International Stocks: Is Now The Time?

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After years of underperformance compared to U.S. stocks, international stocks have sprung to life over the past 12 months. This is welcomed news for investors who've stayed the course with international allocations. And it may get even better!

Stellar Past Performance of Domestic Stocks

U.S. stocks (based on the Standard & Poor’s 500 index) have outpaced international stocks (based on the MSCI ACWI Ex-US index, an all-country world index of stocks from developing and emerging countries) in seven of the past 10 calendar years. From 2006 to 2016, the average return of domestic stocks was 7.51 percent per year. In that same decade international stocks returned only 1.35 percent per year. That doesn't inspire much confidence in international stocks, does it? The disparity is even greater if you narrow that down to the past five years. During that timespan, U.S. equities averaged 15.4 percent per year compared to 8.4 percent for international equities.

In recent years it has clearly paid off for American investors to indulge a home bias. But looking at the performance of domestic versus international stocks over the long term tells a different story. Historically, over the long term, international stocks have performed similar to U.S. stocks. So why have international markets taken such a beating during the past decade?

The answer begins with the 2008 global financial crisis. The U.S. was the first country to recover. You'd expect international market recovery to lag behind the U.S. in this situation. But international markets faced additional obstacles - poor economic and earnings growth, uncertain monetary policy, unstable political conditions - that hindered recovery.

Since the 2008 financial crisis, a variety of factors have worked in favor of the outperformance of U.S. stocks over international stocks, including a stable financial policy that spurred economic and earnings growth. Domestic stocks have enjoyed quite a run, but is the trend shifting in favor of international stocks? According to the fundamentals, the answer is yes!

Prime Position for International Stocks

We've already seen this disparity in returns begin to level out. As of May 31st of this year, the most recent 12 months have ever-so-slightly favored international equities. During that period the MSCI ACWI Ex-US index returned 18.2 percent compared to the S&P 500 index return of 17.5 percent. This slim outperformance from international markets coincides with additional factors that could boost the returns of international stocks.

One of these is monetary policy. The U.S. Federal Reserve raised its benchmark interest rate in December 2016 and again in March 2017. While interest rates are still relatively low and the U.S. monetary policy remains accommodative, these rate hikes indicate a tightening of monetary policy. At the same time, central banks in other countries aren't employing tightening strategies. They continue to maximize their efforts to improve economic growth. For example, the European Central Bank has given no indication it will budge from its extraordinarily accommodative zero-percent benchmark interest rate. The stage is set to boost economic growth and pave the way for equity gains.

Another factor is MSCI ACWI Ex-US valuations. Their price-to-earnings (P/E) metrics are still lower than those of the S&P 500. Currently, the ACWI has a P/E of 17.42, while the S&P 500 P/E is at 21.82. While there's no meaningful relationship between stock market valuations and short-term stock market performance, over the long haul a powerful relationship emerges. Lower stock market valuations have preceded periods of higher future stock market returns.

The Next Big Trend

An emerging trend within some international markets could provide a huge opportunity for investors. This trend is the globalization of the middle-class lifestyle. As the quality of living continues to improve in developing world countries, their citizens will begin consuming goods they previously wouldn't have been able to access. This will likely have huge implications for providers of goods and services of all types. Automobile and other consumer discretionary goods manufacturers stand to benefit as do providers of financial and medical services.

This trend could tip the balance in favor of international stocks and produce a huge opportunity for investors. It’s well worth tracking. After all, you wouldn't want to miss out on the potential windfall!

Summary

If investing for the long term is part of your financial strategy, you'll want to ensure that international stocks are part of your overall asset allocation. It's not too late to reposition your portfolio to take advantage of this shift toward the reemergence of higher-performing international stocks. If you aren't certain your portfolio is properly diversified, meet with a financial advisor to ensure your investments reflect your goals!

Anthony Harcourt is a Portfolio Manager with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at bedelfinancial.com or email Anthony.

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