The international opportunity: Post-COVID portfolios

The advantages of diversification mean we can lower unsystematic risk for a better return/risk profile. The skill comes in doing this at the right time, in the right places and across the right assets.

Currently, there is an argument that U.S. portfolios will benefit from adding exposure to international equities. Four major drivers inform this argument. First, a macroeconomic tailwind from fiscal and monetary stimulus suggests an edge for international equities over U.S. stocks as the global economic cycle progresses. Second, a structural divide in how countries have rolled out COVID-19 vaccines and reopened their economies. Third, global markets have different industry exposures to American ones. And finally, international markets – specifically developing countries – are showing signs of superior prospects for earnings growth.

What goes around comes around

U.S. equity markets have enjoyed a good run since the end of the global financial crisis crash in 2009, outperforming international stocks over this time. Consider that the S&P 500® Index has beaten the MSCI EAFE by an average of 7.5% and the MSCI Emerging Market Index by 6.5% annually during this spell (See Chart 1 above).

But the past is not always good prologue of the future. There are justifications for a position that U.S. stocks are no longer good value relative to the rest of the world. We can see this in the proxy measure of the price-to-book ratio. Here, the stellar U.S. performance of late may be helping to produce relatively high valuations (See Chart 2 below). The price-to-book ratio for the S&P 500 tripled from 1.4x to 4.2x since 2009, leaving the MSCI EAFE and Emerging Markets in its wake.

Traditionally, valuation has been a poor indicator of near-term returns. However, over a longer time horizon, the correlation is a strong inverse one. That is, buying relatively lower valued stocks and applying the time-honored virtue of patience have paid off. This helps to explain the long spell of outperformance of U.S. markets since the end of the technology bubble’s deflation.

The upshot of the valuation gap is a long-term advantage for international stocks over U.S. ones, suggesting that adding global exposure to portfolios may be a suitable move for many client portfolios.

A post-COVID correction

A second factor favoring international stocks comes in the global response to the COVID-19 pandemic. The human cost has been vast, but so has the economic damage. As we begin to see a light at the end of the tunnel with the rollout of vaccines and reopening of commerce, there’s further justification for rebalancing of portfolios.

U.S. lockdowns in response to the pandemic have been relatively effective, if sporadic among different regions of the country. However, the U.S. has led the world in vaccine distribution. Partly enabled by that success, America’s economy has been able to open relatively early too. This is borne out in the date on leading economic indicators. The decline at the start of the pandemic was precipitous, but the revival to pre-lockdown levels was nearly as rapid (See Chart 3 below).

Despite this early success, it does hand other countries a relative advantage in the next spell of the recovery. Reopening has a ceiling, as no economy can be more open than fully open. This suggests that the bulk of the low-hanging fruit lies outside of the U.S. In other words, the U.S. has reaped the early gains by reopening a heavily shuttered economy, but future gains are more likely to be found in places outside of the U.S.

So, our second signal in favor of global stocks is in their potential for superior “returns to reopening” ahead as lockdowns are gradually eased.

Arbitrage on industry

Inherent in the above is that global equities have a low performance correlation with U.S. stocks. There is a source of discrepancy we can add to the calculation. U.S. stock markets are weighted notably differently on average to international equivalents. We know the S&P 500 has plenty of exposure to growth factors. In fact, technology, consumer discretionary and health care comprise more than half of the benchmark U.S. stock index’s weight.

Compare that to the MSCI EAFE Index, where pro-cyclical and value factors tend to dominate. The index was, for instance, at 46% financial, industrial and consumer discretionary sectors at the end of June 2021.

In short, global exposure provides portfolio benefits from industry diversification in addition to macroeconomic diversity.

Earning its keep in portfolios

Last but never least is earnings growth. Between 2013 and 2019, the U.S. just barely led other rich countries on this metric (2.5% annualized compared to 2.2%). But developing countries showed the way with 4.3% annualized earnings growth, beating the global average by a full percentage point. More importantly, there are no signs of these gaps closing any time soon.

For the period between 2019 to 2022, the U.S. is expected to grow a cumulative 6.4% compared to a forecast of 4.3% for wealthy nations. Both of those figures trail the prediction for emerging economies, where 8.9% growth is anticipated.

Earnings growth is likely to be a meaningful lever in the long-term relative performance of U.S. stocks compared to international markets, in particular the contribution of developing markets to the improving trend.

Turning the globe tide

American equities have been the place to be for more than a decade. However, the gradual shifts of ordinary business cycles, coupled with the shock of a crisis, demand that we review international investing with fresh eyes, and it suggests a shift in relative attractiveness towards international equities ahead of American ones.

Download the white paper for additional charts and data, as well as a fuller exploration of the case for added international exposure in U.S. portfolios.