Economic and Market Commentary
In this month’s commentary, we discuss our views on the allocation of international equity exposure to client portfolios. I’d like to thank Parker King and Kristin Ketner Pak for their significant contributions to the analysis.
When we invest in stocks, our goal is to select the best companies and business models. We look for companies that have strong fundamental growth prospects spanning a multi-year time frame and that offer favorable market risks and rewards in thematically attractive sectors. From an asset allocation perspective, we are often asked how much international exposure we target and why we own relatively few non-US companies. The answer is nuanced: we don’t target any specific level of country exposure since we believe that a company’s domicile is of secondary importance to its fundamental strengths and global reach. And that is especially true for the large multinational corporations that we primarily focus on. Given the globalization of the economy, achieving the benefits of international exposure is no longer a matter of finding companies that are located across the developed and emerging markets, but rather an exercise in constructing portfolios that have internationally diversified revenue streams. While more than 90% of our allocation to stocks consists of companies located in the US, approximately 40% of the revenues of our equity portfolios (in US dollars) come from outside the US.
Where a company’s headquarters is located may have more to do with its origin story and tax incentives than its marginal investment value. In fact, decades of returns suggest that, for US dollar-based investors, US stocks have consistently outperformed non-US stocks. The one exception may have been during periods of deep or extended weakening of the dollar. As a result, we view the decision to seek out non-US stocks as tactical rather than strategic. We do not view non-US stocks as a core holding, and our performance benchmarks generally exclude allocations to them.
Before we delve into historical performance, let’s briefly provide some perspective. US companies dominate the world’s equity markets. The US’s share of global GDP is just about 26%, yet US stocks account for a disproportionately high 51% of global equity market capitalization. No other country comes close. In fact, China, the second largest country by share of world GDP, has a disproportionately low share of market cap (see Exhibit 1).
Let’s assume for a minute that we’re content with earning market returns, and, to generate the best results, the only question we need to answer is which market we should invest in. Without context, it might seem reasonable to assume that having exposure to a diversified mix of US, developed and emerging market and small- and mid-cap equities would be preferable to owning only US large-cap equities. However, and perhaps against expectations, this hasn’t been the case for quite a while.
To illustrate this, we compare the performance of the MSCI All Country World Index Investable Market Index (MSCI ACWI IMI) with that of the S&P 500. We also look at several other indexes, including the MSCI Europe, Australasia, and Far East Index (MSCI EAFE), the S&P 400 (mid-cap), the S&P 600 (small-cap), and the MSCI Emerging Markets Index.
The breakdown of countries in the MSCI ACWI IMI is similar to that of the Bloomberg World Index, though the allocations to US and Chinese companies by market capitalization are somewhat higher and lower, respectively. The index is composed of approximately 93% large-cap companies, 88% developed market companies, and 12% emerging market companies. We estimate that about 41% of revenues come from the US and 59% from non-US companies.
While the MSCI ACWI IMI contains several thousand companies compared with the much smaller S&P 500, the historical performance suggests that, over the last 20 years, the allocations to international, as well as small and mid-cap have led to a less efficient index.
If we examine the performance of the major indices in Exhibit 3, a couple of themes emerge:
We therefore question whether it makes sense to strategically allocate into an asset class that has experienced substantially less favorable risk and return characteristics for the sake of diversification.
The first row of Exhibit 4 shows that the correlation between the S&P 500 and the other indices is extremely high. This by itself would not necessarily preclude adding the asset class and realizing diversification benefits. For example, an ideal asset class would be highly correlated during periods of high returns and have low or negative correlation during periods of negative returns. Unfortunately, this has not been the case.
In the second two rows of Exhibit 4, we partition the last 20 years into months when the S&P 500 was positive and months when it was negative, then look at the correlations with the other asset classes. We find that the correlations of international, mid-cap, and small-cap equities with the S&P 500 have actually been higher in negative periods than in positive periods. So when diversification was needed most (in some cases, when markets were melting down), these indices performed in line with or worse than the S&P 500. These disadvantageous correlations, combined with the lower returns per unit of risk in Exhibit 3, are at least some of the reasons that an optimal portfolio would not contain strategic allocations to international, mid-cap, and small-cap.
While we can always find a time period to support almost any asset allocation proposal, the disparity between the S&P 500 and the other indices is even worse if you look at the last 10 years (Exhibit 5). On every metric, the S&P 500 has been more attractive, and the optimal portfolio would still exclude international, mid-, and small-cap.
Source: Bloomberg, AAFMAA Wealth Management & Trust
Here are several reasons we typically hear and our responses to them:
One, “International and US mid- and small-cap stocks add diversification.” Yes, but as we showed above, these stocks have historically added the wrong kind of diversification.
