Beyond borders: Why global diversification still matters, Part 1

Remember that feeling as a kid when you had finished eating everything on your dinner plate—except for the vegetables? The peas. The broccoli. The Brussels sprouts were my personal arch nemesis as a child.

And your parents would coax you—ok, maybe force you—to eat your vegetables because “they’re good for your body, they’ll help you grow big and strong and make your brain faster … yada, yada, yada.”

Yet no matter how reputedly good these vegetables were for my long-term health, they still didn’t feel good at the time.

It turns out that that gut-wrenching, sinking feeling haunts us in our adult life, too, when it comes to investing. It’s how it feels to buy stocks that have been doing poorly. We have that same internal tug of war in the investing part of our life as we do in the eating a balanced diet part of our life:

  • Our brain reminds us that buying low and selling high and diversifying our portfolio are keys to long-term investment success.
  • But our heart just wants what feels rewarding right now: an investment that is going up in value, that is shiny and sparkly and WINNING.

I find that the well-known rollercoasting of investing emotions illustration depicts those mood swings quite accurately.

This hypothetical example is for illustration only.

This hypothetical example is for illustration only.

Well, today, the Brussels sprout equivalent for investors is virtually any non-U.S. stock. After all, as of October  31, 2018, U.S. stocks (S&P 500® Index) have beaten international developed stocks (MSCI EAFE Index) and emerging markets (MSCI Emerging Markets Index) for the quarter-to-date, year-to-date, 1-year, 3-year, 5-year and 10-year periods.

Source: FTSE/Russell, Bloomberg Barclays, MSCI and FTSE NAREIT. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Source: FTSE/Russell, Bloomberg Barclays, MSCI and FTSE NAREIT. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

So, is now the time to hit pause on our heart-strings that are tempting us to buy more of those winning U.S. stocks, and instead follow our brain that’s counseling us to pivot to non-U.S. stocks?

That’s exactly what I sat down with my colleague Mark Eibel, Director of Client Investment Strategies, to talk about recently on the latest Russell Investments podcast.

Here’s a recap of the first part of our conversation, which focuses on the likely causes of the current disparity between the U.S. and other markets, as well as the risks we see in U.S. equities going forward. We’ll follow up with a summary of the second part of our conversation, which highlights the potential opportunities we see in places like Europe and Japan, in a subsequent blog post. As always, you can listen to the podcast for our complete conversation.

What’s powered the U.S. bull market since 2008?

Eibel has a word for the difference in performance between the U.S. stock market and the rest of the world since 2008: Extraordinary. “From 2008 through Oct. 31, 2018, there’s been a 6% annualized difference between the U.S. and the rest of the world. Put another way, every single year, for almost 10 years, the U.S. has outperformed the rest of the globe by about 6%.”1

This isn’t normal. Looking at the 40-plus year period from 1970-2007, U.S. markets were up 11.06%, compared to 10.86% in non-U.S. developed markets2—a wash, essentially. This is because levels of risk and volatility typically even out over the long run. Historically, recoveries in the U.S. stock market do tend to last a bit longer, which also means that when non-U.S. markets outperform, investors tend to get their returns back quicker in the short-term. This is one of the reasons why we consistently advocate a diversified portfolio, as we believe blending U.S. and non-U.S. markets can lead to a little bit better return at a lower risk level.

Given that long-term averages between the U.S. and other non-developed markets are equal, we think that the rest of the world is due to outperform America at some point—and it may only be a matter of time. After all, says Eibel, all good things come to an end—the U.S. bull market’s extraordinary run included.

The great recession: The catalyst for U.S. outperformance?

What’s led to the U.S.’ reign at the top of today’s bull market? For a greater understanding, it’s helpful to look back at the events of 2008. The global financial crisis kicked off in the U.S., with the ramifications then spreading to the rest of the world. In this case, there was a silver lining to being first: the U.S. was able to pull itself out of the recession before other countries.

