Rebalancing International Equities: What to Know. What to Consider.

Given the lessons of market history, the question is not if international equities will outperform their U.S. cousins, it is when. Consistently rebalancing your portfolio is key.


Executive Summary

Diversified investors may be frustrated by the underperformance of their international equity returns relative to their domestic equity returns over recent years. This may have caused some diversified investors to minimize their rebalancing efforts, resulting in a significant U.S. equity overweight and international equity underweight.

  • Although U.S. equities have outperformed their international counterparts in recent years, history suggests we are closer to a reversal than to another long period of U.S. dominance.
  • As tempting as it may be to delay rebalancing, we believe it is vital to consistently rebalance to an investment portfolio’s original desired asset allocation.
  • There are potential rewards of rebalancing and potential risks of not rebalancing. A prudent investor understands both.

Why it May be Tempting to Delay Rebalancing

Walking away from superior performance can be difficult. Rebalancing requires discipline, a longer-term perspective, and an understanding of the potential rewards of rebalancing and the potential risks of not rebalancing.

U.S. vs. International Equity Returns
Growth of $10,000 Since Market Bottom in March 2009

As of September 30th, 2018. Past performance is no guarantee of future results.
Source: FactSet, MSCI, Standard and Poors.

At the portfolio level, a once diversified portfolio is now out of balance and may benefit from rebalancing.

A Refresher on Rebalancing

Over time, some assets in a portfolio may outperform others, creating an allocation that’s not balanced the way an investor originally intended. Rebalancing is the periodic discipline of buying and/or selling assets to maintain the desired level of allocation. The primary objectives are to potentially benefit from anticipated cyclical performance and control risk.

Why Now May be the Time to Increase Your International Equity Allocation

Cyclicality of Performance Between U.S. and International Equities

  • Until 2017, 2009 was the last year international equities outperformed U.S. equities. However, since 1975, the average cycle of U.S. and international equity out or underperformance is 7 years.
  • In the current cycle, based on rolling 5-year returns, U.S. equities have outperformed international equities for approximately 6 of the last 7 years. 2017 was the only exception.
  • It is difficult to predict when the current trend will reverse leading to international equity outperformance. But history suggests that after a reversal, international equities may outperform for several more years.

7 Years: The Average Cycle of U.S. and International Equity Out- or Underperformance
A 40+ year look at U.S. and international return cycles

Source: MSCI, Standard and Poor’s, FactSet as of September 30th, 2018.
The chart displays the difference in rolling 5-year annualized performance of the S&P 500 Index and MSCI World ex USA Index.
Past performance is no guarantee of future results.

In the Current Environment, Valuations for International and Emerging Markets Equities Are More Attractive than U.S. Equities

Valuation U.S. EAFE Emerging Markets
Shiller Price to Earnings (P/E)* 31.3x 19.7x 13.0x
Historical CAPE Perentile* 99th 67th 39th
Price/Book (P/B)** 3.4x 1.7x 1.6x
Historical P/B Percentile*** 86th 43rd 42nd

Source: Thomson Reuters, Robert Shiller, FactSet.
Cyclically adjusted price-to-earnings ratio (CAPE) is a valuation measure that is defined as price divided by the average of ten years or earnings, adjusted for inflation.
* MSCI EM Shiller and CAPE data as of 05/31/18. Data for S&P 500 Index and MSCI EAFE from 03/31/04-05/31/18.
** P/B data is as of 9/30/18.
*** Data for S&P 500 Index from 02/28/01-9/30/18, MSCI EAFE from 01/31/98-9/30/18, MSCI EM from 06/30/00-9/30/18.

  • Many investors believe that lower valuations are a contributor to equity outperformance.
  • As the table above illustrates, Emerging Markets and Foreign Developed (represented by the MSCI EAFE Index) equities are trading at lower valuations relative to U.S. stocks, which may provide more of an opportunity for foreign equities.
  • Not only are current U.S. valuations greater than foreign equities, but the U.S. CAPE and P/B valuations are expensive relative to U.S. history, as represented by the 99th percentile (CAPE) and 86th percentile (P/B) historical ranking.
  • Foreign Developed and Emerging Markets equity valuations are also attractive relative to their own history as represented by the 67th (CAPE) and 43rd (P/B) historical percentile ranking for the MSCI EAFE Index, and the 39th (CAPE) and 42nd (P/B) historical percentile ranking for the MSCI Emerging Markets (EM) Index.

