INNOCENTS ABROAD: The Case for International Diversification APRIL 2015 MARKET PERSPECTIVES

Transcription

1 INNOCENTS ABROAD: The Case for International Diversification APRIL 2015 MARKET PERSPECTIVES

2 executive summary Over the past six years, U.S. investors have been rewarded for staying close to home. U.S. equities have entered the seventh year of the bull market, one of the longest in history, and bond yields have remained contained thanks to massive central bank intervention, restrained growth and low inflation. A traditional 60/40 blend of U.S. stocks and bonds has performed well relative to most other asset allocations. However, with bond yields still near record lows and U.S. equity valuations stretched, this may not be the case going forward. Three arguments support the need for more international diversification, particularly in equities: RUSS KOESTERICH Managing Director, BlackRock Chief Investment Strategist Relative valuations. U.S. equities trade at a significant premium to the rest of the world. Longer term metrics, such as cyclically adjusted P/E ratios, suggest that U.S. stocks are likely to produce, at best, average to below-average returns over the next five years. In contrast, valuations are considerably lower in international markets, including developing countries. U.S. declining share of world GDP. While the United States is still arguably the world s most dynamic economy, its relative share of the global economy is shrinking. Depending on the exact methodology, China is now the world s largest economy or soon will be. Owning a predominately U.S. portfolio underweights the dominant and fastest-growing portion of the global economy. The basic tenets of portfolio construction. Finally, best practices in portfolio construction suggest that owning a portfolio solely focused on the United States may lead to suboptimal risk-adjusted returns. In other words, investors may be taking on risk that could otherwise be diversified away. This is a particularly important point today as stock correlations have fallen to their pre-crisis level, suggesting a greater benefit to diversification. [2] INNOCENTS ABROAD: THE CASE FOR INTERNATIONAL DIVERSIFICATION

3 Simplicity and sexiness, that s what people want. Diane von Furstenberg While few would consider any portfolio to be sexy, the appeal of simplicity applies as much to investing as to any other endeavor. Investors have gotten themselves in trouble on more than one occasion embracing questionable, overly complicated financial products. In the spirit of greater simplicity, some would argue that a basic 60/40 mix of domestic stocks and bonds should suffice for most investors. Market returns in recent years would support this approach. Since the start of the bull market in March 2009, a 60/40 split of U.S. stocks and bonds would have been hard to beat. Over this time period, the S&P 500 has gained approximately 200%. Adding to the returns, not only have equities done phenomenally well but bonds have been surprisingly resilient. Despite the improvement in the domestic economy, U.S. 10-year Treasury yields are actually below where they were at the lows in 2008; collapsing credit spreads have meant a rally in corporate bonds as well. Given the success of this approach, why change? For starters, the recent pullback in U.S. equities coupled with particularly strong performance from Europe and Japan means that a big U.S. equity overweight has been less successful year-to-date. For the first time in several years, U.S. stocks are lagging and investors are shifting money, at least temporarily, out of U.S. equities and into international markets (see Figure 1). A combination of factors are driving this shift away from the United States: lower valuations outside of the United States, more accomodative monetary policy in Europe and Japan, improving economic performance in Europe and the headwind of a strong dollar on U.S. earnings growth. While three months of good relative performance should not change anyone s long-term asset allocation, recent events are a useful reminder that U.S. outperformance is not preordained. FIGURE 1: ASSET PERFORMANCE YEAR-TO-DATE Performance in calendar year-to-date percent* China Shanghai A MSCI Europe Equities Japan Topix MSCI Asia ex Japan Dollar Index MSCI EM U.S. U.K. FTSE 100 Italian BTP MSCI Emerging Markets Latin America Nasdaq Composite MSCI Developed Equities JPM EMBI Emerging Debt German Bund Brent Crude Oil U.S. 10-year Treasury S&P 500 ML Global High Yield Gold Yen ML Global Investment Grade CRB Commodities Index Copper GSCI Soft Commodities * Total return in local currency except currencies, gold and copper which are spot returns. Government bonds are 10-year benchmark issues Source: Thomson Reuters Datastream, BlackRock Investment Institute, 04/13/15. BLACKROCK [3]

