Stocks in China, Europe, and Japan, have recently been outperforming their US peers. We’ve seen similar short-term outperformance from non-US stocks before. Will this shift last longer than prior ones? To find out, let’s examine the factors we believe are contributing to non-US stock outperformance. But first, let’s look at how performance has been the last few years, and when it most recently started to change.
US has bested non-US for years
US stocks have been the best performing market for years. To measure this, we can look at an ETF that tracks the total US stock market, ITOT, versus an ETF that tracks the global stock market but excludes US stocks, ACWX. From 2010-2021, US stocks rose 431%! Over the same period, non-US stocks rose just 87%.
The 2010s saw major outperformance for US stocks. This has created a recency bias that US stocks are the best country to invest in. Consider the effect that the lagging non-US stocks had on a diversified portfolio… if during the 2010s an investor were 70% invested in the US stock market, and 30% invested in non-US stocks, they earned a cumulative return of 331%. That’s 100% less in returns than had they only owned US stocks and ignored international ones all together.
However, in 2022 this trend started to reverse. US stocks fell 19.50% last year as measured by ITOT compared to a 16% fall for non-US stocks via ACWX.
The shift in performance began in the fourth quarter, when non-US stocks started a strong rally. Since November 1st, 2022 through January 12th, 2023, non-US stocks are up 18.60% compared to just 3.15% for US stocks:
What explains the shift?
The main factor causing this shift in performance is the impact of rapidly rising interest rates. When interest rates rise, the cost of borrowing goes up. This most affects companies that are borrowing today to finance the growth of tomorrow (think technology stocks). If the payouts these companies are offering are only offered in the future, then that future value is highly dependent on the current interest rate.
In a low interest rate environment, investors can justify waiting around for that future payoff. But in a high interest rate environment, where you have safe, savings-like alternatives for your money, that future payoff becomes less valuable. J.R. Whalen and Hannah Miao of the Wall Street Journal touched on this in a recent Q & A for readers:
What does this have to do with US stocks and non US stocks? Well, US stock indexes are heavily weighted towards technology stocks, whereas non-US stocks are not. Take a look at the index composition of ITOT vs ACWX.
ITOT has a 24.60% weighting towards tech and is overall less diversified than ACWX.
ACWX has a 21% weighting to financial stocks and only an 11% weighting to tech stocks. In addition it has 7 sectors that make up at least 8% of the fund compared to just 5 for ITOT.
Simply put, non-US stock indexes are more diversified than the US stock market and less reliant on the performance of one asset class. To be sure, the concentration in tech stocks is the main reason US stocks outperformed so immensely in the 2010s. But the 2010s were marked by a generationally low interest rate environment that we’re unlikely to return to anytime soon.
Does the shift have staying power?
We expect this performance shift to have staying power because of where the Fed is likely to keep interest rates. For one, US interest rate policy is already higher than the rest of the world. Secondly, the market expects it to stay that way through the rest of the year.
The graph shown compares current interest rate policy among the worlds four largest central banks: The Fed, the European Central bank (ECB), the Bank of England (BOE), and the Bank of Japan (BOJ). Note that the Fed is the only central bank with a current interest rate above 4%.
The dotted lines show the market’s current projections for the path of interest rate policy. The market currently projects that the Fed will maintain the highest interest rate of the four main central banks through all of 2023.
In addition, when comparing the Fed to the ECB, the market doesn’t expect their policy to converge until 2024. This all represents a solid 1-2 year window where interest rate policy looks more favorable outside of the US than in it.
Another reason the shift in favor of non-US stocks could last? These shifts have had staying power on their own. Since 1971, there’s been four major outperformance stretches:
- Non-US stocks outperforming in the mid 1980s
- US stocks outperforming in the 1990s
- Non-US stocks outperforming in the 2000s
- US stocks outperforming in the 2010s
Lastly, when looking at valuation metrics such as price to earnings, non-US stocks are cheaper than their US counterparts. Of course, they were also cheaper than US stocks during the 2010s and it didn’t matter: US stocks still did better. However, valuation metrics may have been distorted by the low interest rate environment of the 2010s.
Thus, in the current higher interest rate environment, investors may be paying more attention to them again. On that basis, non-US stocks have rarely looked this cheap compared to their US peers, nor provided such higher dividend payouts.
The bottom line
US stocks outperformed non-US stocks on a large scale from 2010-2021. But in a sign that trends may be reversing, 2022 saw non-US stocks fall less than US stocks. This shift in favor of non-US stocks accelerated in the fourth quarter of last year; non-US stocks are 15% higher than US stocks since November 1st, 2022.
We expect that this trend can continue on the back of interest rate dynamics that favor non-US stocks. When the trend has reversed in the past, it has usually had some staying power. And from a valuation perspective, non-US stocks look like a better bargain in the market.
We recommend double checking your allocations to ensure that you are not ignoring non-US stock indexes in your portfolio. This is especially important in 401(k)’s where investors tend to implement a home bias to their investing.
We typically allocate 25-35% of our equity portfolios to non-US stocks. The ACWX ETF we referenced in this article is an excellent index fund that will give you access to the entire non-US stock market. So is VEU from Vanguard.
When selecting non-US stock ETFs, make sure they are indeed NON-US! VT, a popular ETF from Vanguard that tracks the “total stock market” has a 63% allocation to US listed stocks. We recommend using a website like VettaFi if you are screening for particular ETFs.
