A little competition is healthy, right? As an avid golfer, I always enjoy watching the Presidents Cup, a golf competition that pits the best international players against an all-star U.S. team. The level of talent always amazes me. I'll watch for days to see which team ultimately has the honor of taking home the Presidents Cup trophy.
The cup has been passed back and forth between the U.S. and international teams many times in the 23-year history of the tournament. While I have no real opinion about which team will claim victory each year, the competition leads me to think about the investment performance of U.S. versus non-U.S. markets. Just as in golf, the trophy for the strongest returns typically gets passed among different asset classes and regions from year to year. It's the role of BNY Mellon Wealth Management's Investment Strategy Committee, which I chair, to develop opinions about which asset classes we should favour within a well-diversified portfolio. Let's take a deeper dive into our U.S. equity vs. international equity decision-making process.
The Resilience of U.S. Equities
Since the end of the financial crisis, U.S. equities have proven more resilient in their ability to recover than international equities. As illustrated in Figure 1, we can see the dominance in the S&P 500 index over the MSCI World index ex USA, a common measure of non-U.S. equity market performance. The stronger performance of the S&P 500 is attributable to a few factors: extremely accommodative monetary policy, low interest rates, low inflation, solid profit growth and a strong dollar. The Federal Reserve was extremely aggressive in easing financial conditions in the U.S., more so than other central banks. As a result, interest rates remained at near-zero levels for years, which encouraged investors to seek higher returns by investing a higher proportion of their asset allocation in risk assets, like stocks. International investors who invested in U.S. stocks also benefited from currency fluctuations, as a strong U.S. dollar was a boost to their returns when translated into local currency.
Although central banks in many developed countries took steps to ease financial conditions following the crisis, several policy errors were made along the way. For instance, the European Central Bank (ECB) began to tighten monetary policy by increasing interest rates, in an effort to combat above-target inflation, which caused the Eurozone to go into recession for a second time and even caused the U.S. market to fall nearly 20%.
Emerging markets had an even more challenging period. After the financial crisis, the bear market in oil, combined with fears that China's economy would slow down sharply, caused recessions in some emerging market countries. For U.S. investors, a strengthening U.S. dollar also detracted from international equity returns, which were reduced when converted back into U.S. dollars.
We have favoured U.S. large cap stocks until recently, when we anticipated that smaller companies may benefit from the pro-growth policies of the Trump administration. For many of the reasons mentioned above, we were neutral or even underweight to international developed and emerging market equities during much of this period of underperformance. However, over the last year, we have been reducing our underweight to emerging markets, as fundamentals have improved.
Signs of Strength Abroad
The current playing field seems to be shifting. We're beginning to see stronger economic growth, earnings-growth momentum and attractive relative valuations in international markets (when compared to the U.S.). In July, the International Monetary Fund updated its World Economic Outlook for 2017, lowering its U.S. forecast while increasing the forecasts for several emerging market and Eurozone countries. Purchasing managers' indexes (PMIs) in these countries are signaling sustained strength ahead in manufacturing and services.
There has also been a shift in the global earning cycle. After a two-year earnings recession, U.S. earnings are expected to grow at a rate of about 11% year over year. Meanwhile, earnings outside the U.S. are projected to accelerate at a similar or faster pace than the U.S., as illustrated in Figure 2. The combination of stronger economic growth and improved business sentiment in these regions should support a faster acceleration of earnings growth in international markets. Because U.S. companies are further along in the earnings cycle, investors have been willing to pay more for these stocks, pushing valuations higher. In fact, the S&P 500 index is currently trading at a price/earnings multiple of 18.4x forward earnings, while international developed and emerging market indexes are trading at 15.1x and 12.8x, respectively. An improving global growth environment and a pickup in the outlook for corporate profits around the world should continue to support our overweight to equities, in general.
Besides the relative valuations and strong economic- and earnings- growth arguments previously mentioned, there are many other reasons why we are considering adding exposure to international. Differing central bank policies, where the Bank of Japan and the ECB are still in easing mode while the Fed continues to modestly tighten and reduce the size of its balance sheet, also give the nod to non-U.S. investments. Combine that with the relative near-term calm of the election picture globally, following the surprise Brexit vote and the Trump election, and another variable has been removed from concern. Stable commodity prices have also helped some emerging countries that export raw materials. When combined, these factors continue to have our attention and are regularly discussed at our asset allocation meetings.
Time to Pass the Trophy?
Just as it is important to evaluate the strength of both the U.S. and international Presidents Cup teams when assessing which one will prevail, we continuously consider factors such as economic activity, earnings growth, valuations and currency movement when assessing the relative attractiveness of U.S. and international equity markets. We continue to like our overall portfolio positioning and the series of steps we took earlier this year to capitalize on the growing opportunities outside the U.S. For now, we will maintain our posture toward U.S. and international equities, but we stand ready to further tilt our equity weighting away from our U.S. bias as we wait for further evidence that suggests international investments may be poised to outperform.