Why international stocks still make sense

Setting the (world) stage

The level of global economic and geopolitical turmoil over the last few years has led to questions about what the right mix of international exposure is, or if you should hold any international stocks. In this article, we discuss the role of international exposure in your TIAA managed account, and how diversification into international investments can assist in meeting your investment goals. We'll also answer some of the common questions we've been asked.

A global perspective on diversification: the longer-term benefits

U.S. equities are naturally most exposed to the narrow economic forces of the U.S. market. In contrast, international stocks can provide exposure to a wider array of economic and market forces across regions and nations. Different markets and economies can and often do produce returns that vary from the U.S. market.

Over time, the diversification of returns provided by exposure to international investments can benefit investors. In any market environment, spreading investments across domestic and international opportunities can position your portfolio to benefit from the region or regions that are performing well at a particular time and help offset areas that may be underperforming.

Why does exposure to international stocks still make sense in today's economic environment?

"It's a good question," says Scott Abernethy, CFA, Regional Director, Private Asset Management at TIAA Trust, N.A. "The explanation starts with defining the term we're hearing a lot of lately in the press – deglobalization," continues Abernethy.

"In very general terms, "deglobalization" is the decoupling, or the reduction in interdependence and integration between the world's economies," Abernethy explains. "It's the opposite of a globalization trend since the end of WWII, a trend that has gathered steam in the last 30 years." A good example of deglobalization would be the push in the U.S. to utilize domestic oil and gas sources instead of depending on foreign nations for energy needs. Another would be companies sourcing light manufactured goods in the mid-west instead of overseas.

There are both pros and cons to deglobalization. As countries deglobalize they're building up their internal capabilities, and their businesses grow. They're becoming self-reliant and moving away from dependence on other countries. The upside is that it can, in the longer term, mean more diversification of producers, improved price competition, and greater economic independence from country to country. What that means is that when the U.S. economy is down, some international economies may be up, and vice versa. That diversification can be good for your portfolio over the long run.

The downside is that deglobalization can create uncertainties as investors adjust to a shift away from global reliance between nations' economies. This puts pressure on international stocks as companies cope with supply chain and labor issues, many exacerbated by the pandemic. The dramatic changes in the market, especially in the last two years, have created a misperception that deglobalization has already transpired. The reality is that such a significant transformation does not happen overnight, or even over a few years. It's a long-term process whose result will take a long period of time to play out, in the same way that globalization took many years.

"We also need to make sure we know what we mean when we say 'international'", says Abernethy. "There are developed international markets like Germany, England, and France. These markets represent 71% of non-U.S. stocks¹ and have advanced economies, developed infrastructure, and a higher standard of living," he continues. The other group of non-U.S. stocks comes from emerging markets, like China, India, or Brazil. Many emerging markets have less developed markets, less advanced economies and infrastructure, and a lower standard of living. They also tend to have higher volatility, a younger population, and rapid economic growth.

The case for investing in international stocks – challenges and opportunities

The short-term view for international – facing some headwinds

"In the short term, we maintain an exposure to international equities but recognize that both developed and emerging markets face headwinds in the near term," says Abernethy. There are a few reasons for that.

Challenges for the European Union (EU) energy complex. The Russia/Ukraine conflict has disrupted energy production. Any rationing of energy use, voluntary or involuntary, may have a negative impact on production, real activity, and growth for the region. This could cause shortages/rationing of energy in the coming winter season, further challenging Europe's economic outlook.

Continued U.S. dollar strength – A strong dollar is a mixed blessing. A strong dollar means it's cheaper for U.S. consumers to buy imported goods, and for U.S. tourists travelling abroad. But it also means that it's more expensive for foreign consumers and companies to buy our goods, and that hurts U.S. businesses. For the more economically sensitive E.U. and emerging markets, that means U.S. goods are more expensive. When investing internationally, U.S. dollars are exchanged into local currency — and vice versa when an investment is sold. These exchanges can affect the value of and, ultimately, the return on, an investment. Through mid-year in 2022, the strength in the dollar has been a sizeable headwind for the performance of non-U.S. equities.

Interest rates in Europe - The European Central Bank (ECB) has just begun its rate hike cycle, which may slow European economic growth even further. This is important because the European markets are, collectively, the size of the U.S. market, and represent a large portion of non-U.S. stocks.

Fading global consumer demand will weigh on Emerging Markets and China. As of mid-July 2022, inflation was hovering around 9% in the U.S. Inflation will remain elevated in Latin America this year – from a forecast high of almost 8% in Brazil to 4.5% in Peru. The same is true for Eastern Europe, where inflation is running at 22%. Emerging market Asia (Thailand, for example, where inflation is at 6.2%) will likely see more policy tightening during the second half of this year. As inflation has heated up in the U.S., demand has slowed for a lot of non-essentials, like vacations and large home appliances.²

"The pandemic has become an accelerant for deglobalization," notes Abernethy. "During the pandemic when China was shut down, semi-conductors were unavailable in the U.S. This made new cars harder to produce, driving new and used car prices up. This is a good example of the downside of globalization," says Abernethy. China is expected to rebound, but only moderately. China's "zero COVID" policy has delayed economic recovery there, extending supply chain concerns, even as much of the rest of the world reopens. The longer it takes for China to get back to normal, the longer it takes for rest of the world to recover.

On the surface, those factors seem to paint a challenging picture. However, there are opportunities for investing in international stocks, and many reasons why exposure to international stocks still makes sense as a long-term strategy for our clients. While investors are experiencing challenges today, the long-term view is important to bear in mind.

