Looking at the case for international as opposed to US equities, we should emphasize that it doesn’t have to be “either/or.” There’s an argument to be made for owning both. It’s also true that perfect foresight rarely exists, so deciding when to time any transition between the two is likely to be harder than diversifying by owning both from the outset.
What we can say is that US equities have outperformed for a long time. At present, we are more than nine years into a run of US equities outperforming international (i.e., non-US) shares, whereas the average performance cycle is only 7.6 years. This suggests that the cycle may be closer to turning.
US Equity vs International Equity 5-Year Rolling Returns
Sources: Morningstar and Hartford Funds, 10/20. US Equity is represented by S&P 500 Index. International Equity is represented by MSCI World ex USA Index. Past performance does not guarantee future results. The performance shown above is index performance and is not representative of any Hartford Fund’s performance. Indices are unmanaged and not available for direct investment. S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. MSCI World ex USA Index captures large- and mid-cap representation across developed-market countries, excluding the US.
International Equities Can Offer Diversification
International shares can help diversify your investments in a number of ways:
- Exposure to a broader regional and geopolitical sphere.
- Exposure via Asia and other emerging markets to faster growing populations, faster growing middle classes and corresponding rates of consumption, and (in some instances) higher levels of GDP growth.
- Valuations that are significantly lower than the US, even when adjusted for comparably lower growth rates.
- Exposure to other currencies (particularly given the US dollar seems to have reached a plateau and may weaken from here).
- Less concentrated markets and greater opportunities for active investors.
Picking up point five, the narrow breadth of the US market has been a feature of the past few years. This has been mainly due to the phenomenal success of the US tech giants.
The chart below shows how the top five US stocks alone now make up almost one quarter of the S&P 500 Index. By contrast, the top five international stocks account for just 7% of the international benchmark (MSCI World ex USA Index).
Top Five US Stocks Make Up One Quarter of Index
US (S&P 500 Index) vs International (MSCI World ex USA Index) – Top 5 stocks as a percentage of the total index
Sources: Schroders, Standard & Poors, MSCI. Stock names represent largest stocks as of March 2000 and as of August 2020. Stocks shown for illustrative purposes and should not be viewed as a recommendation to buy or sell.
This reflects a period of extraordinary growth for those tech giants. Aside from Microsoft, most of them were barely a twinkle in their founders’ eyes at the turn of the 21st century. There’s no denying that, so far, there has been no good time to bet against their success continuing. But this does raise the question how much further this trend can go on.
As we’ve already said, it’s impossible to predict an optimal time to diversify portfolios. However, this level of concentration in US markets suggests to us that now is probably not the worst time to do so at least.
US Outperformance Reflects Preference for Growth Over Value
The rise of US mega-cap tech has been part of a change in style performance in international markets, too, not just in the US. Our analysis (see chart below) shows that over the long run, as measured from the 1990s to Q2 2020, less expensive high-quality stocks performed well, returning 6.7% on average, and expensive low-quality stocks did not, returning -8.6%.
This is the relationship between valuation, quality, and returns that one would intuitively expect. However, there have been growing signs in recent years of this relationship breaking down as investors sought higher growth regardless of quality, as the 2017-19 and Q1 sections of the chart show.
Less Expensive Stocks Have Been Left Behind Recently, Regardless of Quality
Source: Schroders QEP. Data from January 1990 to June 2020. Past performance does not guarantee future results.
That breakdown has become quite extreme. For example, looking just at Q2 this year, expensive low-quality stocks significantly outperformed expensive high- quality stocks. Less expensive stocks have been left behind.
A lot of this is driven by the performance of companies with high growth potential but no profits. In general, we don’t think this pattern of investors paying more for lower quality can be sustained in the long run.
Expensive stocks are generally expected to grow faster, but this leads to the question: What is already in the price? The right hand side of the chart below shows that expensive stocks—be they low, moderate, or high-quality—now price in returns well in excess of their likely growth. The blue bar is our view of what is implied (“actual” or priced in); the green bar is what we believe is merited (“warranted” or reasonable).
