Despite high inflation, political gridlock and ongoing supply chain issues, the US continues to see strong performance relative to other international markets. In this article, we attempt to explain why international exposure should still be part of an optimized portfolio, how international and emerging markets differ in composition from US markets, and how factors such as the strong dollar and recent geopolitical developments are affecting the outlook for changed the future.
Question 1: US equities have outperformed international and emerging markets over the last 5 years. Do international equities still play a role in a core portfolio?
International commitments have done little to help investors in recent years. A long period of increased globalization and economic integration has resulted in higher correlations between international markets, thereby reducing the benefits of geographic diversification. There is reason to believe that this could change in the future, as reduced economic globalization from the pandemic could mean greater benefits for global asset diversification through lower international market correlations. Accordingly, the question of international exposure should be how much is optimal, not whether or not to include international markets in a portfolio.
Source: Bloomberg as of 06/30/2022
Correlations between US and international markets have been high recently, but may decline as deglobalization progresses.
Question 2: What drives the differences between US and international stock markets?
Thorough evaluation and investing in global sources of return requires careful examination of markets (both developed and emerging) for the different sector exposures and other unique characteristics that different economies offer. Much of the US market’s spectacular growth in recent years has been attributed to the technology sector, which is relatively larger than most other markets. While technology also plays a big role in the Chinese market, there has been little growth in China’s tech sector recently due to regulatory headwinds. Other commodity-driven economies such as Canada and Australia also posted positive returns, in line with the boom in commodity prices.
Source: Bloomberg as of 12/31/2021
Much of the US market’s outperformance can be attributed to the technology sector.
Question 3: How do international equities and bonds benefit from the risk and return of a core portfolio?
A current limitation on the ability of international exposure to improve portfolio efficiency is in fixed income markets. In our view, international opportunities are currently largely limited to equity markets, as fixed income’s currency exposure carries exchange rate risk with no expectation of a higher return. Additionally, bond yields are generally not higher outside of the US, and the US is generally considered to have the lowest risk of default. The exception is emerging market bonds with their higher yields. In equities, however, international investing continues to offer both the opportunity to implement appropriate diversification to minimize portfolio risk at each level of expected return, and the opportunity to seek and lock in higher returns—both of which a purely domestic investment approach lacks.
Source: Bloomberg as of 07/29/2022
The US has consistently been one of the most profitable bond markets among developed economies.
Question 4: Will the US dollar continue to strengthen, or will its strength result in entrenched global inflation that will negatively impact future international returns?
The strength of the dollar is also affecting future international returns. In recent times, the dollar has appreciated in value, in part due to its role as a global reserve currency and a safe haven for investors during turbulent times. It also became more attractive because US Treasury bonds offer higher interest rates than most developed economies and because interest rates are expected to rise even higher. The dollar’s appreciation is also obscuring international stock market returns – recent US and international market returns, often quoted in US dollars, have been similar in dollar terms, but international markets have outperformed in local currency terms. In other words, the strength of the dollar has masked the local outperformance of many international markets. The influence of the dollar on the economy is also affecting the markets. A strong dollar is good for consumers, but a drag on internationally competing producers. This undermines the Fed’s current goal of slowing the economy, which could force more aggressive action and ultimately result in a weaker dollar.
Source: Bloomberg as of 07/29/2022
The relative return of the international and US markets at the local level has reflected the dollar’s rise in 2022.
Question 5: With both equity and bond markets posting negative returns in 2022, what opportunities, if any, are there in international markets?
Looking beyond the current performance of international asset classes and moving towards a long-term view of international markets, we note that recent geopolitical developments make the outlook less certain. Geopolitical risks make the outlook less reliable in general, but Europe and China deserve special attention. European valuations were already relatively low in early 2022, but the Ukraine invasion clearly had a negative impact. This further lowered asset prices and increased volatility, suggesting a potential yield premium for investors willing to accept the risk of investing in the region. In contrast, China’s tighter corporate regulation policy of prioritizing social responsibility over shareholders casts further doubt on expectations that it will reward investors as its economy grows.
Source: Bloomberg as of 12/31/2021
Unlike the US, China’s spectacular economic growth hasn’t translated into commensurate returns for equity investors.
Overall, investors can expect more diversification than usual in international markets, presenting an opportunity for international investing to reduce risk and enhance returns. But it is still important to be diversified against uncertainty and to avoid becoming overly exposed to any particular possible outcome of currently unfolding events. Generally, global diversification improves an investor’s chances of capital preservation through reduced geographic concentration as well as exposure to alternative sectors. For the long-term investor whose primary goal is capital appreciation, the higher risk premia currently associated with international markets such as Europe present an opportunity. For the risk-averse investor willing to sacrifice potential appreciation for greater certainty of capital preservation, the right level of diversification across markets tends to erase losses as underperformance in one area is offset by outperformance elsewhere.
Past performance does not guarantee future results. As market conditions fluctuate, the investment return and capital value of each investment will change. Diversification may not protect against market risk. There are risks involved in investing, including a possible loss of capital. The indices are not investable securities. The performance of each investable security would be reduced by fees and expenses. Any distribution must comply with your company’s policies and applicable rules and regulations, including Rule 206(4)-1 of the Investment Advisers Act of 1940.
market risk. There are risks involved in investing, including a possible loss of capital. The indices are
non-investable securities. The performance of each investable security would be reduced by fees and
Costs. Any distribution must comply with your company’s policies and applicable rules and
Regulations, including Rule 206(4)-1 of the Investment Advisers Act of 1940.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.