The last U.S. recession ended in 2009. Since then, the U.S. equity market has experienced steady growth while international markets have been relatively anemic, returning on average 4.4% compared to the U.S. market’s 14.1%. However, the share of the global economy outside of the U.S. has significantly underperformed the U.S. market. The acceleration of this underperformance hit a new low in October of 2019.
Is this the bottom? In reviewing previous international bottoms, it appears the double bottom pattern between Jun 2018 and Oct 2019 mirrors what happened from June 1983 to Feb 1985 and from Feb 1999 and Nov 2000. Investors should be looking abroad for regions that are in earlier stages of expansion relative to the U.S. Having a meaningful allocation to international equities in their portfolios could provide an important opportunity for investors, providing diversification generating alpha and reducing portfolio risk.
Figure 17 illustrates the calendar year performance for three market segments and their historical three-, five- and 10-year averages vs. their current return for the same time frame. This chart illustrates how close the U.S. markets are to their historical average and how far international markets are from their mean returns. In 2018, we made a case for a reversion to the mean for international investing. The long-term U.S. market averages now exceed their historical rolling averages and international markets are far below their historical averages. After many consecutive years of underperforming, downtrodden foreign securities are still in an excellent position to start to revert to their historic means.
Fig 17. U.S. Equities vs. International Markets
Asset Class History - Rolling Performance Periods Since 1970
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow. Data as of 12/31/2019. |
Fig 18. Technical Strength of the International Market vs. U.S. Market
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow. Data as of 12/31/2019.
Figure 18 illustrates the alpha difference between the international market (average of investible country markets) vs the U.S. market. The last time the divergence was skewed toward the U.S. market (positive alpha) was in October 2000. What followed from November 2000 to October 2009 is that the S&P 500’s annual return averaged -.02% vs. the country average which was 13.3%.
That strong international environment was jump started
by the popping of the technology bubble, and the environment bottomed after the great financial crisis of 2008/2009. The cycle of domestic strength from November 2009 to October 2019 (new peak) was four years longer than other strong U.S. market cycles. Was the last peak in October of 2019 the beginning of a new international strength environment? Only time will tell if the cycle of U.S. strength vs. the world is coming to an end. What investors should understand is that once the transition has started, they should expect to be in this environment for several years (the average of the last two strong international cycles was over nine years).
Are we are starting to shift back to another strong international market? Long averages suggest that the international markets are still very far from their historic averages. Over the last five years, the universe of investible countries has on average generated a 4.5% return compared to the U.S. market’s 11.5%. The average five-year return of the U.S. market since 1974 is 11.0% while the international country average is 13.6%. This past year marked the end of another strong U.S. equity market environment—a cycle that lasted from November 2009 to October 2019 where the S&P 500 annual return has averaged 13.4% vs. the MSCI EAFE’s 5.6%. The U.S. market outperformed all 48 countries
(investable market outside the U.S.) during that period.
Fig 19. International Equities vs. U.S. Equities
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow. Data as of 12/31/2019.
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This outperformance of the benchmark for international equities relative to the U.S. highlights a missed opportunity for investors who utilize international benchmarks that are highly correlated to the U.S. equity market. Stocks of large U.S. companies with operations overseas are sometimes highly correlated to the performance of the international stock markets in developed countries, so these investments may be providing less diversification than investors believe. Among the 43 countries available during the last weak U.S. equity cycle, those countries’ average annual performance was 13.3%
(91% of them outperformed the S&P 500). During the same cycle, the MSCI EAFE was up 3.61% and 79% of the countries outperformed that international benchmark. This illustrates the importance of finding alpha away from the developed markets.
The value of a wider opportunity to invest overseas is evident
when considering that most international countries have a very low correlation to the U.S. equity market. Figure 20 measures the correlation of each of the 48 country markets against the S&P 500 and MSCI EAFE. This correlation grid confirms that over this period, many international markets were not as highly correlated to the U.S. Figure 20 overlays where 85% of the international assets are invested among ETFs and mutual funds as of 12/31/19 (277 out of 1701). Many international products are highly correlated to the broad international market, which is highly correlated to the U.S. market.
Fig 20. International Country Correlation to U.S. and International Markets — 5 Years
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow. Data as of 12/31/2019. There are 1152 international mutual funds (oldest share class) and ETFs for the universe.
If investors are not looking at the correlation of their international exposure to the U.S. market,
they may be narrowing their opportunity to potentially generate alpha and help manage volatility. Global allocation provides diversification benefits, which is one of the underpinnings of wealth management. In Figure 21, we add all the funds that outperformed the U.S. market over the last five years. Among the 38 funds that outperformed the S&P 500, 13 of them were represented among the green dots in Figure 20.
Over the last three years, only six countries outperformed the U.S. market, which averaged 16.4%. The primary international benchmark for most investors (the MSCI EAFE) was up 10.1% over the last three years. Among the 48 investible markets, 22 outperformed the MSCI EAFE and their average return was 13.3%. Among international funds, 87% of AUM is a high correlation (80% or higher) to the MSCI EAFE and 66% of AUM is a high correlation (80% or higher) to the S&P 500.
In Figure 21, we added all the funds (with five years of correlations) that outperformed the U.S. market over the last five years. The international fund average over the last five years was up 6.2% (out of a universe of 1,150). This was similar to the MSCI EAFE performance. During that same time frame, only 38 international funds beat the S&P 500—their average return was 13.7%.
