The last decade has belonged to the US, but history shows that the winners change over time, both within and across markets. Many of the tailwinds that have favored the US equity market are fading or are under threat. Earnings growth differentials1 have flattened, profit margins have peaked, valuations look stretched, and political pressure is mounting against the largest technology firms. Against this backdrop, we think investors would be unwise to have all their eggs in that one basket.
Since the Global Financial Crisis (GFC) in 2007-2008, the US equity market has outpaced the rest of the world by some distance. For example, for the 10-year period ended 12/31/20, US equities, as measured by the MSCI USA Index,2 achieved an annualized return of 14%. In contrast, international equities, as measured by the MSCI All Country World ex USA Index,3 achieved an annualized return of only 5% during that same time period. Even in the wake of the COVID-19 outbreak, this trend has remained intact, leading some investors to question whether they should even bother owning any non-US equities at all.
It’s important to remember, however, that this was not always the case. Although the US has been the best performer this decade, it was one of the weakest performers in the previous decade, as shown in FIGURE 1.
For example, during the 2000s, the bursting of the US tech bubble coincided with increased globalization and the industrialization of China. This paved the way for a boom in emerging-market (EM) equities. Similarly, during the 1970s and 1980s, Japan’s asset market rally appeared unstoppable, as overconfidence reigned over the country’s seemingly infallible economic model. Nevertheless, optimism that these markets would continue to outstrip the rest of the world eventually subsided.
Performance Leadership Tends to Be Cyclical
MSCI USA Index vs MSCI World ex USA Index, quarterly rolling 5-year annual returns
Past performance does not guarantee future results. | Source: Refinitiv Datastream and Schroders. Data as of 12/31/20. Notes: US equities = MSCI USA Index, International equities = MSCI World ex USA Index. Indices are unmanaged and not available for direct investment.
Investors often fall into this trap of extrapolating past performance into the future because they have trouble imagining a future that is different from the present. But if history is any guide, outperformance does not last forever, and US equities could soon suffer this same fate. In this paper, we examine what factors could sway performance in favor of international equities.
Investors often fall into a trap of extrapolating past performance into the future because they have trouble imagining a future that is different from the present.
US Earnings Advantage Has Disappeared
Looking back over the past decade, the main reason US equities have done so well is because of their profit growth. For example, from 2009 to 2014, US earnings-per-share (EPS)4 grew at 17% per year compared with only 7% outside the US (FIGURE 1). Part of this can be attributed to the stronger US economic recovery after the GFC, as Europe was still reeling from its sovereign debt-crisis, while a collapse in commodity prices put an end to the EM growth rally.
At a corporate level, the US is also home to some of the most successful companies in the world, including firms such as Amazon, Apple, and Google, which have delivered significant profit growth and technological innovation. US companies have also engaged in more shareholder-friendly activities such as share buybacks, which have boosted EPS growth (by reducing the number of shares in issue, buybacks raise the level of EPS growth for a given level of aggregate earnings growth).
The problem is that this earnings growth advantage has pretty much disappeared. From 2015 on, nearly all of the relative outperformance was driven by a combination of valuation multiple expansion (i.e., higher P/E ratios)5 and dollar strength. This mirrors the pattern observed in the 1990s shortly before the US stopped outperforming. Of course, valuations can always climb higher, but not indefinitely.
One justification for this valuation premium is that US firms have been able to reinvest their profits at increasingly higher reinvestment rates. For example, since 2008, US public companies have increased their return on equity (ROE)6 by 64% relative to their international peers. ROE can be decomposed into the product of net profit margins, leverage, and asset turnover. FIGURE 2 shows how these component parts have varied for US equities compared to international equities. Since 2008, improving profitability and leverage have both been tailwinds for the US. In fact, research shows that US equity prices would have been 40% lower if not for the secular expansion of profit margins.7
However, the structural forces behind these drivers are now under threat. For instance, although globalization has offered companies access to new export markets as well as cheap labor in places such as China, trade frictions and the disruption to supply chains brought about by the pandemic have increased the incentives for onshore production, which could eventually weigh down on US margins.
Margins and Leverage Have Increased Relatively More in the US Compared to Overseas
Non-financial US versus international equities
Past performance does not guarantee future performance. Indices are unmanaged and not available for direct investment. Source: Refinitiv Datastream and Schroders. Data as of 12/31/20. Notes: US equities = US Datastream non-financials index, International equities = MSCI World ex USA Datastream nonfinancials index.
Similarly, the tax and borrowing environment has been very supportive for corporates over the past few decades. Going forward though, these are unlikely to provide another boost to profitability. After the Trump administration’s tax cuts, the effective US corporate tax rate (the weighted average rate paid by US companies on all of their earnings worldwide) now roughly equals the domestic rate, thereby limiting the potential tax arbitrage of moving revenues abroad. At the same time, with leverage already at record levels, it seems improbable that US companies could take on substantially more debt in the coming years.
Although international equities in general are not immune to any of these changes either, it may prove difficult for US companies to maintain their relatively higher profitability without these tailwinds, let alone increase their margins further. This means US equities could struggle to repeat previous relative gains.
