Potential Catalysts
There are a number of potential catalysts that could spark a new regime of international equity strength.
In the sections that follow, we will outline multiple underlying tailwinds for international equities. But, to set the stage, there are a number of potential catalysts that could push these tailwinds into motion, each of which provide meaningful context to the underlying research itself.
1. U.S. Concentration
Returns in the U.S. have been trending toward all-time concentration levels with over 100% of gains coming from less than 10 companies at various points in 2023. There may be merit to the strength of these U.S. mega-cap giants, but concentration to these extremes poses danger for portfolios if not properly diversified and risk-managed.
2. U.S. Valuations
In a similar vein to concentration, U.S. valuation levels are sitting well above long-term averages. If we simply take a “mean reversion” view of the U.S. market, we would expect an eventual contraction of the U.S. market’s elevated valuation multiples, which could be a net detractor to returns as well as a catalyst for dollars to flow into international markets over the United States.
3. The U.S. Dollar
The U.S. dollar has become the reserve currency for the global economy. With this status has come strength, and that strength provided a tailwind for United States–based stocks. Higher-for-longer interest rates, as well as a U.S. economy that has been treading on thin ice by a number of measures, could lead to this U.S. dollar dominance weakening, providing enhanced opportunity for outsized international equity performance.
4. The U.S. Fiscal Deficit
The U.S. deficit is at its highest level in history and growing, with only three countries in the world owning worse deficits: Pakistan, the Philippines, and Brazil. Again, bringing in the backdrop of higher interest rates, the United States’ increasingly large deficit could pose debt-service issues, lead to decreased future spending, and result in reluctance to pump further stimulus to the U.S. economy in the face of expected weakness.
Potential Catalyst: Concentration
The U.S. stock market is currently highly concentrated, which poses additional concentration and correlation risk to all-U.S. investors.
With the rise of The Magnificent Seven (AAPL, AMZN, GOOG, META, MSFT, NVDA, & TSLA), these seven companies possess a larger combined market cap than every country in the world except the United States and China1. Together they represent about 28% of the total market cap of the S&P 500.
While many investors view the S&P 500 as a diversified holding, the index is as concentrated as it’s ever been among its top holdings — and it contains no non-U.S. holdings. This level of concentration, especially to investors who are potentially under the assumption that they are invested in a diversified index, poses outsized risk to portfolios.
To further illustrate the risk attributed to these levels of concentration, we can simply look at how frequently — and rapidly — the top 10 companies in the world (by market cap) have changed over time. As shown in the graphic below1, very few companies are not highlighted, indicating their ability to maintain top-10 status across decades. Notably, at the end of Q2 2023, Microsoft is the only top-10 company that was in the list at the beginning of the century. Similarly, eight of the current top 10 companies were not on the list as recently as 2010.
Potential Catalyst: Valuations
The S&P 500’s current Shiller CAPE ratio of 28x is well above its average — since 1900 — of about 17x.
Valuations at this level have historically been an indicator of lower forward returns. In this example, the Shiller CAPE ratio levels are split into quintiles, with forward market returns assigned to each quintile. On average, the lowest valuation levels saw forward returns of over 15%, while the highest levels saw forward returns of about 7%. It’s important to note that average returns over time are all still positive (high valuations are not an indication of bear markets or negative returns), but they are much lower in the highest quintile.2
Another reference point using CAPE ratios is the inverse CAPE (1/CAPE), which represents a back-of-the-napkin expected return. With a current CAPE ratio of about 28 for the United States, this presents an expected real return for 3.5%. However, the average expected return for countries outside of the US is nearly 7% based on the inverse CAPE metric, based on an average ex-US CAPE ratio of about 8.5.3
From another angle, we can compare U.S. and international stocks using more traditional valuation measures. The chart below compares an equal weighted average of the U.S.’s price/earnings, price/book, price/sales, and price/cash flow to those of international stocks. In these relative terms, the United States is currently trading at an 84% premium to international stocks, compared to an average premium of 34% since the beginning of the century.
Potential Catalyst: The U.S. Dollar
The strength of the U.S. dollar is vulnerable.
As the primary reserve currency of the global economy, relative shifts in the strength of the U.S. dollar are one of the key determinants of relative performance between domestic and international equities.
