The Case for International Stocks

The S&P 500 Index has outperformed the MSCI EAFE Index (a benchmark of large- and mid-cap stocks in developed regions of Europe, Asia and Japan) by nearly 8% through the end of June, and this performance trend has continued so far into the Third Quarter.  In fact, it has been almost three years since developed international stocks, as measured by the MSCI EAFE Index, have outperformed the S&P 500 over a one-year time period (see chart below).  Therefore, it is appropriate to question the role international stocks play in a diversified portfolio.  However, we believe it would be a mistake to avoid investing in international markets at this point in time.

 

Source: Y Charts, Data as of 7/31/2016; SPY is ticker symbol for SPDR S&P 500 ETF, EFA is ticker for iShares MSCI EAFE ETF

 

Given this performance disparity between the U.S. and the rest of the world, a variety of relative value opportunities exist. While we expect the U.S. economy to grow at a higher pace than other developed economies for the remainder of the year, those economies will receive the added benefit of continued monetary stimulus from central banks.  Similar to the Federal Reserve’s Quantitative Easing program that ended in 2014, the European Central Bank (ECB) and Bank of Japan have programs in place and have recently increased the amount of stimulus into their economies.  Although political factors, such as Britain pulling out of the European Union, may weigh on equity returns relative to the U.S. in the short term, longer term returns should be supported by accommodative monetary policies.

Valuations for international stocks are undervalued when compared to the S&P 500. Currently, the MSCI EAFE Index has a price-to-earnings ratio (P/E) of 15.8x versus 19.9x on the S&P 500 Index (source: Y Charts as of 8/12/16).  In fact, according to a recent report from Charles Schwab, returns on global stocks have never been negative over the ten years that followed valuations similar to where they are today.  The report analyzed earnings and return data going back to 1969, and the current valuation level falls in a historical range of annualized returns of 5-15% over the following ten years (source: Charles Schwab, Factset data as of 7/10/16).  Therefore, as the rate of economic growth in Europe and Japan improves due to central bank intervention, we could see an uptick in developed equity market returns as they recoup some of the performance disparity with U.S. equity markets.

We are optimistic that continued strength in the U.S. labor market will drive consumer spending and economic growth in the second half of 2016, which will support positive equity returns both here in the U.S. and abroad.  Furthermore, accommodative monetary policy by foreign central banks may foster global economic growth and support developed market stocks.  Consequently, we have maintained our allocation to international stocks and have rebalanced into a broadly diversified ETF that provides exposure to markets across Europe, Asia and Japan.