Print
As the fears about Y2K dissipated and the dot-com boom entered its last few months, the world’s equity investment opportunity set was split roughly 50 percent in the U.S. and 50 percent in the rest of the world. Fast-forward to today, and approximately 64 percent of global market capitalization is in the U.S. This shift has resulted from the U.S. equity market’s outperformance since the end of the great financial crisis more than a decade ago.
When you must go back more than 15 years to find a sustainable period of outperformance for international equities, it raises questions for investors. Should an allocation to the world outside the U.S. still be a part of a portfolio? And, if so, what size should that allocation be?
But the fact remains that the rest of the world makes up 35 percent of global markets—representing a lot of companies and potentially a lot of investment opportunities for fundamental investors.
A Valuation Comparison
There are compelling quantitative reasons to include international equities in a diversified portfolio. The biggest one is that international equities are cheap relative to their recent history and U.S. markets.
But this has been the case for a while. The last time international equities traded at a premium to U.S. equities was in the early aftermath of the great financial crisis, which coincided with the beginning of the period of outperformance for U.S. equities. As I have mentioned in previous blog posts, cheap alone does not make for a compelling case for long-term outperformance.
What About Fundamentals?
Interest rates are certainly an important part of the fundamental outlook for stocks. Historically, the current level of interest rates would argue for international stocks to begin to work better on a relative basis.
Understandably, international equities have performed better as rates move higher. There has been more of a value orientation in international markets than there has been at home. The lack of a true innovative technology sector overseas has been part of the reason for international’s underperformance while U.S. equities outperformed. But 10-year Treasury yields moved over 3 percent in the summer of 2022 and have been there for the past two years. While international stocks did rally for a short period (1.3 years), as seen in the first chart, it didn’t last. U.S. markets have returned to their leadership position over the past year.
Economic Growth Required
At the end of the day, sustainable fundamentals to attract investor interest require accelerating economic growth, which provides improving business conditions for corporations and improving earnings. U.S. economic growth has certainly been more resilient than most people thought it would be given the Fed’s rate increase cycle. And there is no doubt that it has been far more resilient than that of the rest of the world.
According to the International Monetary Fund’s World Economic Update (April 2024), U.S. real GDP growth is estimated to be 2.7 percent this year, with Japan growing 0.9 percent and the Euro Area growing 0.8 percent. This growth comes on the heels of the U.S. growing faster in 2023 as well. The outperformance of U.S. markets over that timeframe has been driven by better fundamentals here than exist abroad.
The Headwinds Are Blowing
International markets have also faced headwinds from geopolitical risks. While risks exist in all markets and all countries, international economies have dealt with the impact of Covid policy, the war between Russia and Ukraine and the conflict between Israel and Hamas, supply chain disruptions, and the ongoing disputes between the U.S. and China around trade policy. These headwinds have weighed on both the economic outlook and what the right valuation for international stocks should be.
The Path Ahead for International Equities
This discussion is meant to provide a broad look at international stocks. But in every type of market landscape, there is always a portion of the opportunity set that is attractive for investors willing to put in the time no matter what is going on at the headline level. That is true of international equities as well. There are stocks that have attractive valuations and growth profiles. While they might not get the attention of the so-called Magnificent Seven, they can add value to portfolios. And as we have seen time and again, things can change quickly for the global economy and markets. Economic growth here and abroad can begin to converge, providing a tailwind for international companies and their future earnings growth.
Diversification within portfolios means that you will own some of what is working currently and some of what will be working at some point in the future. There is a place in portfolios for an allocation to international equities as a way to manage risk and diversify return streams. But like all other asset classes, the past is no guarantee of future performance, and an international allocation must be rightsized for the current opportunity set.
