Markets go up, and markets go down. The United States equity market has done both sharply over the past few quarters, dropping 17% from late September through Christmas Eve 2018, and then rebounding 23% from that holiday low through the end of April 2019. This round trip in equity prices serves as a timely reminder that volatility is a feature, not a bug, of financial markets.

Recent volatility notwithstanding, U.S. equities have compounded at an impressive pace over the past several years. As the nearby bar graph illustrates, over the past decade, the S&P 500 has returned a little over 15% annually. This 10-year period begins almost precisely with the nadir of the financial crisis, and therefore might be slightly misleading. Nevertheless, a dollar invested in the S&P 500 in April 2009 would be worth $4.12 today.

International equities have largely been left out of the party. Although absolute returns have been gratifying, both developed and emerging markets have lagged domestic equities over almost all of these time periods when measured in dollars. Developed markets trailed the U.S. by 6.8% (annualized) over the past 10 years, and emerging markets are 7.4% behind the U.S. The opportunity cost to investors has been high: A dollar invested internationally in April 2009 is worth $2.25 today, and the same investment in emerging markets would have yielded a return of only $2.13. Over the past 20 years, emerging markets have done better than the U.S., but this stands out as the sole period of superior non-U.S. performance captured in this historical analysis.

The dominance of U.S. markets over the past decade raises the question of what role non-U.S. equities play in a portfolio. In the pages that follow, we consider the case for including international and emerging markets in a well-balanced investment portfolio.

The Global Marketplace

In Act II of “As You Like It,” William Shakespeare’s melancholy character Jaques observes, “All the world’s a stage, and all the men and women merely players.” If all the world’s a stage, then all the world is a marketplace, too. The U.S. plays an important but shrinking role on the global stage as other economies – particularly those in emerging markets – expand at a faster pace. The U.S. accounted for 21% of global GDP in 2003 but is now down to 16%. Conversely, China and India were only 14% of global GDP in 2003 but as of last year generated 28% of global economic activity. Developed markets other than the U.S. have declined from 32% to 24% as a share of global GDP.

The primary driver of this shifting leadership is the growth of the Chinese and Indian economies. Indian GDP has compounded at 9.8% over this time period, from $2.6 trillion in 2003 to $10.5 trillion in 2018, and China has grown at 11.3%, rising from $5.1 trillion to $25.3 trillion of GDP. Indeed, adjusted for purchasing power,¹ China eclipsed the United States as the largest economy in the world as of 2014.

This analysis is a quantitative demonstration of what we all subjectively know. We live, work, play and spend in a global marketplace. You may have a Swiss watch on your wrist, a Japanese or German car parked in the driveway and a home full of Chinese-made electronics. Commerce yields little respect to international borders. Global companies compete for your consumer dollars, and they should compete for your investment dollars as well.

Globalization has arguably taken a step backward over the past few years as the Trump administration seeks to renegotiate trade agreements with China (in particular) by imposing tariffs on a broad swath of imports. Tariffs on Canadian and Mexican steel remain in place, awaiting congressional ratification of the U.S.-Mexico-Canada Agreement (USMCA), the replacement for NAFTA. And across the pond, the United Kingdom is still trying to figure out how to finalize its divorce from the European Union, with uncertain implications for trade.

Yet even in a political environment that seems to favor tighter borders and steeper tariffs, global trade continues to grow, topping $4 trillion for the first time last year and up $600 billion over the past two years. Over the past 40 years, global trade has grown at an annualized pace of 5.8%, or 6.1% if energy trade is excluded. The few contractions evident in the nearby chart are related to global economic slowdowns, the most obvious of which is 2009. Like King Canute’s vain attempt to stop the incoming tide by royal edict, modern-day politicians are powerless to reverse the rise of economic globalization.

To Every Thing There Is a Season

The sustained dominance of U.S. equities over the past decade can obscure the fact that the relative returns of asset classes is cyclical. This year’s darling can easily become next year’s dog, and often does. This cyclicality is abundantly evident in the fortunes of emerging markets. In four of the past 12 years, emerging markets topped the return league tables, and in another four years, the asset class brought up the rear. The proximity of great years to awful years highlights the volatility of the asset class, which should inform an investor’s exposure to emerging markets.

This heightened volatility is not nearly as prevalent in the returns of domestic stocks. Returns for the S&P 500 Index of large-capitalization stocks linger in the middle of the table from year to year – never the best, but never the worst. The waxing and waning appetite for risk is evident in the relative returns of short-term U.S. Treasuries. This cash-like asset class led the way in the 2008 financial bloodbath, returning 6.7% when just about every other asset class posted double-digit negative returns. More recently, short-duration Treasuries also led the way in 2018 by preserving value throughout the fourth-quarter sell-off.

Although it is human nature to think in calendar years, such an analysis can hide prolonged trends. The nearby graphs illustrate the returns of international and emerging equity markets relative to the U.S. market on a rolling one- and three-year basis. International developed markets have enjoyed prolonged stretches of superior trailing performance to U.S. markets, most notably from 2003 through 2009. Yet the market both giveth and taketh away. The three-year trailing returns of the MSCI EAFE Index of developed international stocks has lagged the S&P 500 since 2011.

