From 1999 to 2007, the US-based S&P 500 Index languished, returning just 38%, while international developed market stocks (MSCI EAFE) gained 91% and the MSCI Emerging Markets Index gained 408%.
By contrast, the S&P 500 has massively outperformed since 2008, gaining a whopping 262% return that has eclipses the 37% total return for the MSCI EAFE and the 17% gain for emerging markets.
The MSCI All Country World Index, which is a market-capitalization index that includes large-cap stocks from around the globe, was up 70% from 1999-2007 and has gained another 109% since 2008, generating a cumulative return of 259%.
An inflection point
Many of the factors that helped fuel US stocks' outperformance since 2008—such as anemic global growth, subdued inflation, and low and falling interest rates—appear to be behind us.
Moreover, the size and persistence of the US stock market's outperformance since the global financial crisis has helped to create a growing number of headwinds that suggest that international stocks are due for a comeback.
We believe there are five key factors that will help a globally diversified portfolio outperform a US-heavy portfolio over the next few market cycles:
1. Valuations. 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).
2. Profitability. In recent years, the US stock market's rise has been driven by more than just expanding valuations; strong earnings growth has also been a significant tailwind. Unfortunately, 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 ballooned from 10% in 2001 to an all-time high of 16% in 2021. Further margin expansion is going to be difficult, especially with interest rates and taxes likely to rise in the years ahead, along with more regulatory pressure (or at least less deregulation) for many US sectors.
3. Growth. Today, US stocks make up a whopping 60% of the global stock market capitalization. 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.
4. Currency. The US dollar is approximately 20% expensive versus US trading partners' currencies. 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.
5. Interest rate risk. Rising interest rates are a headwind for the growth-oriented US market and a relative tailwind for international markets, which are more value-oriented.
Taken together, these five factors contribute to a higher expected long-term return for international stocks. Based on the UBS Capital Market Assumptions, we expect an annual return of 7.4% from international stocks, versus a 6.9% for US large-cap stocks over the next several market cycles. This outperformance can play out faster than you might think; from 16 August 2022 to 23 January 2023 international developed stocks and emerging market stocks have rallied 7% and 3% respectively, while the S&P 500 has fallen 7%.
Today, the market capitalization weight of the global stock market is approximately 60% US stocks, 28% international developed stocks, and 12% emerging market stocks. Maintaining a globally diversified asset allocation that mirrors these weights can help investors to maintain a healthy allocation to US equities, while also tapping into a variety of global growth drivers.
Diversification does more than simply add to return potential; it also helps to reduce the risk that one market will underperform over a given time period. Especially given that the US stock market has become increasingly concentrated in a handful of stocks and sectors—and faces US-specific challenges such as the US debt ceiling, and domestic tax and regulatory policy risks—we believe that this is a good time to take this opportunity to rebalance your stock portfolio to right-size your allocation to international stocks.
If you would like to explore these factors and the benefits of a globally diversified portfolio in greater depth, please speak with your financial advisor.
Main contributors: Daniel J. Scansaroli and Justin Waring