For the past several years, "experts" have been predicting the return of international stock outperformance. So far, they’ve been wrong. Of course, foreign stocks will begin beating the S&P 500 again at some point in the future, but U.S. exceptionalism in the world equity markets has been in place for almost the entirety of the 2010s.
Is the investment case for international stocks any better today than it has been for the past several years? I think the answer is likely an easy yes. Does that mean I think investors should be overweighting foreign investments in their portfolios? There’s definitely a case to be made that the answer to that question is yes, but a few things need to fall into place in order for that to happen.
I have been preaching this week that from a pure valuation standpoint, international stocks are deeply discounted relative to U.S. stocks. That tends to be the case most of the time anyway, but the valuation gap is getting particularly wide right now.
As it stands today, European stocks trade at about a 40% discount to U.S. stocks. Back at the tail end of the financial crisis, the two groups weren’t that far apart in terms of valuation, but the gap has been progressively growing over the past decade. Emerging markets are trading at an even slightly wider discount than developed markets. If you look at price/book ratios instead of CAPEs or P/E ratios, the discount for both groups jumps to about 50%.
While discounts that deep tend to translate into outperformance over the subsequent 5+ years, discounts can remain discounts for a while. If we factor forward-looking growth expectations into the equation, we see that it’s a bit of a mixed bag for international markets.
The global economy is expected to continue its recovery throughout the remainder of 2021 and into 2022 before leveling off to more normalized, long-term levels. Emerging markets in Asia are expected to deliver the biggest growth, although other regions, including Latin America, the Middle East and Africa are expected to be growth laggards. The Eurozone is also expected to lag world average expectations, but the United States should do comparatively well, at least for the remainder of this year.
While there’s probably going to be some need to pick and choose your opportunities, the consensus is that the post-COVID economic recovery is happening and the world is going to begin reopening sooner rather than later. The timing of the recovery in some areas is still very uncertain as scattered outbreaks still exist and vaccination numbers are still low in many developing areas of the world. Over the next year, however, I expect continued progress to be made on this front. Supply chain bottlenecks will begin to go away and global business can resume as normal.
That type of cyclical recovery should play well for sectors, including financials and industrials, as well as value stocks and dividend payers. We know that the value trade has been considered dead for more than a decade, but it’s been making a strong comeback over the past nine months and has plenty of room left to run in order to make up for 13 years of underperformance.
That could mean an ideal environment for international stocks to begin leading again, especially if we continue to see downward pressure on the dollar. Historically, U.S. stocks and international stocks have traded leadership in roughly 10-year cycles all the way back to the 1980s. Guess where we are in that cycle today?
We’re nearly a decade into the current run for U.S. stocks. Much of the 2000s belong to international stocks coming out of the tech bubble crash all the way through the end of the financial crisis. The 1990s were again dominated by U.S. stocks following a 5-year run that saw foreign equities deliver their biggest outperformance in more than a half century.
It’s difficult to say that international stocks are ready to lead again just because “it’s time”, but this trend has tended to follow very defined cycles. Given the undervalued nature of many stocks in these regions, both developed and emerging, as well as favorable growth expectations and a potentially weaker dollar, conditions could finally be setting up for overseas investments once again.
It could, however, be the value trade that drives international outperformance in the 2020s. I don’t need to tell you that growth has walloped value over the past decade and more, but the degree of underperformance has been getting historically wide.
The last time value performed this badly was, not surprisingly, the peak of the tech bubble. U.S. value stocks aren’t quite at that level of underperformance today, but there are few instances where the growth/value gap has been this wide. If the cyclical recovery theme continues to play out, as I expect it will over the next 12 months or so, value could finally see that elusive extended stretch of outperformance that it hasn’t experienced in years. Given the relative performance and valuation gap between the two groups, there’s a lot of room for catch up here.
Replace value/growth with international/U.S. and you’re looking at a similar story.
Over shorter-term periods, U.S. stocks have been leading the world stage pretty consistently ever since the financial crisis. This alone doesn’t mean that a turning of the tide is imminent, but if you look at current conditions, a pretty compelling case can be made.
Investors have already begun flocking to value-oriented stocks from cyclical sectors as the recovery picks up steam. The steady weakness is the U.S. dollar fueled by heavy government spending and a virtually limitless mountain of debt could add an important tailwind for overseas equities. At a high level, developed and emerging markets equities are expected to see greater growth rates over the next decade and trade at historically wide discounts relative to the S&P 500.
Home country bias is still strong for many investors, but the evidence is growing that a changing of the guard could finally be nearing.
Use me as a sounding board, thanks.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President