Fundamentals No Longer Support Valuations
For most of the post-crisis period, US outperformance has moved in tandem with relative earnings expectations. However, the gap between relative returns and earnings expectations has recently widened significantly (FIGURE 3). This is not sustainable. At some point, earnings expectations will need to catch up, or US stock prices must correct.
The gap between US relative returns and earnings expectations has widened significantly and may not be sustainable.
US Outperformance Has Decoupled From Relative Earnings Expectations
US equities / international equities, rebased to 100
Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. Source: Refinitiv Datastream and Schroders. Data as of 12/31/20. Notes: US equities = MSCI USA Index, International equities = MSCI ACWI ex USA Index.
The Price You Pay Matters for Returns
Although valuations have a poor track record of predicting short-term returns, they have far greater power as a guide to long-term prospects. Historically, the cyclically-adjusted price-to-earnings ratio (CAPE)8 has had a correlation of -0.83 with subsequent relative 10-year US returns (a high US CAPE relative to an international CAPE has preceded low returns for US equities relative to international equities, and vice-versa) and explains 68% of its variation over time.
For example, back in December 2007, US equities had a CAPE ratio of 22x, compared with 27x for international equities. Since the US market was relatively cheaper, it was poised to outperform over the subsequent decade. Today, however, US equities trade at a multiple of 33x earnings versus 18x for international equities. Betting that US equities could continue to outperform over the next decade no longer looks like a winning trade.
Admittedly, the composition of the US market has evolved somewhat over time, with an increased weighting to capital-light businesses, and this may warrant a higher valuation compared to before. This brings us to the next issue: the dominance of technology firms.
Valuations Imply US Investors Could Be Disappointed Over the Coming Decade
Subsequent relative 10-year return per year (US vs international), %
Past performance does not guarantee future results. Forecasts included are not guaranteed and should not be relied upon. Indices are unmanaged and not available for direct investment. | Source: Refinitiv Datastream and Schroders. Data from January 1974 to December 2020. | Notes: US equities = MSCI USA Index, International equities = MSCI World ex USA Index.
Too Big to Fail?
Investors often reassure themselves that “this time is different” and on certain fronts, the FAMAGs—Facebook, Amazon, Microsoft, Apple, and Google—certainly stand out as impressive businesses. Historically, they have rapidly grown their profits, commanded large market shares, and continued to innovate to stay ahead of their competition. The pandemic has accelerated these trends by making us more dependent on their services.
However, these companies have become so large that they are essentially driving the market. In 2020, the S&P 500 Index9 climbed 18%, and the FAMAG stocks—just five companies out of 500—contributed 9% (half of the Index’s total return). Their combined market-cap weight has more than doubled from about 8% of the S&P 500 Index in 2015 to 23% today (FIGURE 5). This means the largest US stocks now account for a larger slice of the market than at the peak of the dotcom bubble in 1999.
The largest US stocks now account for a larger slice of the market than at the peak of the dotcom bubble in 1999.
The Tech Giants Have Doubled Their Market Share of the S&P 500 Index
% weight of S&P 500 Index
Portfolio composition is subject to change over time. | Source: Refinitiv Datastream and Schroders. Data as of 12/31/20.
Investors seem to think that these companies are unstoppable. But the truth is that the bigger they get, the harder it becomes for them to replicate that performance. After all, once a company dominates an industry, it can only grow as fast as the market size grows. Going forward, the only way they can continue to justify their growth multiples is by developing other game-changing products or leveraging their existing resources to branch out into other services. For example, Amazon, Google, and Microsoft have all ventured into the market for cloud computing, yet even here competition is quickly heating up and this may eventually eat into their margins.
Size Breeds Government Attention
Regulation is by far the biggest risk looming over the tech giants. Over the past two years, the FAMAGs have faced a barrage of criticism over their anticompetitive behavior. The bigger these firms get, the more likely they will become more heavily regulated. History is replete with such examples. At some point, this could have serious implications for their growth prospects.
With a number of governments turning to tech companies to help manage the virus outbreak, one possibility is that the major digital platforms could become regulated like public utilities given their increasing size and influence. In the past, governments did not hesitate to regulate services that were deemed essential public goods, such as railways and energy suppliers. New regulations could be imposed that limit how these firms monetize data and in which markets they can participate. Tech valuations could grind lower if the regulatory environment deteriorates.
The Winner’s Curse
While it is tempting to argue that these powerful firms are unlike their historical predecessors, it is naïve to assume their stock market dominance will continue indefinitely. This is not to say they will not remain industry leaders in their respective fields. Cisco, IBM, and General Electric are just a few examples of firms that are no longer the motorboat for equity returns. Often when big companies rise quickly, their market matures, they fall asleep at the wheel in innovation, or regulation hinders their growth; their stocks prices suffer as a result.
So even if these companies are not displaced, they can become eclipsed. It is difficult to foresee what new companies could emerge that could overshadow the FAMAGs. But it’s important to remember that change and disruption is constantly happening around the world, from healthcare to automation to financial technology (see “A Portfolio Manager’s View” below). Financial markets are often slow to recognize this disruption or are reluctant to accept its impact. Investors should not become complacent.
