While domestic stock markets have been bullish since March 2009, with the S&P 500 Index up 281% from the start of that period, the same cannot be said for most international equities. Indeed, from the same March 2009 starting point, the MSCI Europe Asia Far East (EAFE) Index is up only 120%*. This disparity and trailing performance gap has led some investors to question an allocation to international equities. Yet, if you look beyond past performance to other important investment criteria, the case for investing in international equities – in both developed and emerging markets – is compelling for a number of reasons:
1. Market cycles and past outperformance
Comparing investment in international companies to investment in domestic companies historically shows many periods of international outperformance. Like most investments, international equities can be “in favor” or “out of favor,” depending on many factors. A well-diversified portfolio will always have winners and losers over most time periods. Periods of excess returns are often followed by periods of reduced returns, and no one can accurately or repeatedly predict when the cycles will shift. By maintaining a target allocation to international equites, our clients benefit when we add or withdraw from their portfolio, or when we rebalance back to target allocation. While international equities have risen less during this cycle, our balanced approach results in buying proportionately more of the asset class while at lower costs. This, in other words, is “buying low.” Alternatively, we tend to sell what has risen more; this refers to “selling high.”
2. Relative value and economic factors
When comparing valuation measures of domestic versus foreign companies, a key driver of stock value is the company’s earnings. As global economies have recovered since 2009, company earnings have also risen, supporting the rising stock prices. Foreign companies, when grouped together at the end of 2016, were earning more per dollar of share price than the domestic company group. This translates to better value. Foreign economies also had stronger forward looking growth indicators, signaling an earlier position in the economic cycle than the more mature US cycle. This results in another plus – strengthening economies.
3. Trade deficits and currency swings
For many decades, the US has run a large trade deficit. We pay for imports with US dollars, flooding the world with our currency. Due to our perceived relative strength on the global stage, the dollar’s value has not declined as one would expect relative to the basket of other global currencies. Should this perception change, the dollar could weaken. Portfolio ownership of foreign stocks is typically accomplished by managers in the local currency. If the currency of those countries in which we invest strengthens (or the dollar weakens), portfolios receive the benefit in the form of higher rates of returns on the foreign holdings when converted back to dollars. This also runs in cycles, and for some time, the trend has been working in favor of dollar denominated assets and against foreign denominated assets. This trend should change in time, giving a boost to foreign investing.
We all know that “past returns are no indication of future returns” and that attention is best focused on determining and setting the appropriate strategy for you, maintaining a well-diversified, low cost, tax efficient portfolio, and investing in all regions and sectors of the world. Relative valuations today in international and emerging market stocks are cheaper than in the US, and forecasted GDP growth rates are higher for many regions outside of the United States. In the next cycle, market and currency swings may well move in favor of international equities. These are compelling reasons for continuing to invest in them.
*Return data for the S&P 500 Index and the MSCI Europe Asia Far East (EAFE) Index reflect returns from 3/1/2009—2/28/2017.