The relative returns of emerging markets show similar cyclicality, particularly on a three-year rolling comparison (there is less history for emerging markets, so the timeframes of the two graphs are not directly comparable). Good performance in 2017 helps boost the rolling three-year returns, but, as the graph shows, emerging markets have generally struggled to keep up with the U.S. over the past decade.

This analysis illustrates not only the cyclicality of relative returns, but also their range. Developed markets have posted three-year trailing returns as high as 20% compared to the S&P 500, as recently as the middle of the last decade, a period in which the trailing three-year returns of emerging markets were regularly close to 40% better than domestic stocks.

Diversity Initiatives

This cyclicality of returns implies that exposure to more than one asset class can benefit a portfolio over time, as long as the cycles of different investments are not perfectly correlated. Harry Markowitz won the Nobel Prize in economics in 1990 for proving that an investor could diversify between asset classes to minimize the volatility of her portfolio for any desired level of return, or conversely, to maximize return for any given level of volatility. Although our own investment philosophy does not concur with Markowitz that price volatility is the best definition of risk, we do agree that appropriate diversification and disciplined rebalancing are essential tools in constructing a well-balanced portfolio.

History bears this out. The correlation between international and domestic equity returns since the creation of the MSCI Index in 1970 has been 0.63. Emerging markets show a correlation of 0.44 to domestic stocks since the MSCI Emerging Index was formed in 1988.² Any correlation less than 1.0 indicates that diversification offers a benefit. As the nearby graphs reveal, however, correlations are as volatile as prices. In each graph, the red line shows the correlation of trailing one-year returns, and the dotted blue line is the average of the whole period. Over the past year, international developed markets have had a 0.90 correlation with U.S. equities, and emerging markets have had a correlation of 0.74.

These graphs also imply, however, that the benefits of international diversification have waned over time. From the 1970s to the 1990s, MSCI EAFE had a negative correlation with the S&P 500 about 16% of the time, but correlations have been positive since the turn of the 21st century. A similar observation holds for emerging markets; correlations were negative 20% of the time in 1990s but only 3% of the time since then. Portfolios still benefit from the lack of tight correlation between markets, but diversification does not provide as much benefit as it used to.

This article has already alluded to some of the reasons for this change. Globalization implies that economies and markets are more tightly linked, and more reliant on each other, than ever before. Local booms and busts influence what happens elsewhere. The advent of the internet and email throughout the 1990s meant that developments in one part of the world were more readily communicated and reflected in prices throughout global markets. No longer do analysts and investors have to wait for a corporate filing to arrive by mail. And as markets globalized, regulations harmonized. Accounting standards, communication requirements and laws regarding nonpublic information are more consistent across borders than they used to be.

Why not avoid the international question altogether and obtain the benefit of foreign demand through the ownership of U.S. multinationals? In an environment of waning diversification benefits, can an investor have the best of both worlds by staying at home and investing in domestic companies that derive sales and earnings from international markets?

The answer is a qualified yes. About 44% of the revenues of the S&P 500 come from outside the United States, but this exposure is almost always hedged, thereby mitigating much of the diversification benefit.³ Companies with foreign sales often locate production facilities outside the United States as well so that the currency exposure of costs and revenues are more evenly matched. In addition to this operational hedging, companies usually financially hedge foreign revenues so that swings in currency values do not translate into volatile earnings when reported in dollars. And a search for international exposure through U.S. multinationals might lead to unintentional sector weights. Most of the foreign revenues in the S&P 500 come from three sectors: energy, technology and materials.

Multinationals certainly play a role in equity portfolios. Companies often find better growth opportunities for their products and services outside the United States. But as U.S. companies with hedged foreign exposure and dollar-based accounting, they offer little to no diversification benefit compared to other domestic equities. Despite the waning benefit that true international and emerging diversification offers to a portfolio, the benefit is still greater than that provided by U.S. multinationals.

Top Dollar

Part of the appeal of investing in equities outside the United States is that it provides exposure to currencies other than the U.S. dollar. We fundamentally believe that investing is ultimately an exercise in balance sheet management – that assets should be arrayed to match current and future liabilities, however an investor defines those obligations. By extension, the currency exposure of one’s liabilities should also be largely matched by the currency of one’s assets, but here, too, some diversification away from the dollar may be warranted.

Currencies move in cycles just as asset classes do, and the cycles can be just as prolonged. The nearby graph illustrates the past 20 years of the U.S. dollar against a trade-weighted basket of global currencies. The cycles are obvious. Since touching a low in summer 2011, the dollar has appreciated 33% against global currencies,⁴ largely because the United States was the first global economy to emerge from the financial crisis and the first central bank to begin raising interest rates and lifting the extraordinarily easy monetary policy required by the recession. This is not to say that U.S. interest rates are high, or that monetary policy is tight, just that compared to other major currencies the rate of return on short-term dollar bonds is more attractive. The dollar has strengthened by almost 8% since the beginning of 2018 alone, a period in which the Federal Reserve raised interest rates four times while the rest of the developed world has struggled to find economic footing.