Apart from 2018, the dollar has been experiencing steady growth since the global financial crisis, which has fairly accurately correlated to out-/underperformance for U.S. equities relative to international. In 2023, the dollar has fallen from its two-decade high in 20224, potentially signaling an end to its bullish trend.
The U.S. Federal Reserve’s “higher for longer” stance on interest rates will very likely take a toll on the strength of the U.S. economy, leading to slower domestic growth that could put additional downward pressure on the dollar. As the U.S. weakens and relative international performance improves, we could see more downward pressure on the dollar, thus creating the catalyst of a broadly weakening dollar and relative strength for international equities, much as we experienced in the lost decade from 2000 to 2009.
In addition to headwinds facing an already weakening dollar, the dollar is currently overvalued relative to fair value needed to achieve current account balance. According to the below table5, the U.S. dollar is the most overvalued in a select group of 14 major currencies. Given this data, we believe there are both fundamental and multiple-related headwinds that could come to fruition for the dollar, giving relative advantage to international over domestic equities.
Finally, while the U.S. dollar is on the verge of gaining for a third consecutive year6, history shows that strength is unlikely to carry over for a fourth year. This could be another potential tailwind for international equities.
Potential Catalyst: The U.S. Fiscal Deficit
The fiscal deficit in the United States is among the highest in the world.
The U.S. fiscal deficit clocked in at about $1.7 trillion at the end of September 20237, representing the largest deficit on record outside of pandemic-fueled spending in 2020 and 20218. While the United States has not been in a budget surplus since 20018, the dramatic increases in the deficit in recent years are alarming.
As a percentage of GDP, arguably a more relevant figure than the nominal deficit, we now have a deficit/GDP ratio (see chart below)9 that is above the long-term average of 6.4% since 195010.
Again, bringing in the backdrop of increased interest rates and a higher-for-longer stance from the Federal Reserve, this increased deficit spending could pose greater issues for the US economy.
Politics aside, as the economy continues to soften and potential recession arrives, the U.S. government may be less likely to splurge on stimulus spending due to its already elevated debt service responsibilities. If, in fact, recession hits the United States and the economic effects are unabated by a stimulus safety net, we could see below-average growth in the United States over a span of (potentially) many years, giving a default advantage to international equities.
Strategic Reasons for International Diversification
Strategic Reason: Larger Investment Opportunity Set
The global investible market is not leveraged to its fullest potential by many U.S.-based investors.
It is commonly known in behavioral finance that investors tend to overweight “what they know.” All else being equal, even professional investors tend to overweight the regions or sectors that are under their research purview, but the investment universe is much larger than what most of us have in our immediate sights.
Home bias is one of the major investor biases explored by behavioral finance experts (including Orion’s Chief Behavioral Officer Dr. Daniel Crosby). Currently, the United States is home to about 60% of the investible market cap of the global market11 but just 10% of the world’s listed companies12 and just over 15% of the world’s GDP13. Of course, the United States is home to many of the world’s largest companies, but this disparity gives opportunity for growth in non-U.S. market caps compared to potential growth opportunities of the U.S. market.
Despite the magnitude of international investment opportunities compared to the domestic market, U.S. mutual fund investors have an average of just 22% of their portfolio allocations in non-U.S. stocks, and that number has been in a downtrend since its 20-year peak in 200714. With those figures in mind, the average investor is therefore nearly 20% underweight in their international exposure from a total investible market perspective.
Given this larger opportunity set and the average investor’s current underweighting, there lies an opportunity for enhanced risk-adjusted returns from further regional diversification.
Strategic Reason: Volatility Reduction
While increasing international exposure can create opportunities for capital growth, it also has the potential to decrease volatility.
According to the Vanguard white paper “Why the Time Is Now for International,” allocations to non-U.S. stocks between 20% and 50% represent the maximum volatility reduction range for portfolios, with allocations up to 70% reducing overall portfolio volatility.
With the beginning of (and expectation of continuing) deglobalization, there lies even further opportunity for volatility reduction from international allocations. While correlations between U.S. and non-U.S. equities rose among rising globalization and the free flow of information, this relationship could begin to reset. Lower correlations between the two asset classes would contribute positively to the diversification benefit of international addition, as well as enhance expected risk-adjusted returns.
Equities crash at the same time, so why bother?
