U.S. equities have outpaced international equities since 2011, with stocks providing returns well into the double digits.
Within the international equity segment, developed international equities and emerging markets equities have both provided disappointing returns relative to their U.S. counterparts. Returns from developed international equities were in positive territory, but lagged far behind U.S. equities. Emerging markets equities trailed the pack, ending 2016 not far from the starting point in 2011.
In addition to the disappointing performance cycle for international equities, markets are thought to be more synchronized, eroding the diversification benefits promised in academic studies and experienced in prior market cycles. Consequently, some investors are considering abandoning their international investments in favor of a U.S.-focused investment approach.
[See: The 10 Best Dividend Stocks of 2016.]
Despite recent challenges for international equities, there are four compelling reasons to include international stocks as a meaningful component of a comprehensive investment portfolio.
International equities still offer diversification benefits. Over multi-decade periods, portfolios with international exposure ranging from 20 percent to 50 percent that were annually rebalanced to target weight offered similar returns and lower volatility than U.S. equities.
Although the long-term evidence strongly supports proponents of diversification case, the internet and globalization of trade has made the world a “flatter” place, while advances in computing power make it possible to analyze information far more rapidly. Consequently, markets appear far more synchronized than was the case before the year 2000.
Correlations between international and domestic stocks peaked during the global financial crisis and its aftermath, but have returned to more moderate levels in recent years. Correlations are now above the low levels of the pre-internet era but far below the levels reached at the peak of the financial crisis. With correlations at more moderate levels, international equities are likely to positively contribute to risk-adjusted returns.
The U.S. is a minority of the global economy and a portfolio without international stocks excludes many of the world’s best companies. The U.S. represents only about one-quarter of global GDP, while emerging markets represent more than one-third of global GDP. China is the leading contributor to global growth and the dominant consumer of industrial commodities. The U.S. also only represents slightly more than half of global stock market capitalization. Companies from other developed countries such as Japan, the U.K., Canada and the eurozone represent more than one-third of global stock market capitalization and emerging markets such as China, India, Brazil and Korea represent more than 10 percent.
At a company level, until relatively recently U.S. companies dominated lists of the largest and “best” companies in the world. Today, many of the most successful companies in the world are located outside the U.S. Industry leaders include non-U.S. companies such as automakers BMW and Toyota Motor Corp. (ticker: TM), technology companies Alibaba Group Holding ( BABA), Baidu ( BIDU) and Samsung Electronics Co., consumer companies Unilever ( UL) and Nestle, and retailers H&M and Zara.
Ignoring companies domiciled outside the U.S. means avoiding investing in some of the leading companies in the world.
[See: 10 of the Worst Performing Stocks of 2016.]
Leadership among asset classes and regions of the world rotates in unpredictable ways. Investors commonly weigh recent performance more heavily, while underestimating more distant performance. Investors often buy recent winners while selling recent losers, a behavioral tendency that is difficult even for professional investors to overcome. However, rotation of market leadership is a common phenomenon and shifts in leadership are notoriously challenging to predict.
The 2000s are widely described as a “lost decade for stocks,” which was true for investors who exclusively invested in U.S. large company stocks. Often forgotten is that investors in the 2000s who owned international stocks and small company stocks thrived by having a diversified portfolio that was less reliant on U.S. large company stocks.
The transition from 2008 to 2009 is another dramatic example of how rotation in leadership is hard to predict. Emerging markets equities was the worst-performing asset class in 2008, but was the best-performing asset class in 2009 as fundamentals and sentiment rebounded from the lows of the global financial crisis. Rotation in leadership is extremely hard to anticipate, but it seems likely that international stocks will again have their day in the sun.
Emerging markets equities offer higher potential economic growth and superior demographics to the U.S. Emerging markets are expected to offer nearly two-thirds of global economic growth through 2020, with population growth and the rise of the middle class helping emerging markets grow more rapidly than the aging developed world.
Emerging markets consumption is expected to represent approximately half of global consumption, with China a visible example of the importance of the emerging markets consumer. Chinese consumers accounted for about one-quarter of iPhone sales and 40 percent of worldwide vehicle sales by General Motors Co. ( GM) and Volkswagen in 2015.
Developed international markets offer lower potential growth than emerging markets, but have improving economic momentum, lower valuations than the U.S. and profit margins that have room to rise. Developed international stocks have lagged, particularly in Europe, because of political uncertainty regarding Brexit and various key elections scheduled for 2017. Although political developments in Europe are a significant near-term concern, positive news on the political front could be a catalyst for a rebound in European stocks.
Despite recent challenges, international equities should be a core asset class within investor portfolios. International stocks may reduce risk in an unpredictable world, while offering the potential to participate in worldwide growth and enhance returns.
[See: Chinese ETFs: 9 Ways to Play the Middle Kingdom.]
Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as believe, estimate, anticipate, may, will, should and expect). Although TFC Financial Management believes that the beliefs and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such beliefs and expectations will prove to be correct. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. The author’s clients may or may not hold the securities discussed in their portfolios. The author makes no representations that any of the securities discussed have been or will be profitable.
More from U.S. News
The 7 Best Bank Stocks to Buy for 2017
The Best Energy Stocks to Buy for 2017
7 of the Best Stocks to Buy for 2017
4 Reasons Investors Shouldn’t Abandon Global Equities originally appeared on usnews.com
