In a dynamic geopolitical landscape, an allocation to international developed-market equities can benefit portfolios over the long term.
August 3, 2023
By Sean Killin
Over the past 10 years, U.S. equities have significantly outperformed their international developed market peers. Since 2013, the S&P 500 has generated annualised returns of 13.6 percent through July 2023, compared to 6.2 percent for the MSCI EAFE Index, a proxy for international stocks outside North America (EAFE stands for “Europe, Australasia, and the Far East”).
In our view, this wide performance gap materialised for a number of reasons, including:
As persistent outperformance has led investors to increasingly favour U.S. stocks, this trend has also been reflected in a shift in equity valuations over the past decade.
The price-to-earnings (P/E) multiple (a measure of what investors are willing to pay for a stock based on its trailing 12-month earnings) of the MSCI USA Index averaged 20.6x over the past 10 years compared to 16.9x in the decade prior, suggesting that investors have become more willing to pay a relative premium for stronger U.S. corporate profitability and growth prospects.
On the flip side, the average P/E ratio of the MSCI EAFE Index, in which Europe and Japan account for over 80 percent of constituent stocks, fell to 16.7x over the past decade from 21.0x in the decade prior. A nearly stagnant Japanese economy over the past decade and a multiyear debt crisis affecting the eurozone in the early 2010s were notable factors that undermined investor confidence in international developed stock markets.
Bar chart showing the average price-to-earnings ratios for the MSCI USA Index and the MSCI EAFE Index for three periods. For 2002 to 2012, the averages are U.S.: 16.9x, EAFE: 21.0x. For 2013 to 2023, the averages are U.S.: 20.6x, EAFE: 16.7x; For 1996 to present, the averages are U.S.: 20.2x, EAFE: 21.8x.
Source – RBC Wealth Management, Bloomberg; monthly data through 7/31/23
While history shows that regional equity leadership cycles tend to be lengthy, it also shows that leadership does rotate.
There have been several prolonged episodes of strong international developed-market equity outperformance over the past 50 years. The previous outperformance cycle for international markets started in the aftermath of the dotcom bubble in the early 2000s, a backdrop characterised by extreme market concentration and elevated valuations for the U.S. market.
The present period of U.S. outperformance has been much longer and more pronounced than any other since 1970. While there is always a degree of uncertainty when it comes to timing market trends, we think the lesson from history that market leadership tends to alternate in multiyear periods over the long term is likely to hold true in the future.
At a time when the U.S. equity market has become quite top-heavy, with fewer than 10 stocks representing an outsized share of S&P 500 returns, we think international markets can provide compelling opportunities to broaden sector and company exposures in portfolios at relatively less demanding valuations.
Line chart showing periods of cumulative outperformance of the MSCI USA Index vs. the MSCI EAFE Index, dating back to 1970. It shows that there are periods where the U.S. market outperforms EAFE and roughly equivalent periods where the EAFE market outperforms the U.S. The U.S. market has outperformed the EAFE since late 2007.
With ongoing geopolitical tensions leading to more fragmented trade relations, the shift away from globalisation may also create opportunities in international equity markets.
Given the lack of clarity on how the world economy could be transformed under a new trade paradigm, companies in Europe and Japan can serve as useful ways to position for a wider range of potential economic outcomes in an era where protectionist policies such as onshoring, friend-shoring and trade barriers are likely to become increasingly common.
Meanwhile, we think currency headwinds should soften for international equities.
A persistently strong U.S. dollar has meaningfully curtailed returns for USD-denominated investments. Since 2013, the MSCI EAFE Currency Index – in which the weight of each currency is equal to the weight of the issuing country in the MSCI EAFE Index – has depreciated by almost 23 percent through July 2023, representing an annualised drag of 2.4 percent on performance in U.S. dollar terms.
According to RBC Global Asset Management’s fair value model, the U.S. trade-weighted dollar remains overvalued by more than 20 percent based on purchasing power parity. The current valuation suggests the U.S. dollar could enter a multiyear weakening cycle to work off this overvaluation, which would likely help improve currency-adjusted returns for international equities in the years ahead.
Although U.S. equities have handily outpaced their EAFE peers over the past decade, we believe diversified portfolios should continue to maintain a strategic allocation to international equity markets.
While market shifts are difficult to time, history informs us that equity market leadership tends to ebb and flow between different regions over the long run.
Most importantly, the opportunity set in international markets can provide several benefits, including diversifying sources of risk and returns, an income stream we see as attractive (the MSCI EAFE Index carries a dividend yield of 3.4 percent compared to 1.5 percent for the S&P 500 Index), a more balanced industry mix and sector composition, and differentiated exposure to broader geopolitical trends.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. Deposits made with Royal Bank of Canada (Channel Islands) Limited in Jersey are not covered by the UK Financial Services Compensation Scheme. Royal Bank of Canada (Channel Islands) Limited is a participant in the Jersey Bank Depositors Compensation Scheme. The Scheme offers protection for ‘eligible deposits’ up to £50,000 per individual claimant, subject to certain limitations. The maximum total amount of compensation is capped at £100,000,000 in any 5 year period. Full details of the Scheme and banking groups covered are available on the Government of Jersey’s website www.gov.je/dcs or on request.