Do Growth Stocks Deserve Their Premium Ratings?
Global – Actual and Warranted Two-Year Forward Price/Earnings
Source: Schroders QEP as of 9/30/20. Price/earnings (P/E) is the ratio of a stock’s price to its earnings-per-share. The warranted forward P/E is calculated using inputs of sales growth, return on capital, and the cost of capital. The actual P/E uses two-years-forward Institutional Brokers Estimate System (IBES) smart estimates. Past performance does not guarantee future results. There is no guarantee that any forecasts or estimates will be realized.
The historically poor performance of cheap (value) stocks means this part of the market now implies significantly lower returns, as displayed on the left hand side of the table.
In other words, expectations of value are very low—perhaps too low—giving it a much lower hurdle to clear in order to surprise on the upside.
Value Stocks Trade Well Below Their Long-Run Average
The poor returns from value stocks over the past decade have led to a very substantial valuation gap to the overall market. The chart below shows that international value trades at a significant discount to the international benchmark currently.
Value Trades at a Steeper-Than-Usual Discount
Value vs Market Discount: How Cheap Are Value Stocks Compared With the Market?
Sources: Schroders QEP, IBES, data from July 1997 to September 2020. “Market” refers to the cap-weighted MSCI ACWI Index, a free float-adjusted market capitalization index that measures equity market performance in the global developed and emerging markets, consisting of developed and emerging market country indices. Past performance does not guarantee future results. There is no guarantee current market conditions will continue or produce favorable results. Investors cannot directly invest in an index.
The chart also highlights that value is now priced at a similar discount as in late 1999/early 2000 during the height of the dotcom boom. This isn’t to argue that value is necessarily poised for a multi-year rally as in the early 2000s, but the pattern is worth noting.
Value Investing Generally Works Better in International Markets
Investors could choose to diversify into value stocks but keep their exposure within the US. However, our final charts below indicate that value investing has historically worked better in international markets than in the US.
These final charts show the rolling returns of value versus growth for both US and international stocks. They show that international value has historically underperformed its benchmark less. As a consequence, it has offered a lower cumulative drawdown than value on a global basis.
International Value Has Performed Better Than US Value
Value vs Growth 3- and 5-Year Rolling Returns, Shown on Monthly Basis
Sources: Schroders, Refinitiv. Chart on left: MSCI USA Value Price Index vs. MSCI USA Growth Price Index. Chart on right: MSCI World ex USA Value Price Index vs. MSCI World ex USA Growth Price Index. Past performance does not guarantee future results. MSCI USA Growth and Value Indices are free float-adjusted market capitalization indices designed to measure the performance of the large- and mid-cap segments of the US market by their respective growth/value styles. Investors cannot directly invest in an index.
Of course, past performance doesn’t always translate into future performance, but there are two ways to think about this.
First, if you were explicitly looking to invest in value today, then non-US equities could be an interesting space to add that exposure. Second, if you were explicitly considering adding international exposure to diversify away from the rich valuations of the US market and a declining US dollar, then the value style in international equities could be considered.
Could Now Be the Time to Diversify?
We would reiterate that we’re not looking to predict the future, but we can remember some lessons from the past. It may not seem like it right now, but international equities have regularly outperformed the US for significant periods of time. They can also offer diversification.
But there are several reasons why we think now is probably not a bad time to gain exposure to non-US equities. Recent US outperformance has been led by US mega-cap tech stocks. The success of these companies is well heralded and well deserved; however, they are richly valued and expectations are high, leaving them vulnerable to disappointment.
Meanwhile, international equities, and the value style in particular, are offering record discounts to their benchmarks and appear to be in a zone that could be considered mispriced. A significant opportunity may be available if one can identify cheap stocks with quality characteristics, such as good business fundamentals and good financial strength.
Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. • Diversification does not ensure a profit or protect against a loss in a declining market.
Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.
The views expressed herein are those of Schroders Investment Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Schroders Investment Management or Hartford Funds.