4 FIGURE 2: HISTORICAL NORM Current Valuation vs. One Year Ago PERCENTILE RANKING FIXED INCOME 100 EXPENSIVE 75 AVERAGE Source: Thomson Reuters Datastream, OECDBlackRock CHEAPInvestment Institute 02/01/15 EQUITIES 0 German Bund U.K. Gilt Japanese GB U.S. Treasury U.S. TIPS Euro High Yield U.S. High Yield Euro Credit U.K. non-gilts U.S. Credit EM $ Debt Developed U.S. Germany Canada France Australia Spain Italy U.K. Japan Emerging South Africa India Mexico Taiwan Brazil Korea China Russia Developed Emerging Frontier Asia ex-japan Europe ex-u.k. Asia Europe Latin America 2014 Sources: BlackRock Investment Institute and Thomson Reuters. Data as of 03/31/15. Notes: Percentile ranks show valuations of assets versus their historical ranges. Example: If an asset is in the 75th percentile, this means it trades at a valuation equal to or greater than 75% of its history. Valuation percentiles are based on an aggregation of standard valuation measures versus their long-term history. Government bonds are 10-year benchmark issues. Credit series are based on Barclays indexes and the spread over government bonds. Treasury Inflation-Protected Securities (TIPS) are represented by nominal U.S. 10-year Treasuries minus inflation expectations. Equity valuations are based on MSCI indexes and are an average of percentile ranks versus available history of earnings yield, trend real earnings, dividend yield, price-to-book, price-to-cash flow and 12-month forward earnings yield. Historical ranges extend back anywhere from 1969 (developed equities) to 2004 (EM $ debt). THE MOST EXPENSIVE HOUSE ON THE BLOCK Over the past five years, one of the most repeated refrains used to defend a strong U.S. equity bias was that the United States was the best house on a bad block. In retrospect, this was completely true. The U.S. economy outgrew the rest of the developed world and still enjoyed the massive tailwind of unconventional monetary stimulus. The United States has also been less prone to deflation than Europe or Japan. Finally, relative to the rest of the world absent a government shutdown or two the United States has enjoyed a period of relative political stability, although some might better describe it as stasis. At the very least, nobody was worried about the demise of the dollar. A willingness to pay up for U.S. equities has resulted in several years of steady multiple expansion. As a result, U.S. large-cap stocks now trade at nearly 19x trailing earnings, roughly a 15% premium to the 60-year average. Even looking at the more recent past, the trailing P/E ratio for U.S. large caps is roughly a third higher than it was three years ago. 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 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 Higher U.S. valuations are also evident when comparing an aggregate of U.S. value metrics against those of other countries (see Figure 2). The average U.S. value metric is in the 75th percentile versus its own history. Most of Europe, ex-germany, is closer to the 50th percentile, Japan the 40th, while emerging markets are even cheaper. Longer term valuation metrics, most notably the cyclically adjusted price-to-earnings or CAPE ratio, are even more troubling. As we discussed in our February Market Perspectives, Highway to the Danger Zone, the CAPE on U.S. equities is approximately 27, versus a historical average of roughly 16. The current reading is well into the upper quintile of historical observations. This should worry longterm investors. Historically, similar levels have been associated with below-average returns over the subsequent five years. By comparison, CAPE ratios are much lower in other developed markets. [4] INNOCENTS ABROAD: THE CASE FOR INTERNATIONAL DIVERSIFICATION

