A REVIEW OF U.S. AND INTERNATIONAL MARKETS
June 22, 2022
Since U.S. stocks have outperformed international stocks for more than a decade, as shown in the table and charts below, clients often ask for our insight on the benefits of investing in international markets. Despite U.S. stock outperformance, international markets have an important role to play as part of a diversified portfolio.
Aside from showing that the total U.S. stock market experienced a strong 10+ year return relative to international markets, the data also illustrates a few other points. For one, in this recent period of stress, the U.S. market is down 20%+ year-to-date as of 6/16/22 (a decline of 20% or more from the prior peak is often defined as a bear market). While returns are still negative across all markets, international stocks have held up slightly better, despite suffering more severe disruptions due to COVID-191 and being geographically closer (and more exposed) to the Russia-Ukraine War.
By taking a broader look at history, we can also see that U.S. and international markets tend to trade leadership as illustrated in the chart above, and that there have been extended periods of outperformance for non-U.S. markets. We believe it is reasonable that this could happen again. The table below, a 20-year summary from our Fourth Quarter 2020 Market Commentary, illustrates that international exposure has protected us from lost decades in the U.S., like the 2000s, while contributing to strong returns over multiple decades.
Looking under the hood at different markets highlights reasons why the U.S. and international markets complement each other and why there can be extended periods of relative outperformance. Over the past 10+ years, technology companies have done well amid a low interest rate environment and other factors. When analyzing the composition of the U.S. market, we recognize that technology is the biggest sector while it is a less significant sector in international markets, which helps explain the past decade of outperformance. Conversely, these sector compositions can also explain why international markets (with greater exposure to energy, commodities, materials, etc.) have held up a bit better recently, and why they tend to do better than the U.S. during periods of inflation, or when the dollar is weakening, thus boosting international returns in past inflationary environments.2
While reviewing past drivers of market returns is important, we also must keep an eye toward the future and analyze what could drive future returns. In the table below, there are a few interesting aspects. For one, the U.S. only makes up about 4% of the world population. There isn’t a significant expectation that population growth in the U.S. will be as strong as in foreign countries,3 so growing our gross domestic product (GDP) may depend on getting foreigners to buy our products. However, we would expect them to prefer buying local products when possible, boosting international market returns. From a nominal GDP perspective, we have the largest economy in the world at about 24%, but that is shrinking as China and other economies modernize. Despite these potential imbalances, the size of the U.S. stock market still stands at roughly 60% of the world market.
Even though stock market valuations aren’t useful from a market timing perspective, they should hold some importance over the long term.4 Looking at data from J.P. Morgan in the graphic below, we can see that relative to historical price-to-earnings (P/E) ratios, the U.S. market looks slightly elevated on a forward P/E ratio basis, while most international markets look inexpensive. This is important because over the long term, history shows that being able to pay less for an asset can lead to higher future returns.
Putting absolute market returns aside, despite being perceived as riskier, international investing can help reduce volatility over the long run as illustrated by the Vanguard chart below. This shows that while any market can have high volatility in isolation, building a diversified global market portfolio and being able to rebalance across different regions can lead to lower volatility than just having a U.S. stock market portfolio.
