Why International Diversification Matters Today

Given the breadth and diversity of the U.S. economy and market, it’s understandable that many U.S. investors feel comfortable keeping their money within U.S. borders. Indeed, over the past six years, U.S. investors have been rewarded for staying close to home.

Since the start of this bull market in March 2009, one of the longest in history, a 60/40 split of U.S. stocks and bonds would have been hard to beat. The S&P 500 has gained roughly 200% during this time period, while U.S. bonds have been surprisingly resilient.

However, while the tendency to invest close to home is understandable, it may not be optimal. Case in point: A big U.S. equity overweight has been less successful year-to-date, given the recent pullback in U.S. equities and particularly strong performance from Europe and Japan. While three months of relative performance shouldn’t change anyone’s long-term asset allocation, recent events are a useful reminder that U.S. outperformance isn’t pre-ordained and that it’s important to consider having exposure to international stocks. In fact, as I write in my new Market Perspectives paper, “Innocents Abroad: The Case for International Diversification,” there are three reasons why international diversification matters now more than ever for U.S. investors.

Relative valuations.

A willingness to pay up for U.S. equities has resulted in several years of steady multiple expansion. While the current premium on U.S. stocks makes some sense in the context of low inflation and low rates, valuations look stretched relative to stocks in the rest of the world. This is particularly true based on the price-to-book (P/B) measure. Currently the P/B on the S&P 500 Index is roughly 75% higher than for the MSCI ACWI-ex U.S. Index. This is the highest premium since the market bottom in 2003. Longer-term metrics, such as cyclically adjusted price-to-earnings, or CAPE, ratios, are even more troubling, suggesting that U.S. stocks are likely to produce, at best, average to below-average returns over the next five years. The U.S. may have the best fundamentals, but U.S. equities have rarely posted stellar returns from today’s valuation levels, as I note in my Market Perspectives paper.

U.S.’s declining share of world GDP.

While the U.S. is still arguably the world’s most dominant economy, its relative share of the global economy is shrinking. Thirty years ago the United States accounted for roughly one-third of global output. Today the number is closer to 20%. Depending on the exact methodology, China is now the world’s largest economy or soon will be. While China’s rate of growth is slowing, China along with India, Indonesia and many other emerging markets may continue to outgrow the United States and other industrialized countries for the foreseeable future. This suggests that owning a predominately U.S. portfolio underweights the potential dominant and fastest growing portion of the global economy.

The basic tenets of portfolio construction.

Finally, owning a portfolio solely focused on the United States may lead to sub-optimal risk-adjusted returns. In other words, investors may be taking on risk that could otherwise be managed with diversification. This is a particularly important point today as stock correlations have fallen to their pre-crisis level, suggesting a greater benefit to diversification. To be sure, diversification isn’t a magic elixir, and it may not protect against market risk or loss of principal. The biggest caveat is that it’s least likely to work when most needed, i.e. during a crisis. Instead, the benefits are derived, almost imperceptibly, over a multi-year time frame. But given the state of the U.S. market and economy, while international diversification may be a sensible idea for most U.S. investors, its benefits are even more likely to accrue in the coming years.

Source: April 2015 Market Perspective

(c) Blackrock Investment Management



© BlackRock

Read more commentaries by BlackRock