5 THE CHINA SYNDROME Outside of valuations, there is another argument for broader international exposure: The United States, while still the dominant economy, accounts for a shrinking share of global output. Thirty years ago, the United States accounted for roughly one-third of global output. Today, the number is closer to 20% (see Figure 3). While China s rate of growth is slowing, China along with India, Indonesia and many other emerging markets will continue to outgrow the United States and other industrialized countries for the foreseeable future. This suggests that the U.S. share of relative GDP should continue to decline. Some will argue that investors can simply get their international exposure from large U.S. companies that sell abroad. While it is true that international sales represent a growing portion of revenue for U.S. companies, even for large-cap companies in the S&P 500 foreign revenue still only accounts for approximately 35% of the total. In aggregate, the companies in an all-u.s. portfolio still derive the overwhelming majority of their sales from U.S. customers. Investors who remain concentrated in the United States will be lacking exposure to the majority a growing one of the rest of the world. HOME ALONE Beyond valuation and the relative economic position of the United States, there is a more basic reason to consider adding international equities to even a conservative portfolio. While an overweight to the United States has benefited portfolios over the recent past, over the long term investors should consider the potential benefits of diversification and better riskadjusted returns that meaningful exposure to international equity markets can offer. FIGURE 3: U.S. RELATIVE SHARE WORLD GDP 1985 to Present PERCENT Source: Bloomberg, as of 12/31/13. FIGURE 4: COUNTRY MARKET EQUITY CORRELATION Average of Individual Countries with MSCI World Index CORRELATION Source: Thomson Reuters Datastream, MSCI, BlackRock Investment Institute, 04/10/15. A structural underweight or even the total exclusion of markets outside of one s home country is a common phenomenon, so common in fact that it has a name: home country bias. And in fairness to investors, a U.S. home country bias is probably much less dangerous than for investors in other markets. The United States is one of the best diversified economies and markets in the world. For example, today the largest sector in the S&P 500 is once again technology, with a 20% weight; the largest company is Apple, with a 4% weight. In contrast, in many markets, even developed markets, sector and company concentration is much higher. In Switzerland, just four stocks Novartis, Nestle, Roche and UBS represent more than 60% of the market. BLACKROCK [5]

6 Given the breadth and diversity of the U.S. economy and market, it is understandable that many investors feel comfortable keeping their money within U.S. borders. But while the tendency is understandable, it is still not optimal. International markets do offer diversification, in the process lowering the volatility of the overall portfolio. Of course, there are never guarantees with investing and diversification may not protect against market risk or prevent losses. ALL TOGETHER NOW Indeed, while few object to diversification in principle, many investors argue that it doesn t work when most needed: during a crisis. It is true that during the financial crisis about the only two asset classes that provided any real hedge were safe haven bonds, including Treasuries, and gold. Virtually all other risky assets moved in lockstep. Even in the immediate aftermath of the crisis, correlations remained unusually high as investors fixated on macro events the European debt crisis, the U.S. fiscal cliff, Greece that transcended asset classes and geographies. However, a crisis is the exception that proves the rule. While frustrating, the recent tendency toward higher correlations during periods of stress is completely consistent with history. For example, in the prelude to the Asian crisis in 1997, the U.S. equity market had a relatively low correlation, around 0.32, with non-u.s. stocks. That correlation jumped by more than 50% as the world focused on the turmoil in Asia. A similar phenomenon occurred a year later with the Russian default in Prior to that event, the correlation between U.S. and non-u.s. equities was As the crisis hit, correlations once again rose, hitting 0.75, a 25% increase. In other words, correlations will invariably rise during a crisis. Investors, who normally have different time horizons and strategies, all suddenly focus exclusively on the here and now. As everyone s focus narrows to a single event or issue, risky assets all behave in a similar fashion. Fortunately, these periods do not last. Recently, correlations have been falling as economies diverge and company fundamentals begin to reassert themselves. At the peak in 2011, the average correlation of individual countries was as high as 0.80 (see Figure 4). At this level, the benefits of international diversification are more muted. Regardless of the country in which they are domiciled, stocks are mostly moving together when correlations are this high. However, over the past three years, correlations have been dropping. Intercountry correlations recently hit a post-crisis low of around While they have bounced back somewhat since then, this reversion to the mean suggests that the benefits to international diversification should be greater than they have been during most of the post-crisis environment. What exactly are those benefits? The argument for international diversification rests on modern portfolio theory and the premise that combining assets with low, or ideally negative, correlation produces better risk-adjusted returns. While the steady move toward a more integrated global economy suggests that equity market correlations are unlikely to be negative, in many instances they are low enough to offer diversification relative to an all-u.s. portfolio (see Figure 5). For example, while the correlation between U.S. large-cap and small-cap indexes is nearly 0.90 (1 represents perfect correlation, 0 no correlation, and -1 a perfect inverse relationship), the correlation drops to 0.60 for Japanese equities and emerging markets. The correlation between U.S. large caps and frontier markets, which include countries in an early stage of development, such as Nigeria or Bangladesh, is a relatively modest PRACTICED DIFFERENCES While diversification may be a desirable characteristic in a well-constructed portfolio, this leaves the question of how much international exposure is enough. As with most questions in finance, the answer is: it depends. This is not a dodge, but a reflection of the fact that portfolio construction is as much a matter of risk tolerance and constraints what you will and won t invest in and to what degree as market views. Investor risk tolerance can determine a portfolio s composition as much, if not more, than expected returns. If an investor is very conservative, equity exposure will be limited no matter the geography or how attractive stocks might be relative to bonds and cash. That said, even for more conservative portfolios, the international equity allocation should rarely be zero. Looking at a few hypothetical portfolios, international equity allocations look similar for both all-equity portfolios and more balanced portfolios. For an all-equity portfolio, a typical allocation to non-u.s. equities both developed and emerging markets would be roughly 25% (see Figure 6). Nor would the relative allocation change much within a multi-asset class portfolio; international stocks still make up around 25% of the overall stock allocation within a traditional 60/40 portfolio (60% stocks and 40% bonds). [6] INNOCENTS ABROAD: THE CASE FOR INTERNATIONAL DIVERSIFICATION