The 38 funds had on average a low correlation to the S&P 500 (.75) and MSCI EAFE (.74). These funds also represented about 1.5% of the overall assets invested in international equity products. This indicates that a majority of the funds allocated to international markets did not benefit from these diverse instruments.
Determining when to invest in these countries can be difficult, which is why it’s important to find investment strategies that have discipline and exposure to foreign stocks or countries—these strategies potentially ensure that investors are not missing significant gains when markets overseas rally, or suffer significant losses when U.S. stocks decline.
U.S. stocks in 2019 were very strong, 31.5% in 2019 relative to other foreign markets. Several markets outperformed: Egypt, Greece, Ireland, Netherlands, New Zealand, Russia, Switzerland and Taiwan.
Fig 21. International Country Correlation
to U.S. and International Markets — 5 Years
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow. Data as of 12/31/2019. There are 1152 international mutual funds (oldest share class) and ETFs for the universe.
In 2019, the international benchmark was up 22.7% and ranked 19 among the 48 countries. Many of these countries (14) were in the developed market.
The long-term rally in U.S. stocks has benefited many investors. The performance of the U.S. market has also indirectly led to equity bias to a single country for many investors. This leaves these U.S. investors vulnerable when downturns occur in the U.S. and leaves them underexposed to equity rallies in other parts of the world.
Fig 22. Generating Returns from International Exposures
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow. Data as of 12/31/2019.
While there is still room for growth in the U.S. market, investors should understand that the overall strength of the U.S. market vs. the world may be changing. A majority of market capitalizations are outside the U.S., providing investors with opportunity to generate greater returns from their international exposure over the next few years. Having a sizable exposure to the international market in your portfolio, like many endowments do, can be sensible and opportunistic. Additionally, it can enhance diversification and potentially help reduce risk.
Constructing a portfolio to prepare for the unknown events of 2020 and beyond may require more than a static stock/bond blend
(60/40 portfolio). Investors may wish to consider diversifying their international exposure. Strategy diversification is often overlooked as an important part of diversification. Investors often fail to incorporate tactical and adaptive (alternative/absolute return) elements that have the ability to respond to changing markets.
Fig 23. International Asset Class Matrix
*As of 12/31/2019. Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow. Data as of 12/31/2019.
And of course, asset classes to consider for 2020 should include those often referred to as alternative assets. Most investors have very little exposure to international markets. Yale, on the other hand, is currently allocating 31% of its equity exposure to international equity market.
For 2020, investors may wish to add tactical (such as country rotation, yield focused) and adaptive such as active strategies that are tactical or global macro strategies to their traditional assets. When doing so, it is important to consider correlation in order to seek true diversification. The markets are always unknown; they go up and they go down. It
is important to use a strategy that matches the individual investor’s investment objective, risk tolerance and time horizon. Endowment strategies may not be suitable for all investors and no investment strategy is perfect or can guarantee positive returns in every environment. Being too defensive against a downturn can lead to missed opportunities in the way of upside potential. But taking on too much risk can lead to excessive losses and cause irrational reactions. The strategies discussed here are not without their own risks. Each one has defensive elements, but can also provide upside potential. It is not necessarily a matter of preparing for a black swan drawdown event, as the markets may ultimately provide positive returns for the year. But time and the law of averages are working against traditional asset classes,
so portfolios should be adapted to prepare for a less predictable outcome than we have seen in previous years.
Asset Class Proxy Disclosure:
Past performance does not guarantee future results. Categories display the returns of current funds in the Morningstar category during the time period shown, subject to survivorship and/or re-categorization. Index and strategy research returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and are not available for direct investment.
Asset class proxies (in order as shown above by figure): Figure 17: Int’l Country Markets (average of 48 investable countries- Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Malaysia, Mexico, Netherlands, New Zealand, Nigeria, Norway, Pakistan, Peru, Philippines, Poland, Portugal, Qatar, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, UAE, United Kingdom and Vietnam); Figure 18: Stocks (S&P 500 Index), Int’l Countries (see Fig 17 note above). Figure 19: US Market (S&P 500) and Int’l Countries (See Fig 17 note above); Figure 20 & 21: Country Mean Reversion (AI Research, AIMR Strategy), Country Rotation (AI Research DWCR Strategy), Int’l Country Average (48 countries: see Fig 17 note above), Emerging Market (MSCI EM); Frontier Market (MSCI Frontier Market). Figure 22: Country Mean Reversion (AI Research, AIMR Strategy), Country Rotation (AI Research DWCR Strategy), Int’l Country (48 countries: see figure 17), Emerging Market (MSCI EM); Frontier Market (MSCI Frontier Market). Figure 23: U.S. Equity (S&P 500), U.S. Bonds (BBgBarc U.S. Agg Bond), International Momentum (AI Research DWCR Strategy), Global Value (AI Research, AIMR Strategy), Global Macro (AI Research DWGM Strategy), Commodity (AI Research AECB Strategy), Sovereign Debt (HY) (AI Research CSSD Strategy), Morningstar Categories: World Allocation, World Bond, Global Real Estate, Diversified Emerging Mkts, Emerging Markets Bond, Diversified Int’l (Foreign Large Blend). |
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