The long-term view for international – opportunities to continue to benefit from international exposure

Historically, the U.S. equity market has not always been the top performer. Figure 1 below illustrates the U.S. has only been the top performer four times since 1988. For perspective, that's the same as Switzerland, and less than Austria.

While U.S. stocks have outperformed most non-U.S. developed markets as a whole for the past 10-year period (7/1/2012–6/30/2022), it doesn't mean that has always been the case ─ or that it will continue in the future. For example, during the period 1/1/1970 - 7/21/2022, Hong Kong, Denmark, Sweden, the Netherlands, and Switzerland have all had a higher average return than the U.S. equity market.³ Despite the smaller size of these economies, the example helps illustrate the importance of diversification, as there is often a country other than the U.S. that is the top performer.

Don't I get enough international exposure with large U.S. multinationals?

"While U.S. Investors do get some foreign exposure from investing in U.S. multinationals, (generally defined as U.S.-based companies generating at least 25% of revenue outside the U.S.), in the sense that these companies profit from economic growth overseas, U.S. investors should hold non-U.S. stocks, for several reasons," says Abernethy.

U.S. multi-national companies tend to represent certain parts of global industry and not others. For example, by only owning U.S. multinationals investors will likely end up holding a lot of technology and healthcare firms. However, they'd be underrepresented in other important parts of the global economy, such as basic materials.

In addition, most U.S. multinationals fall in the Large Cap category, those companies with $10B or more in market capitalization. Our research has shown that the benefits of international diversification are greatest when investing in smaller companies, and that international small stocks helped to diversify equity portfolios of U.S. investors more than large stocks. U.S. multinationals provide little exposure to international equity from an investment return standpoint, even when a high percentage of revenue comes from foreign sales.

Investing outside U.S. markets: Putting risk in perspective, seeking opportunity

"Although the benefits of investing internationally are widely accepted, many U.S. investors are still hesitant to invest abroad, primarily because they believe it is much riskier to invest overseas," Abernethy notes. "It's important for U.S. investors to understand some of the primary global investment risks, like currency, political, interest rate, and liquidity. While individual country markets may be more volatile/risky than the U.S., historical data show that investing globally could result in similar volatility to the U.S., which might be surprising to many investors," he concludes.

For many investors, "maximum drawdown," or significant market downturn, is a more intuitive way to define risk over any given period. It's defined as maximum loss in a peak-to-trough decline before a new peak is attained.

Figure 2 below compares the maximum drawdowns for the U.S. and Global Market (1988–2021). Most of the time, the differences between maximum drawdowns are not large. The largest differences (>5%) were where the red arrows are, 1990 (~10%), 1992 (~6%), and 2008 (~6%). At all other times, the maximum drawdowns are similar. "When looked at in this historical context, the data suggests that the drop in non-U.S. stocks is not that much greater than U.S. stocks," Abernethy says.

What's the right mix of international exposure over the long term?

While there may be short-term fluctuations in the performance of international stocks, over the long term it is our view that it makes sense to maintain international exposure. One of the methods we employ is something called Modern Portfolio Theory (MPT). MPT suggests investing in the global market, with each asset class weighted to its market capitalization weight. The U.S. market is ~61% of the global market, so according to MPT a U.S. investor should have ~61% invested in U.S. and the remainder (~39%) in non-U.S. stocks.

"Every investor's needs are different," says Abernethy. "However, arriving at the right balance of international exposure over the longer term is informed by both rigorous process and historical experience," he says. Abernethy concludes, "It's our belief that asset allocation is one of the most important decisions that investors make."

As we can see in Figure 3 below, volatility decreases as non-U.S. stocks are added to the portfolio incrementally. Historically, portfolio risk is minimized when non-U.S. equity represents between 35% and 40% of total equity exposure, reflecting a potential optimal diversification point.

Another reason to own international stocks over the long term is that valuations are more attractive overseas. Our research shows that below-average valuations for international stocks today suggest above-average returns in the next 15-20 years. That means non-U.S. stocks are priced at a discount relative to their U.S. counterparts. Cheaper valuations now for these stocks suggest that they have the potential to deliver above-average returns in the long term. This has been influenced by the uncertain economic and political environment during the COVID-19 pandemic, where investors have paid a premium for the lower volatility and more stable, predictable returns offered by U.S. equities.

"In our assessment, an allocation in the 35% - 40% range provides the potential for increased diversification and improved risk-adjusted return," states Abernethy. "We do not believe even with the current market/geopolitical shocks that this will significantly change potential growth/allocations in the long term," says Abernethy.

How do you decide how much developed vs. emerging markets exposure you should have?

There are some compelling reasons to make allocations to Emerging Markets. For starters, they represent about 11% of global market capitalization. "We believe up to 11% of the overall equity allocation, depending on your strategy and risk tolerance, is appropriate. There has been a significant increase in the growth of emerging markets over the past 10 years," Abernethy says. Historically, emerging markets have delivered higher average returns, albeit with higher volatility, than those of developed markets. Data also shows that individual emerging markets are relatively uncorrelated across countries, so the risk of investing in all countries as a group (vs. Individual countries) is lower.

The bottom line?

Abernethy concludes, "Our fundamental approach is one of diversification. Regardless of where the markets go, your managed accounts portfolio is positioned to benefit in the long term. With a professionally managed account, you have the benefit of ongoing professional management, monitoring, and oversight through all market conditions."

Need to know more?

We've touched on the basics of investing in international stocks and some of the short and long-term issues and opportunities to be aware of. If you'd like to know more about how international investing factors into your managed portfolio, schedule time to speak with your Advisor or Portfolio Manager.