7 FIGURE 5: ASSET CLASS CORRELATIONS S&P 500 Russell 2000 Emerging Markets Japan Europe 20+ Year Treasury iboxx High Yield International Equities Short Treasury Gold International Bonds Frontier S&P Russell Emerging Markets Japan Europe Year Treasury iboxx High Yield International Equities Short Treasury Gold International Bonds Frontier Source: Bloomberg, 03/15/15. Indexes referenced are: S&P 500, Russell 2000, MSCI Emerging Markets Investable, MSCI Japan, MSCI Europe Investable Market, Barclays U.S. 20+ Year Treasury Bond, Markit iboxx USD Liquid High Yield, Barclays U.S. Short Treasury Bond, LBMA Gold Price, S&P/Citigroup International Treasury Bond Index Ex-U.S., and MSCI Frontier 100. FIGURE 6: HYPOTHETICAL ASSET ALLOCATIONS 50% PORTFOLIO ALLOCATION (%) U.S. Large Cap U.S. Large Cap Value U.S. Small Cap U.S. Mid Cap EAFE Emerging Markets Equities 100% Equities 60:40 Model This information should not be relied upon as research, investment advice or a recommendation regarding any security in particular. This information is strictly for illustrative and educational purposes and is subject to change. This information does not represent the actual current, past or future holdings or portfolio of any BlackRock client. BLACKROCK [7]

8 FIGURE 7: THEORETICAL MINIMUM RISK AND MAXIMUM RETURN PORTFOLIOS 35% 28 PORTFOLIO ALLOCATION (%) S&P 500 Russell 2000 EM Equities Japanese Equities European Equities Long-Term Treasury High Yield REITs Cash Gold International Developed Bonds Frontier Equities Minimum Risk Maximum Return Source: BlackRock MPS team. This information should not be relied upon as research, investment advice or a recommendation regarding any security in particular. This information is strictly for illustrative and educational purposes and is subject to change. This information does not represent the actual current, past or future holdings or portfolio of any BlackRock client. It is also worth highlighting that the allocation to international stocks remains sizable even with conservative assumptions for international equity returns. The capital market assumptions (CMA) that we used in the portfolio construction exercise included higher expected returns for U.S. equities. 1 We assumed expected returns of roughly 9% for U.S. large caps, but just 7% and 8%, respectively, for Japanese and European equities, based on historical returns adjusted for current valuations. While the model does assume a higher return for emerging markets (a function of higher risk), the expected return is only slightly above what is expected for U.S. large caps and slightly below the expectation for U.S. small caps. In other words, the 25% allocation to international stocks is not a function of aggressive return assumptions but instead rests on their diversification benefits. A sizable allocation to international equities holds even when the organizing goal of the portfolio changes. Using the same return assumptions, we ran another set of optimizations using U.S. equities, non-u.s. equities as well as other asset classes. 2 We ran two separate optimizations with contradictory goals: maximize return or minimize risk. Not surprisingly, the portfolio seeking to maximize return, with no consideration given to risk, contained a large allocation to stocks, both U.S. and non-u.s. The overall equity allocation for this portfolio was 90%, with the remaining 10% in REITs. The allocation to non-u.s. equities was approximately one-third of the total equity allocation and roughly 30% of the total portfolio allocation (see Figure 7). 1 MPS Capital Market Assumptions Asset Class E[R] Asset Class E[R] U.S. Large Cap Long Treasuries U.S. Small Cap International Government Bonds Japanese Equities High Yield European Equities Short-term Treasuries Emerging Market Equities REITs Frontier Market Equities E[R] as of 02/2015, E[R] is total. 2 Opportunity set included: U.S. large caps, U.S. small caps, emerging market equities, Japanese equities, European equities, long-term Treasuries, U.S. high yield, global REITs, cash, gold, international developed bonds, and frontier market equities. [8] INNOCENTS ABROAD: THE CASE FOR INTERNATIONAL DIVERSIFICATION

