Around two months ago, I wrote a blog post titled "The Case for International Equities". Since then, investing in foreign markets has become something of a consensus view. The investment flows demonstrate this fairly clearly as there were over $20 billion in inflows to international equity ETFs in May. Some may look at that figure and worry that this indicates a trade that is becoming overcrowded. While this is a concern, it is important to recognize that year-to-date inflows don't yet replace the outflows from international developed and emerging markets that occurred over past years, and other measures of investor positioning support the idea that investors remain generally underexposed to foreign markets. Still, it is helpful to review the thesis for international equity exposure and consider the potential catalysts that could warrant a change in positioning.
When I wrote my piece two months ago, I identified three reasons for favoring exposure to international equity markets: better relative valuations, earnings momentum, and the potential for diversification:
With respect to valuation, while international markets have outperformed the U.S. market recently, the run-up hasn't been nearly enough to eliminate the valuation gap between the domestic market and its foreign counterparts. Normally, the cycle of relative valuation between the U.S. and international markets takes many years to play out. So, while it is possible that valuations normalize quickly due to rapid outperformance by foreign stocks, I'd suspect that valuation concerns will not be an immediate cause for repositioning.
The Citi Economic Surprise Indices show that economic activity outside of the U.S. is surprising to the upside. Many countries are exhibiting strong earnings growth backed up by positive economic data. At the same time, this situation bears watching. There are many geo-political events that could alter the generally constructive global economic trajectory, but predicting these occurrences and extrapolating the likely impact on different equity markets requires a great deal of guesswork. On the other hand, the Chinese economy - and the policy makers that control it - is a more constant and predictable source of concern given the substantial amount of global growth tied to that market. As Chinese policymakers seek to de-lever their economy, the recent rise in short-term rates and potential policy missteps could have a negative effect on economic activity. The reverberations from a 'hard landing' in China would be felt globally, but Asia and Europe are likely more vulnerable to a slowdown there than U.S. companies . While this certainly doesn't alter the case for international equity exposure, it does serve as a reminder of the risk present in this asset category.
Two months ago, I pointed out that correlations between the S&P 500 and developed or emerging market indices had fallen substantially - indicating that there were meaningful diversification benefits to be gained by investing abroad. These correlations have risen slightly over the last two months but are still well below 10 year averages. There are two important factors that support continued divergence between the equity markets of individual countries: (1) the end of concerted central bank actions which made the selection of individual countries or regions less impactful; (2) the bifurcation of political leaders into populist/protectionist versus globalist branches which makes uniform participation in the global economy less likely. Irrespective of these dynamics, the correlations between U.S. and international equities should be monitored. If they rise to the point at which there is little benefit to diversification, then holding large allocations of domestic and foreign equity holdings will increase portfolio risk, and repositioning may be appropriate.
A breakdown in the valuation, earnings momentum, or diversification arguments above could warrant a reassessment of portfolio allocations to international equities. Regardless, foreign equities are an important asset category that has a place in many investor portfolios. The extent and nature of international equity positioning is dependent upon a number of factors including those touched upon above. If you have questions about investing internationally, you can contact me at andrew@lpastrategic.com.