Two, “US stocks are expensive relative to international stocks.” It’s true that US stocks currently trade at higher price/earnings ratios than international stocks (see Exhibit 6). But that does not necessarily make them expensive.
We argue that the US large-cap market premium relative to other markets is justified for at least the following reasons: 1) US companies have generated materially higher returns on investment compared with companies in other regions; 2) US companies’ earnings growth has been higher than that of companies in other regions of the world; and 3) the US market has structural advantages that US companies can leverage.
Further, we believe that US stock valuations are more reasonable when adjusting for sector weightings (see Exhibit 7). Roughly 30% of the large-cap US stock universe is comprised of Information Technology shares that trade at a relatively high price/earnings ratio compared with about 13% of the non-US stock universe. Conversely, US large-cap stocks have a smaller weighting in the Financial and Energy sectors that trade at relatively lower P/Es.
In addition, valuation differentials haven’t historically been a useful signal of a country’s future relative performance. Relative changes in price/earnings ratios appear to explain about 11% of the variation in the outperformance of US stocks over non-US stocks over the past 20 years.[1] However, except for a brief period following the Great Financial Crisis, US stocks have traded at higher ratios, and the differential has consistently increased since then.
Three, “US stock outperformance has been driven by appreciation of the dollar. Buying international stocks is a hedge against dollar depreciation.” Over the last 20 years, changes in the value of the dollar have explained about 27% of the variance in the outperformance of US stocks over non-US stocks. Typically, when the dollar has strengthened, US stocks have outperformed, and when the dollar has weakened, US stocks have underperformed.
Since 2011, the general trend has been toward a stronger dollar. Today its value is about 104, up from 73 in April 2011. The average over the past 20 years has been approximately 89. Over the past 50 years, the dollar has ranged from a low of about 72 to a high of about 160, with an average of about 97. The high occurred in the mid-1980s, following rampant US inflation and interest rates.
Despite the long periods of ups and downs, it’s hard to argue that the dollar has been mean reverting in any timeframe that’s been relevant to tactical or strategic portfolio construction. It’s also hard to argue that the dollar is currently rich by historical standards. But even supposing it was, let’s look at the potential impact of an immediate decline in the dollar from today’s 104 level to 89, the average over the past 20 years.
On average, for every one point the dollar has increased or decreased over the course of a month, US stocks have outperformed or underperformed non-US stocks by about 0.5%, respectively. For example, based on that relationship alone, if the dollar increased from 100 to 102 in a given month, we might expect US stocks to outperform non-US stocks by about 1%. That suggests that if the dollar were to decrease from 104 to 89 in a month, we might expect US stocks to underperform by about 7.5%.
Now let’s compare the difference in performance under the same scenario between a portfolio that had 100% exposure to US stocks and a portfolio that owned 80% US and 20% international. We choose these allocations because they fall within the range of recommendations many advisors commonly make. The 100% US portfolio would be expected to underperform by 1.40%. There are three important points to take away from this:
As we noted at the beginning of this discussion, approximately 40% of the revenues of the stocks in our portfolios are derived from markets outside the US. We achieve this by identifying the best companies with the best business models. By necessity, these companies tend to have significant global reach. There will undoubtedly be periods when we tilt the portfolio for any number of reasons to a higher international allocation. But those moves will be tactical, temporary, and with defined exit strategies.
We understand that our point of view may be somewhat different than what you’ve seen elsewhere. It’s based on objective, rigorous analysis.
We’d love to know your thoughts as well.
Yours In Trust,
Paul
[1] Based on an analysis of monthly returns of the MSCI USA Gross Total Return Index and the MSCI ACWI EX US Index. The following discussion on the impact of a large decline in the dollar is also based on these indexes.
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© 2024 AAFMAA Wealth Management & Trust LLC. Information provided by AAFMAA Wealth Management & Trust LLC is not intended to be tax or legal advice. Nothing contained in this communication should be interpreted as such. We encourage you to seek guidance from your tax or legal advisor. Past performance does not guarantee future results. Investments are not FDIC or SIPC insured, are not deposits, nor are they insured by, issued by, or guaranteed by obligations of any government agency or any bank, and they involve risk including possible loss of principal. No information provided herein is intended as personal investment advice or financial recommendation and should not be interpreted as such. The information provided reflects the general views of AAFMAA Wealth Management and Trust LLC but may not reflect client recommendations, investment strategies, or performance. Current and future financial environments may not reflect those illustrated here. Views of AAFMAA Wealth Management & Trust LLC may change based on new information or considerations.