At shorter horizons (months and quarters), worst cases for individual countries are similar to worst cases for globally diversified portfolios. Short crashes are of course painful, but there lies a bigger risk for investors, which would be long-term pain. Extended bear markets can prevent investors from meeting their long-term wealth goals. In a 2011 study by AQR’s Asness, Ilmanen, and Villalon15, they found that over short horizons global portfolios can suffer almost as much as an average local portfolio; however, over a couple of years the global portfolio recovers much better than a local portfolio. This is due to cyclical and secular moves in economic and market performance, which can diverge widely across countries.
Tactical Reasons
The relationship between domestic and international equity performance is highly cyclical.
Over the last 20 years (see the chart below), international stocks (represented by MSCI ACWI ex USA) have outperformed the total U.S. market (represented by the Russell 3000) in 9 of those years, or nearly 50% of the time.
While the U.S. has broadly outperformed for 8 of the last 10 years, international-versus-domestic outperformance is highly cyclical. With 2022 representing the first year in nearly 6 years that international stocks outperformed domestic stocks4, the tide could be beginning to turn for the next relative performance cycle.
Tactical Reasons for International Diversification: Relative Valuations/Expected Returns
When looking to research industry-leading asset managers, we find further confirmation of our positive outlook on international equities. Additionally, if we point to industry-leading asset manager research, Vanguard16, Research Affiliates17, and GMO18 have an average expectation of about 4% outperformance for international equities per year, over the next 5 to 10 years. Given the headwinds that are facing the U.S. economy, and subsequently U.S. stocks, capital assumptions broadly point to international outperformance.
To further this point, you can look at Research Affiliates’ Asset Allocation Interactive Tool for an expected return analysis. Over the next 10 years, on a real, after-inflation basis, both developed and emerging international equities are set to outperform U.S. equities. Even more jarring than this relationship is the very low return expectation for U.S. large cap stocks, which have topped this chart over the last 10 years.
From a total return perspective, international equities provide a larger average dividend compared to U.S. equities. Not only does this increased cash flow boost returns, it can also smooth volatility with a consistent distribution stream. According to Vanguard (see chart below)16, the dividend yield for non-U.S. securities is nearly double that of U.S. securities, resulting in a stable source of potential outperformance.
How To Size Your Position
We believe in a strategic international allocation based on the global market cap mix.
With all these factors and potential catalysts considered, we are left with one final question: how should advisors and investors be sizing their allocations to international equities?
While in the short term we can experience cyclical underperformance from international (or domestic) equities, for long-term investors, a strategic weighting to a mix of both markets has been empirically shown to provide superior risk-adjusted returns.
This may be difficult to believe based on the key behavioral factor at play here: recency bias. According to Buckingham Strategic Wealth’s Larry Swedroe:
“For many financial advisors, the current run of outperformance for U.S. over international equities has made it increasingly challenging to communicate with clients about the wisdom of diversifying globally. And while the numbers from the last 15 years look bad enough on their own, certain behavioral biases such as recency bias (which can cause people to overweight the importance of recent events over those that occurred farther in the past) and confusing the familiar with the safe (which can lead to U.S. investors downplaying how risky U.S. equities really are) have made international diversification look even worse in the eyes of the investing public.”
In addition to recency favoring U.S. equities, it’s also rather important to understand the source of U.S. outperformance since the 1990s, which has ultimately been due to multiple expansion. As we mentioned earlier, one of the key catalysts to a regime shift in market performance trends could be multiple contraction, which the United States has not, by and large, experienced over the last 30-odd years.
According to AQR’s “International Diversification – Still Not Crazy after All These Years,” the trend of “richening valuations” in the United States has pushed relative valuations to international equities to their highest levels in recent years. AQR’s conclusion? The price that investors have been willing to pay for U.S. fundamentals is likely not repeatable.
“If anything, valuations have a slight tendency to mean revert, at least when they are at extreme levels.”
All this evidence combined brings us back to the original question: How should an international position be sized within portfolios?
With consideration given to the size of the global opportunity set, cyclical performance, optimized volatility management, and headwinds to U.S. markets, we advise the implementation of an allocation to international stocks based on the global equity benchmark. While this allocation is a strategic, or baseline, allocation, there are merits to active tilts around this weighting scheme given changes in fundamental outlook on the global market.
