Why US investors should diversify globally
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Thought of the day
Thought of the day
US investors have become accustomed to their home stock market outpacing the rest of the world. Since 2008, the S&P 500 has returned 262%, compared to just 37% for the MSCI EAFE, which captures the performance of 21 developed markets excluding the US and Canada, and 17% for the MSCI Emerging Market Index.
Recently, however, the US's star quality appears to have dimmed. So far in 2023, the S&P 500 is up 4.7%, lagging the MSCI EAFE's 7.8% return and the MSCI EM's 8.4% return. US stocks also underperformed global stocks by 2 percentage points in 2022.
While the margins are relatively small, we believe the trend of US underperformance is likely to persist over the longer term. For US investors with an excessive bias to the domestic market, we see a compelling case for global diversification.
US stocks are expensive relative to history, while a period of exceptional margin expansion for US businesses looks likely to end. The US stock market is trading at one of its most expensive levels in 15 years, while international market valuations are relatively cheap. The S&P 500 trades at about 17.7 times the consensus estimate for 2023 earnings, which is 40% richer than the MSCI Europe Index (12.5x) and the MSCI Emerging Markets Index (12.3x).
In recent years, the US stock market's rise has been driven by more than just expanding valuations; strong earnings growth has also contributed. But much of this earnings growth has been driven by tailwinds that are unlikely to persist at the same pace going forward. For example, operating margins grew from 10% in 2001 to an all-time high of 16% in 2021. Additional margin expansion is going to be difficult with interest rates and taxes in the years ahead likely to be higher than previously, along with more regulatory pressure (or at least less deregulation) for many US sectors.
The US share of global stock market capitalization is set to contract, in our view. At present, US stocks make up 60% of the global stock market capitalization, versus 28% for other developed market stocks and 12% for emerging market stocks. By contrast, the US economy is only 16% of global GDP. In both cases, the US share of the global “pie” is expected to shrink, especially as emerging market economies contribute a greater share of economic growth and open their economies to public markets.
An overvalued dollar and higher interest rates should be further drag on the US's relative performance. The US dollar is approximately 20% more expensive than US trading partners' currencies, based on our analysis. Over a full business cycle, we expect the US dollar to weaken against major currencies, such as the euro, which should provide a tailwind to US investors’ international stock market returns. Meanwhile, higher interest rates are a headwind for the growth-oriented US market and a relative tailwind for international markets, which are more value-oriented.
So, we expect international stocks to deliver a superior return to the S&P 500 over the next several market cycles. As a result, we advise US investors with a strategic over-exposure to their home market to diversify. We are also Least Preferred on the US over the near term, given the relatively expensive valuation of US stocks and the market’s heavy weighting toward the tech sector, which is particularly vulnerable to higher interest rates and slower economic growth. By contrast, we expect emerging market and German equities to be among the main early beneficiaries from an inflection point in global growth in 2023.