Dollar strength is equivalent to foreign currency weakness, which poses a stiff headwind to the returns of asset classes denominated in other currencies when those returns are translated into dollars. For example, if a Japanese stock rises 10%, but the dollar strengthens 12% against the yen, the net return to a dollar-based investor is -2%. The currency movement negates the stock price appreciation and then some.

Yet currency movement can be a tailwind as much as a headwind. From 2002 through 2008, the dollar declined 27% against the trade-weighted basket, thereby boosting the returns of international stocks in dollar terms. The adjacent bar graph shows the returns of domestic, international and emerging equities in these two different periods, all expressed in U.S. dollar terms. As the dollar strengthened since 2011, developed markets (as measured by the MSCI EAFE) lagged the U.S. by an annualized 8%, while emerging markets (as measured by the MSCI EM) lagged by 11% annually. However, from 2002 to 2008, the opposite was true: A weakening dollar magnified international returns. MSCI EAFE outpaced the S&P 500 by 9% annually, while emerging markets posted annualized returns that were 19% better than domestic equities.

Currency cycles are historically long. Without projecting the end to the current period of dollar appreciation, we nevertheless note that this strengthening cycle is approaching nine years in duration. Should growth outside the United States accelerate, recent dollar strength would likely reverse, adding another argument to the case for international or emerging equities. An opinion on currency should not be the sole driver of an allocation to foreign equities, but investors should recognize that their portfolios can benefit as much as suffer from currency movements.

Value Judgment

Our investment philosophy is built on the attempt to exploit the difference between price and value. Fundamental analysis leads to an estimate of intrinsic value, and discipline leads to the acquisition of that value only when the price drops to an appropriate discount. Not only does this approach create a margin of safety that results from not paying full price for an asset, but it also creates a second engine of return. Growth in intrinsic value can be complemented by a narrowing price discount to that value. The good news is that value investing is a consistent and repeatable way to preserve and grow wealth. The bad news is that it is a horrible timing tool. Securities that are cheap can get cheaper, while expensive things can get more expensive. As John Maynard Keynes wryly noted, “The market can stay irrational longer than you can stay solvent.”

We find a value approach to be best applied at the security specific level rather than for broad asset classes, and relative valuations between markets or asset classes does not determine our asset allocation policies. Nevertheless, a comparison of values across asset classes and time can indicate how broad the selection set of attractive securities may be in one asset class or another.

International and emerging stocks appear cheap relative to the U.S. on traditional valuation measures such as price-to-earnings (PE) and price-to-sales (PS) ratios. As of the end of April, MSCI EAFE stood at 16.0x earnings and 1.2x sales, vs. 19.3x earnings and 2.2x sales for the domestic S&P 500. Historically, MSCI EAFE has been valued on par with the PE multiple of the U.S. market. Emerging markets are even cheaper, at a current valuation of 13.6x earnings and 1.2x sales. This represents a 29% discount to the valuation of domestic stocks on the basis of PE.

These comparisons are intriguing but suffer from the fact that accounting standards still differ from market to market, and the definition of “earnings” or “sales” might not be consistent across the board. In particular, the way in which local accounting regulations allow companies to recognize revenues can vary widely. Another approach to valuation – one favored by Warren Buffett, in fact – is to compare the size of an equity market to the size of an economy. Comparing market capitalization to GDP ratios tells the same relative story as more traditional valuation measures.

At 155% of GDP as of the end of April, the U.S. market is more highly valued on this measure than at any point in the past 15 years. International developed markets are almost exactly the size of aggregate GDP, ranging between 80% and 100% of GDP for the past decade. Emerging markets have remained right around 25% of GDP over the same time period. There is nothing magic or prescriptive about these numbers – there is no “right” level.

The apparent discount of emerging markets is a reflection of less developed financial markets, where much corporate wealth is owned either by the government or private families instead of the public. Nevertheless, the widening valuation gap of the United States to the rest of the world indicates that there are increasing value opportunities abroad. These valuation gaps do not guarantee that international assets will outperform domestic assets, but they do indicate that the search for value outside the United States may be more fruitful than it has been in quite some time.

When All Is Said and Done

Asset allocation is an idiosyncratic exercise, based on the needs and risk tolerance of an individual investor. No single element of the analysis in this commentary should sway an investor to increase her allocation to international or emerging equity markets. Taken together, however, these observations argue that non-U.S. assets play an important strategic role in the pursuit of wealth preservation and growth. They offer a broader selection set than domestic equities alone, a dose of diversification and a hedge against the possibility of dollar weakness. Furthermore, although a poor indicator of timing, the valuations of international assets argue that the long cycle of domestic outperformance is due to reverse at some point. Investing is an exercise in probability, not certainty. And the probabilities of better international returns are increasing.