Higher Dividend Yields for Foreign Equities May Attract Capital

  • With global interest rates near historic lows, investors may continue to search for income in a variety of asset classes that may include global equities.
  • As of September 30, 2018, the dividend yields for the MSCI EAFE Index (3.18%) and the MSCI EM Index (2.70%) are significantly higher than the yield of the S&P 500 Index (1.74%), which may attract more capital to foreign equities in the current low interest rate environment.
  • Furthermore, as of September 30, 2018 the yield spread of the MSCI EAFE minus the Euro 10yr Bond Yield (2.7%) is 4.02% greater than the yield spread of the S&P 500 Index minus the US 10yr Bond Yield (-1.31%).

Historical Spread of Stock Market Dividend Yield Minus the Local Government Bond 10yr Yield

As of September 30th, 2018. Past performance is no guarantee of future results.
Source: FactSet, MSCI, Standard and Poor’s.

Foreign Central Bank Policy May Remain Accommodative

  • Many foreign central banks, such as the European Central Bank (ECB), the Bank of Japan, and the Swiss National Bank, have signaled for ongoing accommodative monetary policies and negative target short-term interest rates. The U.S. Federal Reserve (the “Fed”), on the other hand, raised the target short-term interest rate in 2015, 2016, and during several meetings in 2017.
  • If foreign central banks maintain their extremely accommodative monetary policies while the Fed continues to raise the target short-term rate, investors may have an opportunity to benefit from this discrepancy. Put another way, given the foreign central banks’ encouragement for investors to invest in risk assets, foreign equities may be more desirable than U.S. equities.1

September 30, 2018 Yield (%)

Source: FactSet, MSCI, Standard and Poor’s. Past performance is no guarantee of future results.
*
Equity Index yields for U.S. and EMU are S&P 500 and MSCI EAFE Indexes, respectively.
1 Foreign equities may be more desirable, relative to U.S. equities, given the foreign central banks’ encouragement for investors to invest in risk assets relative to extremely low interest bearing securities.

Current Central Bank Interest Rate Policies

Source: Federal Reserve, Bank of Japan, ECB, Swiss National Bank, as of September 30th, 2018.

Diversified investors understand the potential benefits of allocating equity assets outside the U.S. to seek to enhance the risk/return profile of their investment portfolios. One thing we know for certain is this: The cyclicality, valuations, and economic fundamentals of the equity markets will continue to change.

Given the lesson of history, the question is not if international equities will outperform their U.S. cousins, it is when.

The answer may very well be “soon.” We believe the key is to consistently rebalance to the portfolio’s original desired asset allocation.

Diversification does not guarantee a profit or protect against a loss in declining markets.

Investments in international securities are subject to certain risks of overseas investing including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets.

Price/book (or P/B) ratio is calculated by dividing the market price of a company’s outstanding stock by its book value (total assets of a company less liabilities) and then adjusting for the number of shares outstanding. Stocks with negative book values are usually excluded from this calculation. Price/earnings (or P/E) ratio is a comparison of the company’s closing stock price and its trailing 12-month earnings per share.

Yield to Maturity (YTM) is the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield, but is expressed as an annual rate.

The MSCI All Country World ex-USA Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI All Country World ex-USA Index consists of 22 developed and 24 emerging market country indices.

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the U.S. market. With 617 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the U.S. MSCI All Country World Index.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of 24 emerging market country indices.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.  The MSCI EAFE Index consists of 21 developed market country indices.

Please go to msci.com for most current list of countries represented by the MSCI indices.

The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The S&P 500 Index is proprietary data of Standard & Poor’s, a division of McGraw-Hill Companies, Inc. All rights reserved.

Foreign Manager’s Purchasing Index definitions:
U.S.: A monthly index of U.S. manufacturing compiled by the Institute of Supply Management (ISM). Previously known as the National Association of Purchasing Management (NAPM) Index, the ISM Manufacturing Index is derived from the institute’s “Report on Business” survey of purchasing and supply executives across the nation.

Euro Zone: The Eurozone Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

United Kingdom: The United Kingdom purchasing managers’ index is a monthly survey compiled by financial information firm Markit and the Chartered Institute of Purchasing and Supply (CIPS) for the UK manufacturing, construction and services sectors.

Japan: The Nikkei Japan Manufacturing Purchasing Managers’ Index measures the performance of the manufacturing sector and is derived from a survey of 400 industrial companies.

China: The Caixin Manufacturing PMI Purchasing Managers’ Index measures the performance of the manufacturing sector and is derived from a survey of private 430 industrial companies.

The indices are unmanaged, are not available for investment and do not incur expenses.

AMG Distributors, Inc., a member of FINRA / SIPC.

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