Recent headlines from overseas have been grim: Debt-wracked Greece is struggling to avoid economic collapse, while slowing growth and rampant speculation has triggered a plunge in China’s stock markets.
For many, the bad news will reinforce a perception that investing beyond our shores is to be avoided. The fact that the S&P 500 has beaten international stocks since bottom of the market in 2009 seems only to reinforce the argument for keeping one’s money home.
Annualized Stock Returns by Region
3/31/2009 to 06/30/15
S&P 500 20.2%
International Developed 13.3%
Emerging Markets 13.9%
Source: Crestwood Advisors, FactSet, MSCI and Standard and Poor’s
But long-term investors should try to look beyond day-to-day headlines, set aside their emotions, and dig into the data. And it makes sense even after five years of U.S. outperformance. Basically, there are two compelling reasons to own any investment: portfolio diversification and potential for returns. Investing in international stocks fulfills both of these criteria.
Let’s look at why.
Portfolio Diversification
Adding international stocks to a portfolio of all U.S. stocks creates diversification that can lower portfolio volatility (i.e. risk). As the chart below illustrates, as you increase your exposure to international stocks, the risk within that portfolio actually decreases. However, at a certain exposure point, the benefit recedes and even becomes a handicap. The optimal international exposure appears to be between 20%-40% of a stock portfolio.
Notes: Monthly returns since 1970 for the S&P 500 and MSCI EAFE index
Source: Crestwood Advisors, FactSet, MSCI and Standard and Poor’s
Bear in mind that the benefits of diversification depend on the strength of correlation between the asset classes in question. Lower-correlated assets trade less directionally with one another (i.e. when one rises the other falls) while higher correlated assets tend to trade more consistently in the same direction (i.e. both rise/fall at the same time). While the diversification benefits can be weaker over shorter periods of time, over longer periods, international and U.S. stocks have demonstrated sufficiently low correlation offering long-term investors worthwhile diversification benefits for their portfolios.
Return Potential
Despite recent underperformance, the chart below reveals that international stocks have enjoyed many, sometimes lengthy, periods of superior relative returns versus U.S. stocks.
Notes: Quarterly returns since 1990 for the S&P 500 and MSCI All Country World index
Source: Crestwood Advisors, FactSet, MSCI and Standard and Poor’s
It’s worth noting that international markets have outperformed the United States so far this year, even with the drag created by the Greek debt crisis. Whether the trend continues remains to be seen. But stimulative monetary and lending policies in Europe and Japan appear to be providing a tailwind for international corporations, even as U.S. businesses contend with tightening monetary policy and a strong dollar, which can hamper exports.
Stock Returns by Region
12/31/2014 to 06/30/15
S&P 500 1.2%
International Developed 4.3%
Emerging Markets 2.9%
Source: Crestwood Advisors, FactSet, MSCI and Standard and Poor’s
It’s true that since the Great Recession (2008-2009) earnings in Europe are depressed; they are still 16.6% below their peak in 2007, while S&P 500 earnings have recovered and are 24.7% above 2007 levels. But recently European earnings have started to trend upward (see chart below) and the European Central Bank’s program of quantitative easing has spurred higher bank lending and improved the region’s economic outlook. What’s more, valuations for European stocks, as well as their Japanese counterparts, are now more attractive than those for U.S. stocks.
Source:Crestwood
How Crestwood Is Investing
We are currently optimistic about international stocks based on attractive valuations and the improving economic outlook – despite the recent period of underperformance and current concerns over Greece’s default. Thus, since late last year, we have been adding to our developed markets international holdings. Additionally, our objective review of the data reinforces our belief that maintaining exposure to international stocks is an important part of an effectively diversified portfolio. However, because each client has unique circumstances and risk tolerances, international exposure will vary.