When you have a solid investment strategy, it’s easy to fall into a “set it and forget it” mentality. But resting on one’s laurels doesn’t equate to future gains. Mean reversion, the idea that stock prices move toward an equilibrium level over time, continues to remind us that today’s winners might be tomorrow’s losers. And while simple tasks such as periodic rebalancing can go a long way, we also consider when a long-term trend may be nearing its end and take active steps to reallocate client portfolios.
Within our asset allocation, we have maintained a preference for U.S. equities over non-U.S. equities for years, a stance that has served our clients well. But evidence of a stronger economic recovery outside the U.S., a weakening dollar and attractive relative valuations warrant considering whether it may be a good time to add to non-U.S. equities. Let’s take a closer look at these developments and how they factor into our latest thinking about international equities.
For some time, U.S. equities have outperformed international equities. Over the 10-year period ending August 31, U.S. stocks gained 15.2% annually, as measured by the S&P 500 index. This compares to 5.9% for developed international, as measured by the MSCI EAFE index and 4.1% for emerging markets equity, as measured by the MSCI EM index. The outperformance of U.S. equities during this period is largely due to an abundance of monetary policy support from the Federal Reserve coming out of the great financial crisis, stronger relative economic and earnings growth, heavier exposure to technology and a strong U.S. dollar.
U.S. stocks have also been leading markets out of the 30%+ bear market reached in March. While non-U.S. equities lagged in the early part of the recovery, they appear to be gaining momentum since June. Could this signal a better environment for international equities moving forward?
At the start of this pandemic, we believed that the U.S. economy would recover from the COVID-induced recession better than other countries. In fact, that was part of the rationale that factored into our decision to lean into U.S. large cap stocks during the March-April selloff, while reducing international developed equity. We believed that the quick and unprecedented actions from the Fed and U.S. government would help to support growth and markets, which they continue to do. While economic data such as manufacturing, retail sales and confidence rebounded off their lows, the pace of recovery has softened as a surge in cases in some states caused a roll back of some reopening efforts.
Meanwhile, other countries and regions are recovering ahead of the U.S. in part because their lockdowns and reopening efforts began before the U.S., but also because of their efforts to contain the virus were more effective. In particular, China is further along in its recovery, with second-quarter GDP already positive led by a recovery in manufacturing. Europe also reopened earlier than the U.S. and although there have been pockets of virus surges, it has succeeded in bringing the count down. Also, supporting the Eurozone’s recovery is the latest fiscal relief of €750 billion ($890 billion), which is the first regional package designed to help those countries harder hit. So while we believe a V-shaped global recovery is still the most likely scenario, different regions and countries will take the lead as they recover from the pandemic at different speeds.
The outperformance of U.S. stocks has pushed valuations, as expressed by the price-to-earnings (P/E) ratios, far above international equity valuations. U.S. equities, as measured by the S&P 500, are currently trading at a multiple of 24x their consensus 12-month forward earnings, far above their 10-year average of 16x. With U.S. earnings growth declining 34% during the second quarter, it is common for P/Es to become elevated ahead of a recovery in earnings. International equity valuations, both developed and emerging, are above their 10-year average but to a lesser degree than U.S. equities. International developed equities are trading at a multiple of 19.1x, versus an average of 14x, while emerging market equities are trading at 15.6x compared to an average of 11.7x.
U.S. Dollar Weakness
The outperformance of U.S. equities over international equities in recent years is due in part to the strength of the U.S. dollar, which has been increasing when compared to a basket of currencies since 2015. The dollar’s strength was a result of higher interest rates in the U.S. and a faster pace of economic growth relative to other countries.
Amid the height of the COVID-19 volatility, we saw a flight to safe-haven assets, with the U.S. dollar benefiting from that trade. However, the combination of swift actions by the Federal Reserve to cut short-term interest rates to zero and expand its balance sheet, as well as the diminished fears of a major financial crisis, caused the dollar to lose some of its relative strength. For example, the euro has strengthened relative to the dollar, with the exchange rate increasing from $1.07 (U.S. dollars to buy one euro) to $1.19.
A weaker dollar can help support U.S. growth by making exports cheaper, but it can also act as a tailwind for international equity markets. Since investments are not hedged to protect against currency fluctuations, a decline in the value of the U.S. dollar can add to returns on non-U.S. assets, while the opposite is also true. Exhibit 1 looks at the performance of equity markets over the last 20 years and breaks down performance in periods of U.S. dollar strength and weakness. In periods of dollar strength U.S. markets do well. Emerging market equities also tend to do well, but international developed equities are barely positive. However, in periods of dollar weakness, emerging market equities beat U.S. equities by over 500 basis points, while international developed equity delivered similar returns to that of U.S. equities.
In general, emerging market equities do better in a weaker dollar and low interest rate environment. International developed equities are more heavily tilted to cyclical stocks, which tend to do better coming out of a recession and when the dollar is weaker. Thus, our expectation for continued dollar weakness should be one factor aiding international equities moving forward.
Exhibit 1: Impact of the Dollar
Taking all of these factors together, we recently recommended a slight shift from U.S. large cap stocks to international equities. Given the strong gains in U.S. large cap stocks since the March lows, it allowed us to realize some of those gains and add exposure to both international developed and emerging market equities. While we still favor U.S. large caps within a fully diversified portfolio, adding exposure to non-U.S. equities should enable portfolios to benefit from the global recovery and weakening dollar. Resting on one’s laurels rarely works in investing, and we don’t plan on starting that practice now.