Strategic investing beyond North America

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:

• Faster economic expansion and corporate earnings growth in the U.S. relative to Japan and Europe;
• The sector composition of the U.S. market, which gives greater weight to Tech and technology-related sectors that have experienced secular growth; and
• The general strength of the U.S. dollar against the euro and the yen.

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.

Trading places

Average price-to-earnings ratio

But U.S. stocks don’t always outperform

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.

Leadership rotation

Cumulative outperformance of MSCI USA and MSCI EAFE indexes

Geopolitics and the U.S. dollar

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.

A strategic case for overseas markets

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.

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