Happy 4th of July!
This week, as we celebrate the birth of this country and all things USA, we’d like to spend a moment focusing on other parts of the world as well. Even “America’s favorite pastime” has taken to international adventures with the Yankees-Red Sox game at London Stadium, and today our women’s soccer team is playing England in the World Cup semi-finals. So while we are celebrating our own country, keep reading for what we at The Trust Company of Tennessee believe about our opportunities for the global investment world.
Amid the longest bull market in recent memory, with its primary beneficiary being the S&P 500, it is natural to question the rationale of investing in any other asset class. Bonds1 have returned about 3.8% annualized over the last ten years, and the S&P 500 has posted an annualized return of nearly 14% over the same period2. The international benchmark3 for global equities, which actually includes US stocks, has produced a 9.4% annualized return over the last ten years, underscoring the drag international stocks have had on performance.
So why do financial professionals continue to beat the drum for diversification? The answer is simple. Sometimes the S&P 500 outperforms all other asset classes, and sometimes it doesn’t. It is impossible to predict when these periods of outperformance will come and how long they will last. Even during long periods of outperformance, diversification can lower the volatility, providing for a smoother ride along the way.
With international investments in particular, investors get diversification in their portfolios against slowing growth at home, overvalued domestic equity prices, and business-specific policies that may have a negative impact on US equity prices, such as taxes. Exposure to developed markets abroad, like Germany, Israel, Spain, Australia, Japan, and others, allows investors to benefit from stable governments and robust security markets while reaping the benefit of a diversified portfolio.
Growth is the overarching argument for investing in emerging markets. In general, the nine countries that make up a majority of the emerging market investments are China, South Korea, Taiwan, India, Brazil, South Africa, Russia, Mexico, and Thailand. A handful of other countries in Asia and South America are included, and sometimes South Korea is left out of the category. These countries tend to have some diversity in their economies and plenty of investable opportunities for foreigners. And most of these countries are growing faster than the United States and are forecast to grow much faster in the years ahead4.
While the long-term outlook for domestic equities is good, there are certain trends in emerging markets that make them more attractive. Emerging markets have very favorable demographics, with a lot of young people to support their economies and growing middle classes. Some of the best periods of equity performance comes when more and more of a population is moving into the middle class, creating lots of demand for goods and services, and lifting sales growth for companies along with GDP growth5.
Another argument in favor of international equities today is that they have not gone up as much as domestic equities. Valuation6 of international stocks as a whole compared to the S&P 500 is lower. One could argue that given our legal system, stable currency, and relative political stability, the US should demand a premium, and valuation of domestic stock prices would be higher. That may be true, but even when you examine how international stocks have compared to domestic stocks historically, we are at a relatively low period on valuation. So, by most measures, international stocks are cheaper compared to domestic stocks. Following the old adage of, “buy low, sell high”, it’s an attractive time to be invested in international stocks.
Of course, there are different risks in international investments than US investments. Some countries may be more dependent on commodity prices, some countries may have more sensitivity to currency movements, some countries may have governments that aren’t as stable. While you can use passive index funds to get exposure to international markets, it’s helpful to have an active manager who is paying attention full-time to any risks or changes in these types of investments. Active managers can sift through each country to find the companies they think have the best chance of growing and generating returns for investors. Also, this is where diversification also helps a portfolio. Risks in international investments can be offset by other holdings in the portfolio.
At the Trust Company, we believe diversified portfolios are a great way to manage return and risk objectives for our clients. We use both passive and active managers in our equity and fixed income portfolios to benefit from low-cost index-based investments and high skilled managers who can be selective in areas where they have the best chance to outperform a passive index. If you would like to learn more about our investment philosophy and how we can help with your investment portfolios, please give us a call.
1 The Barclays US Aggregate Bond Total Return Index has gained an annualized return of 3.83% over the last ten years as of 5/31/2019.
2 The S&P 500’s annualized return over the last ten years ended 5/31/19 has been 13.95%.
3 The MSCI All Country World Index is made up of stocks from the following regions: 55% US, 12% emerging markets, 14% Europe ex-UK, 5% UK, 7% Japan, 4% Pacific, 3% Canada.
4 For example, China is expected to have GDP growth above 6% in 2019 and 2020. India is also expected to grow 6% to 7% in the next year.
5 GDP (Gross Domestic Product) growth is the main measure of economic growth of a country.
6 As measured by price-to-earnings (P/E) or price-to-book (P/B). These ratios measure how much investors are willing to pay today for $1 of earnings. For example, a P/E ratio of 15 indicates that investors are willing to pay 15 times a company’s earnings today, in expectation that future earnings will be higher. This is reflected in the stock price. If a company reports earnings per share of $3.00, and the stock is trading at $45, it has a P/E ratio of 15.