Stocks outside of the United States have shown some signs of strength recently. For example, in the fourth quarter of 2020, the Morningstar Global Markets ex-US Index returned 17.4%, compared to a 14.2% return for the Morningstar US Market Index. This quarter was a rare glimmer of hope amid an unusually long slump in performance. Over the past 10 years, annualized returns on international stocks have lagged their domestic peers by an average of more than 7 percentage points per year.
On the bright side of this long and painful performance slump, while few markets are considered cheap, markets outside the US offer relatively more attractive valuations.
As the novel coronavirus pandemic affects economies, businesses, industries and people on a global scale, most major international markets lost at least 30% of their value during the COVID-19-driven bear market in early 2020. Asia (including Japan) was the only major regional market to lose less than 30%.
Since then, global markets have recovered strongly. Most major markets have recouped the losses suffered and are back to their pre-crisis highs.
But some markets have yet to fully recover. The Morningstar UK Index was just above its pre-crisis level in mid-April 2021, while emerging markets in Europe and Latin America are still below previous highs.
This recent underperformance continues a longer-term trend. As shown in the chart below, international equities have underperformed domestic benchmarks in each rolling five-year period since the reporting period ended in March 2011. It’s not uncommon for US and non-US stocks to experience longer-term win and loss cycles. but regression to the mean is a powerful force. After several years of performance trends, the winners and losers eventually reverse their positions.
International equities have lagged behind for a variety of reasons. In general, market benchmarks outside of the US are relatively poor in all of the characteristics that have led the market until recently: growth, momentum, and technology. About 27% of the Morningstar Global Markets ex-US Index consists of growth stocks, compared to a 34% weighting for the US market benchmark. Similarly, the ex-US index has just a 12% weighting in tech stocks — about half of the US index.
An unfavorable currency environment was another negative factor. The dollar’s general appreciation over the past 10 years has weighed on returns for investors holding assets denominated in other currencies.
The assessment case
On the positive side, the long dry spell for international equities makes valuations more attractive. As shown in the chart below, traditional valuation metrics such as price/earnings, price/book, and price/sales are all significantly lower for non-US stocks when compared to the domestic market. Japan, some parts of Europe and the UK are looking particularly cheap on traditional valuation metrics.
Admittedly, some of this reflects weaker fundamentals for non-US equities. On average, non-US stocks have lower net margins, profitability metrics, and historical earnings growth rates compared to their US counterparts. On average, stocks included in the Morningstar Global Markets ex-US Index have returned 8.5% on invested capital over the trailing 12 months, compared to 12.6% for stocks in the US market benchmark. This partly reflects differences in sector exposure; As mentioned above, benchmarks for foreign stocks have a heavier weight in economically sensitive sectors such as materials and industrials. Companies in these sectors have not generated profits to the same extent as companies in the technology sector, but should enjoy stronger growth trends as the global economy improves.
Non-US stocks are also looking more attractive (if not exactly cheap) according to Morningstar’s fair value estimates. We estimate a company’s fair value by looking at the present value of all the cash flows that we expect the company to generate in the future. Because it is a measure of long-term intrinsic value, the fair value estimate takes into account differences in growth and cash generation growth rates over time. The average non-US stock currently trades at a 7% premium to estimated fair value, compared to an 18% premium for stocks in the US market. While most major regional markets are currently trading above fair value, UK stocks are trading at a slight discount, while Latin American stocks are trading on average around 12% below estimated fair value.
What it means for your portfolio
It’s important to note that international stocks are still not considered bargains in absolute terms. It’s also not clear whether international equities will offer the same diversification value as in the past. As detailed in our recent portfolio diversification study, correlations between most global markets have increased over the past few decades. Correlation coefficients between US and non-US markets have historically been as low as 0.10 but have risen to around 0.90 over the past 20 years. Cross-correlations between international markets also tend to be higher.
However, over longer periods of time, international investments have not always moved in step with the US market and have nonetheless brought diversification benefits. Currency exposure is another important aspect of international diversification. Now that the US dollar is showing signs of weakness, international diversification could become increasingly important.
How much to allocate to international equities? Purists would advocate owning a basket, with the size of each asset class reflecting its current market value. With the US accounting for only about 58% of global market capitalization as of March 31, 2021, this would argue for holding up to 42% of a portfolio’s equity exposure in non-US stocks, or about 25% of total assets for a portfolio with one 60/40 stock/bond split.
Even investors who are not satisfied with so much commitment should still be careful not to put all their eggs in the US market basket. Despite its strength over the past 10 years, the US may not dominate global markets forever, so it is prudent to keep some equity exposure in other markets. The lower prices for non-US stocks are another argument in their favor.
Disclosure: Morningstar, Inc. licenses indices to financial institutions as tracking indices for investable products, such as exchange traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution primarily based on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representation as to the advisability of investing in an investable product that tracks a Morningstar Index.