“If you cause a problem, you know it—and therefore, you‘re the first to remedy it,” Eibel says. In this instance, the fix for the U.S. was dropping interest rates to zero, and pumping additional money into the system via quantitative easing. Not surprisingly, the U.S. was the first major economy to implement both of these measures, which led to roughly 2% economic growth in the following years. While such a number may not be show-stopping, the ensuing U.S. stock market performance certainly has been. Eibel believes some of this is attributable to the fact that because the U.S. was first in implementing a solution, U.S. markets were first to be rewarded. After all, as the old saying goes, the early bird gets the worm.

At this juncture last year, however, it appeared that the rest of the world was poised to catch up. After all, emerging markets led the pack in 2017 market performance, followed by non-U.S. developed markets in second place. The U.S. was only third.3 But then, the calendar flipped to 2018 and the U.S. kicked things into overdrive.

The anomaly of 2018: What’s behind it?

“Normally, ten years into an economic recovery, you don’t accelerate—you slow down,” Eibel remarks. So, why the continued outperformance in U.S. equities this year? One overarching reason: Tax reform—and its impact on year-over-year comparisons.

During the second quarter of 2018, the U.S. economy grew at a 4.2% clip, when compared to the second quarter of 2017. Similarly, overall company earnings during the second quarter of this year were up approximately 20% in the U.S., when compared to the same period a year ago. “The impact of tax reform is definitely being reflected in the earnings and economic growth numbers for 2018,” Eibel states, “but of course, it wasn’t in the 2017 numbers, so it’s a bit of an unfair, apples-to-oranges comparison.”

While the quarterly economic and earnings numbers witnessed so far in 2018 are very strong, the forward-looking outlook appears much murkier. Sustainability is perhaps the biggest question mark—in part due to what we see as the latter innings of the current market cycle, but also because next year’s comparables will be measured against this year’s. What might this mean? Consider some preliminary numbers from Thomson Reuters, which predicts U.S. earnings to the tune of 10% in 2019. That’s a good number, no matter how you slice it. Yet, such a figure would only amount to half the rate of growth seen during the second quarter of 2018. “If these numbers pan out, U.S. markets will likely see a slowdown in 2019,” Eibel predicts.

Other concerns about the U.S.

In the U.S., valuations are also historically high, with cheaper prices everywhere else. While this doesn’t mean the U.S. market can’t grind higher from here, make no mistake: it’s overvalued, says Eibel.

Data as of September 2018. Source: Datastream, MSCI Country and regional Indexes. Russell Investments calculations. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. See appendix for ratio definitions.

Data as of September 2018. Source: Datastream, MSCI Country and regional Indexes. Russell Investments calculations. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. See appendix for ratio definitions.

There is, however, an argument to be made for the costliness of U.S. stocks—chiefly, the aforementioned 4.2% economic growth. In other words, perhaps equities are expensive because the U.S. is performing in such extraordinary fashion, lending credence to a pay-to-play line of thinking.

While this certainly has merits, the sustainability of U.S. growth moving forward is why, in Eibel’s opinion, the better game is probably outside the U.S. “The way I see it, if I’m going to be paying more money for U.S. equities than I would for any other asset class in the world, the story has to be getting better,” he says. “Otherwise, I’m going to go out and purchase a similar product at a cheaper price somewhere else.”

Others appear to be in agreement. According to recently released data from the FUSE Research Network, three of the top six asset classes with the greatest expected allocation increases among advisors over the next 12 months are emerging markets, international core and global equities.4 In other words, non-U.S. equity strategies are surging to the forefront as a growing number of advisors lay plans for more globally-diversified portfolios.

Outside of questions around U.S. sustainability, we think another key reason for this is the risk to U.S. markets of rising interest rates, as the Fed appears committed to its cycle of quarterly interest-rate hikes. The central bank’s actions seem prudent, notes Eibel, in order to keep inflation under control. This, however, presents more competition for stocks. “Bonds may start to look more attractive in a rising interest-rate environment,” he remarks.

In addition, interest rates remain low outside of the U.S.—particularly in Europe and Japan. It’s these areas in particular that Eibel believes make the global diversification story an attractive one. And to the extent that history rhymes, asset class leadership reversals tend to happen quickly—so unless you’re positioned in advance to capitalize on the turning point, you’re likely to miss it.

