Through the first three quarters of 2017, the benefits of global diversification have paid off for patient and disciplined investors. Entering the year, concerns and doubt about the historical merit of maintaining exposure to international equity markets seemed to grow. These feelings were understandable with lingering challenges caused by recent events such as the continued uncertainty surrounding the impact of Brexit, constant threats of nuclear war from North Korea, and concerns about the effects on international economies of President Trump’s U.S.-focused agenda. In addition, investors who shunned international stock exposure following the Global Financial Crisis have been greatly rewarded. Since bottoming in March of 2009, U.S. stocks have more than tripled in value while broad-based international indices have “only” doubled. The lagging performance was reflective of their struggling economies which entered a double-dip recession in 2011 and inconsistent, often conflicting, monetary policies from the various foreign central banks.
The steady, yet unspectacular, growth of the U.S. economy carried over into an equity bull market that has begun to approach historical proportions and the ensuing investor behavior was all too reflective of previous patterns – investor assets rushed out of international stocks and into U.S.-based investments chasing this stronger performance. And with the slow-and-steady U.S. economic expansion now being supported by accelerating growth trends in corporate earnings, the up-beat sentiment was grounded in solid fundamentals. The drawback of these concurrent positive developments was that the prices of U.S. stocks began appearing a bit expensive based on traditional measures such as Price-to-Earnings (P/E) ratios. While it is true that P/E ratios are essentially useless at predicting near-term performance, the track record of forecasting returns over longer periods of time (7-10 years) has been much more reliable. With P/E ratios sitting at relatively high levels compared to historical averages, investors have appropriately dampened their expectations of returns from U.S. stocks in the years ahead.
But as is often the case, the divergent paths of U.S. and international markets over the past 7 years has seemingly created a timely opportunity for investors. The gap in P/E ratios between U.S. and international stocks began approaching levels not seen for nearly 15 years. And while U.S. stocks were expensive compared to their own historical averages, international stocks traded at a discount. Compounding these favorable conditions, international economies have finally started showing signs of improvement as foreign central banks learned from the aggressive monetary policies enacted earlier on by U.S. central bankers. The combination of attractive valuations and improving growth prospects has translated into 3 consecutive quarters of strong performance on both a nominal and relative basis for international stocks. Through the end of the 3rd quarter, international stocks have out-performed U.S. stocks in each quarter. And while U.S. stocks produced a solid return of about 14% through quarter-end, international stocks in developed economies were up almost 20% and stocks in emerging economies produced an astounding return of over 27%.
Investors who remained committed to international stock exposure were great beneficiaries of these trends and, in our opinion, should continue benefitting as these favorable conditions persist. While the long and steady economic expansion in the U.S. appears poised for continued growth, much of this optimism is already reflected in U.S. valuations. After struggling to find solid footing following the financial crisis, international economies finally seem ready to break out. With P/E ratios of international markets not yet reflecting this, we could be in the early stages of a shift in market performance leadership.