A Portfolio Manager’s View: Simon Webber, Schroders Global and International Equities Team
Case Study 1: Cloud computing
This pure-play cloud software company focuses on small business accounting products. The company has successfully built strong positions in Australia, New Zealand, and the UK. At the core of its success has been its very strong product offering and its cloud-first strategy, disrupting the incumbent desktop software providers.
The potential for growth in cloud accounting software is vast. The company boasts a strong product offering and brand, alongside leading bank and app integration, as well as the ability to attach services and software. All of this points to a potentially bright outlook.
Case Study 2: Automation of online grocery fulfilment orders
This company began life as a start-up online grocery business in the UK. The ‘Hive’ concept that they pioneered allows the company to automate the fulfillment process of online grocery through a matrix of robot boxes that bring items to the picking point to fulfill individual orders.
This technology is now being licensed all over the world, empowering traditional grocers in Canada, France, and the US to compete with Amazon and other online grocery companies.
By lowering the cost of online grocery fulfillment through automation, the company is very disruptive to incumbent grocers who do not have the margins or resources to develop such a technology-driven solution.
Source: Business Insider
Any references to securities are for illustrative purposes only, not representative of any Hartford Fund, and not a recommendation to buy and/or sell.
International Equities Offer Cheap Exposure to a Cyclical Recovery
An important similarity between the current environment and previous market cycles is the composition of the US equity market. As of 12/31/20, cyclical stocks represented only 39% of the S&P 500 Index while non-cyclicals represented 61%. This mirrors the experience in the early 2000s, as shown in FIGURE 6. By comparison, cyclicals today represent 55% of the MSCI All Country World ex USA Index while non-cyclicals represent only 42%. Typically, cyclicals have generated strong performance after the economic cycle bottoms, so a lower relative weighting in this segment could limit the rebound in US equities once global growth recovers, which is inevitable at some point. For example, despite a recovery in cyclical indicators in the early 2000s, tech stocks continued to pull back from their lofty valuations, effectively dampening the overall market performance. This same scenario could play out again.
The US Market Composition Mirrors the Experience of the Dotcom Bubble
S&P 500 Index, %
Source: Refinitiv Datastream and Schroders. Data as of 12/31/20. Notes: cyclical = materials, industrials, consumer discretionary, energy, financials, real estate. Non-cyclical = utilities, IT, consumer staples, healthcare, communication services.
US equities have benefitted from several tailwinds relative to international equities over the past decade: profit growth, rising leverage, improving profitability, world-beating companies, and investors being more prepared to pay ever-higher prices to invest in them. However, we believe it would be unwise to bet that these will all continue unchecked. While timing an inflection point is very difficult, all signs tell us that gravity will eventually bring these “rockstar” large-cap equities back down to earth.
US share prices now bake in earnings growth that is at odds with analyst expectations—and analysts are not exactly known for their pessimism. Valuations have been stretched to levels that would have historically foreshadowed low returns for US stocks versus the rest of the world. Meanwhile, we believe politicians and regulators are unlikely to allow large US technology companies to wield ever-greater power. And compositional differences indicate that international equities could outperform in a cyclical upswing. A tilt toward international equities may also prove beneficial if the dollar weakens.
Let’s also not forget that winners, both within markets and between markets, vary considerably over time. The last decade has belonged to the US, but history shows that performance leadership is cyclical. Therefore, we think it would be prudent for equity investors to consider diversifying their equity exposure across international markets.
To learn more, talk to your financial professional about your allocation to international equities.
Hartford Funds 4- and 5-Star International Funds
1 Earning growth differentials refers to US companies whose profits are growing at the same pace as foreign companies.
2 MSCI USA Index is a free float-adjusted market capitalization index that is designed to measure the performance of the large and mid cap segments of the US market.
3 MSCI ACWI ex USA Index is a broad-based, unmanaged, market capitalization weighted, total return index that measures the performance of both developed and emerging stock markets, excluding the US.
4 Earnings Per Share is the projected growth rate in earnings per share for the next five years.
5 Price/Earnings (P/E) is the ratio of a stock’s price to its earnings per share.
6 Return on Equity is the average amount of net income returned as a percentage of shareholder’s equity over the past five years.
7 “Peak-Profit Margins? A US Perspective.” Bridgewater, February 2019
8 The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
9 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.
Appendix: We compute the market cap weighted implied and forecast growth for the MSCI USA index and the MSCI AC World ex US Index. We compute the spread between these measures as the MSCI USA Index minus the MSCI AC World ex US Index. We trim the growth metrics at 5th and 95th percentile to reduce the impact of outliers. We extract the implied growth from the Residual Income Valuation Model – this is the short-term growth rate which if applied to consensus earnings forecasts results in the current valuation. The key assumptions in this model are the cost of capital which is the measure we use to discount future earnings back to present value and the time periods over which we expect a company’s growth rate and profitability will deviate from the market. 3 Year Forecast Annualized Growth is the growth rate over the next 3 years based on IBES Consensus Estimates.
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Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. Diversification does not ensure a profit or protect against a loss.
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