9 What is more surprising is that a portfolio designed with the opposite objective minimize overall risk also evidenced a sizable, albeit smaller, allocation to non-u.s. stocks. In this instance, the optimization resulted in a 12% allocation to international equities. While the overall allocation was much smaller than in the previous example, this reflects the lower allocation to equities within a risk-constrained portfolio. When you look at the international allocation as a percentage of the overall equity slice, international stocks comprise roughly 40% of the equity allocation. At first, this seems a counterintuitive result. Why would a more conservative portfolio, particularly one with a relatively modest allocation to equities, allocate a greater percentage of the equity exposure to riskier, non-u.s. markets? The rationale again has to do with diversification. Most of the minimum risk portfolio roughly 65% is allocated to bonds and cash. These assets serve to help minimize the volatility. But as discussed previously, in addition to overweighting low volatility instruments, the other mechanism to lower portfolio level volatility is diversification. While international stocks are generally riskier they are denominated in foreign currencies that also fluctuate, adding to the volatility of returns the relatively low correlations of certain foreign markets with U.S. equities help to lower the volatility of the overall portfolio. The inclusion of international stocks, particularly in lower risk portfolios, raises another concern: Should investors hedge the foreign exchange risk when owning international equities? While the answer obviously depends on expectations for the dollar, as a rule of thumb, the decision has not, at least historically, had a material impact on returns. According to research from the BlackRock Investment Institute, over the last 15 years the return impact of currency on international market equities has been modest or negligible (see Figure 8). That said, currency fluctuations can matter over shorter time frames (2-5 years). Investors with a shorter term horizon who have a strong conviction in an appreciating dollar may consider employing currency hedged vehicles. FIGURE 8: CURRENCY IMPACT Period MSCI EAFE Index Currency Impact Period MSCI EM Index Currency Impact 2000 through % 4.74% 2000 through % 4.39% 2005 through % -0.10% 2005 through % 4.40% 2010 through % -2.52% 2010 through % -0.13% 2000 through % 0.71% 2000 through % 2.89% Source: MSCI, as of 12/31/14. USD Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. BLACKROCK [9]

10 CONCLUSION Everything should be made as simple as possible, but not simpler. Albert Einstein Simplicity has its own benefits. For most investors, a portfolio with broad exposures and fewer moving parts is preferable. However, too much simplicity may not be ideal either. A portfolio that is concentrated in just one market, even a large, diversified market such as the United States, will rarely produce the best long-term risk/reward trade-off. Diversification is not a magic elixir. The biggest caveat is that it is 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. Long term, a well-diversified, global portfolio can help minimize unnecessary risk. The benefits can even accrue to more conservative investors, as some international diversification provides for a more balanced, and hopefully less volatile, portfolio. While international diversification may be a sensible idea for most investors, we believe these benefits may be even more likely to accrue in the coming years. The United States is expensive relative to other markets. While this has not inhibited returns over the past couple of years, valuations matter most over longer horizons. The United States may have the best fundamentals, but U.S. equities have rarely posted stellar returns from these valuation levels. In contrast, international equity valuations are not nearly as stretched. Finally, an all-domestic portfolio inherently underweights the growing portion of economic activity that occurs outside of U.S. borders. Even optimists who believe the United States will be the dominant economy for years, if not decades, to come have to admit that the relative footprint of the United States is likely to decline. [10] INNOCENTS ABROAD: THE CASE FOR INTERNATIONAL DIVERSIFICATION

11 BLACKROCK [11]

12 Want to know more? blackrock.com is Unless otherwise indicated, all sources of data are Bloomberg. This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 2015 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. 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International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets. Diversification and asset allocation may not protect against market risk or loss of principal BlackRock, Inc. All rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, ishares, SO WHAT DO I DO WITH MY MONEY, INVESTING FOR A NEW WORLD, and BUILT FOR THESE TIMES are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners T-0415