Source: Non-U.S. developed markets represented by MSCI EAFE Index. U.S. equities represented by S&P 500® Index.

Source: Non-U.S. developed markets represented by MSCI EAFE Index. U.S. equities represented by S&P 500® Index.

In part 2, we’ll dig deeper into why we believe these parts of the globe offer better potential. For now, though, suffice it to say we believe there are plenty of warning signs in the U.S. Looking beyond America’s borders may well be the best way to offset some of this risk.


Don’t want to wait for part 2? Listen to the complete podcast on global diversification today

Disclosures:
1 Source: Russell 3000® Index and MSCI ACWI ex-USA Index

2 Source: S&P 500® Index, MSCI EAFE Index

3 Source: Emerging Markets represented by MSCI Emerging Markets Index had a calendar-year return of 37% in 2017. Non-U.S. developed markets represented by MSCI EAFE Index had a calendar-year return of 25% in 2017. U.S. Equity represented by Russell 3000® Index had a calendar-year return of 21% in 2017

Source: FUSE Research, November 7, 2018: Non-US Equity Strategies Feature Prominently in Advisor Allocation Plans for 2019.

Trailing price-to-earnings (P/E) is a relative valuation multiple that is based on the last 12 months of actual earnings. It is calculated by taking the current stock price and dividing it by the trailing earnings per share (EPS) for the past 12 months.

Forward price to earnings (forward P/E) is a quantification of the ratio of price-to-earnings (P/E) using forecasted earnings for the P/E calculation.

Cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.

Price-to-cash-flow ratio is a stock valuation indicator that measures the value of a stock’s price to its cash flow per share. The ratio takes into consideration a stock’s operating cash flow (OCF), which adds non-cash earnings such as depreciation and amortization to net income. It is especially useful for valuing stocks that have positive cash flow but are not profitable because of large non-cash charges.

Price-to-book ratio compare a firm’s market to book value by dividing price per share by book value per share.

Price-to-sales ratio is a valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the value placed on each dollar of a company’s sales or revenues. It can be calculated either by dividing the company’s market capitalization by its total sales over a 12-month period, or on a per-share basis by dividing the stock price by sales per share for a 12-month period.

Performance quoted represents past performance and does not guarantee future results.

Indices and benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Index return information is provided by vendors and although deemed reliable, is not guaranteed by Russell Investments or its affiliates. Due to timing of information, indices may be adjusted after the publication of this report.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indices or financial products. This report is not approved or produced by MSCI.

Bloomberg Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

Bloomberg Commodity Index Total Return: Composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased. This process is known as “rolling” a futures position.

FTSE EPRA/NAREIT Developed Index: A global market capitalization weighted index composed of listed real estate securities in the North American, European and Asian real estate markets.

The MSCI AC (All Country) Index: Captures large and mid cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries*. With 2,791 constituents, the index covers approximately 85% of the global investable equity opportunity set.

MSCI country indices: Indices which include securities that are classified in that country according to the MSCI Global Investable Market Index Methodology, together with companies that are headquartered or listed in that country and carry out the majority of their operations in that country.

MSCI EAFE (Europe, Australasia, Far East) Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

MSCI Europe Index: A free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. The MSCI Europe Index consists of the following 15 developed market country indexes: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Frontier Markets Index: Captures large and mid cap representation across 29 Frontier Markets (FM) countries. The index includes 115 constituents, covering about 85% of the free float-adjusted market capitalization in each country.

MSCI World Index: A market cap weighted stock market index of 1,653 stocks from companies throughout the world.

MSCI World ex-USA Index: The MSCI All Country (AC) World ex U.S. Index tracks global stock market performance that includes developed and emerging markets but excludes the U.S.

Russell 1000® Index: Index measures the performance of the largest 1000 U.S. companies representing approximately 90% of the investable U.S. equity market.

Russell 3000® Index: Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The S&P 500® Index: A free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500® are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ.

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Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

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