By Ann Guntli, CFA, Senior Analyst
Over the past few decades, economies around the world have become more integrated, and global growth has increasingly stemmed from countries other than the United States. While the U.S. stock market offers the comfort of familiarity for U.S. investors, investing both in the U.S. and international markets can benefit those with long-term perspectives. We encourage our clients to look at their equity investments from a global standpoint – domestic, developed international, emerging, and frontier markets – with the goal of investing in high-quality companies irrespective of where the company is located.
A Snapshot of Global Economies & Markets
The economies in all countries experience business cycles – expansions and recessions, peaks and troughs. Where any given country is in its business cycle impacts its gross domestic product (GDP) and its attractiveness from an investment standpoint. As shown in Exhibit 1, the U.S. economy makes up about 24% of global GDP. Emerging and frontier market countries – which together make up nearly 40% of world GDP – have stronger estimated growth rates than the developed world (Exhibit 2).
Over the past two decades, international equities have grown to make up nearly half of the global equity market (Exhibit 3). Despite the size of international markets, U.S. investors typically have only 25% of their equity allocation in non-U.S. equities, according to Morningstar. Investors tend to have a bias to their home country (this is not just a U.S. phenomenon), which can lead them to miss out on a large opportunity set of investments around the world.
Rationale for a Global Investment Perspective
One of the primary benefits of investing in equities outside of the U.S. is diversification, which is commonly measured by correlation. Even though correlations between U.S. and non-U.S. equities have increased as global markets have become more integrated over the past two decades (Exhibit 4), diversification benefits still exist.
As mentioned previously, given countries’ distinct business cycles, companies based outside the U.S. are exposed to different economic and market environments than U.S. companies are. Different currencies also influence the diversification benefits of investing outside the U.S. equity markets.
Over time, currency movements have helped to reduce the correlation between U.S. and non-U.S. equities, and reduced correlations decrease volatility for global equity portfolios when compared to the U.S. equity market alone (Exhibit 5).1
Furthermore, given the tendency to avoid the unfamiliar, companies domiciled outside the U.S. tend to be underfollowed by U.S. investors. As a result, it’s possible to invest in high-quality international companies at very reasonable valuations. The benefits of international diversification can be more pronounced when investing in international small-cap stocks versus international large-cap stocks, as shown in Exhibit 6.
Many large companies domiciled outside the U.S. sell their products and services all over the world and are affected by global market conditions. Smaller companies are more dependent on local market conditions and offer investors more pure access to international markets.
Another advantage of international equity diversification is that it enables participation in whatever region is performing best at the time. Again, countries’ business cycles impact how their equity markets perform. Exhibit 7 shows the trailing 12-month performance differential between U.S. and non-U.S. equity indices. Relative performance of these markets moves in cycles, but the cycles vary in length and scale. Attempting to time when an equity market is going to outperform and for how long is typically a fruitless activity. Having an equity allocation with constant exposure to different global markets can help smoothen performance over the long term.
In closing, we believe the case for including international markets in equity allocations is strong and enduring. This conviction has led us to increase international equity exposure within our clients’ portfolios over the past five years, including distinct allocations to Japanese equities and small-cap international stocks. We have also expanded our asset management team and capabilities by hiring portfolio managers who have deep expertise in international markets and who share our belief that quality trumps domicile when selecting companies for our clients’ equity allocations.