S. equities into a statistical optimization methodology provides a more disciplined and elegant solution to this allocation question. This analytical approach calculates an allocation that maximizes a portfolio’s overall return while minimizing portfolio risk. Following this process, an investor could justify establishing 15-25% of overall equity exposure to international equities (depending on overall risk tolerance) as a baseline long-term strategy.
However, from a current tactical standpoint, a moderate underweight in international equities relative to an established strategic target seems warranted given the multitude of global economic and geo-political challenges. International equities, like U.S. value equities, are much more cyclical. As such, when there is evidence that a synchronized global upswing in economic activity is at hand, a decided overweight would likely be warranted.