Why International Equities?

Below is a transcript of this week’s video.

Hi, this is Ilona Vovk with Investment Strategy at Glenmede.

Let's discuss a critical aspect of portfolio management: the role of international equities. In recent years, the U.S. equity market has largely outperformed its international counterparts, leading some to question the latter’s place in portfolios. Glenmede’s research shows allocating between 20-30% of a long-term equity portfolio to international markets is optimal for U.S. investors. That range is less than the approximately 40% weight international stocks have in major global indices when measured by market cap.

Why the disparity? This analysis reflects the benefits of home bias, which comes from the typical preferential tax treatment of investing in one’s domestic equity markets, as well as the advantage of owning assets that are denominated in the same currency as one’s expenses. This is in recognition that foreign currency risk is uncompensated and should not be given equal standing. With that said, investors shouldn’t take home bias to the extreme, as investments in foreign markets are crucial for diversification purposes to improve the longer-term balance of risk and reward.

Now let's take a moment to reflect on the performance of the U.S. equity market. Recently, domestic stocks have been stealing the spotlight, outshining international markets. But when zooming out to see the bigger picture, the story isn't so one-sided. The battle for market superiority between foreign and domestic stocks isn't a sprint; it's more like a marathon, marked by cycles that span several years. Let’s take, for instance, the stretch from 2002 to 2009. During this period, international equities outperformed their U.S. counterparts in eight out of nine years, and not just by a slim margin. And if we rewind even further back, the period from 1982 to 1989 was a golden era for international developed stocks, which cumulatively beat U.S. stocks by a staggering 401%.

This dance of dominance suggests a pattern – a pendulum that swings between U.S. and international markets. Given this behavior and the last decade’s outperformance of U.S. stocks, investors should consider the possibility that another run of foreign leadership is possible.

Currently, according to Glenmede's Global Expected Returns Model, U.S. markets remain more richly valued relative to their international counterparts. This is particularly evident when looking at Japan, which is trading at a notable discount and emerging markets valuations sitting just a hair above fair value.

From an earnings perspective, aside from Europe, foreign equities are actually expected by analysts to offer more attractive growth.

Additionally, a weakening dollar may be a tailwind for foreign equities. The dollar has receded from its peak, which was near the 2nd standard deviation high. In the past, during phases of dollar depreciation, international equities have shown remarkable performance. Since 1973, in months when the dollar was softening, international equities have recorded an impressive, annualized return of 35.9%. This figure contrasts with the 18.5% annualized return of the U.S. large cap index, and 19% annualized return for U.S. small caps during the same periods. This underscores how important it is to have some investments in portfolios denominated in currencies other than U.S. dollars. Of note, both U.S. equities and the dollar have risen to extreme levels compared to their counterparts, exposing non-diversified investors to a notable risk if such exceptionalism reverts to more normal levels.

So to summarize, a well-diversified portfolio of equities should contain roughly 20-30% international exposure; U.S. stocks outperformed during the last decade, but market leadership may be due to swing back in the other direction. Many international markets trade at a relative discount while U.S. market valuations appear to price in high expectations for the future and at this point foreign equities offer competitive earnings growth, aside from Europe being a notable exception. A modest allocation to international equities provides protection against a decline in excessive optimism surrounding the U.S. and the dollar.

And with that, thank you for listening! And please don’t hesitate to reach out with any questions.