Third Quarter 2014 WHITEPAPER As the World Shrinks, Equity Opportunities Grow Reasons Investors Should Consider International Equities: A Growing Opportunity Set Attractive Valuations Diversification Benefits As the distance between countries grows smaller, the global economy expands and matures, and investment opportunities outside the United States multiply. Like a forest of trees with varying heights, the economies of individual countries grow at varying rates. Within those differences lie opportunities for savvy investors. KEY POINTS The U.S. is shrinking as a percentage of global GDP, and this trend is projected to continue. Non-U.S. developed equities are trading at about a 14% discount to U.S. equities. International equities rose from 1999 to 2009, a flat period for U.S. equities. But despite the opportunity that international equities represent, U.S. investors remain underweight international equities. In this paper, we ll make the case for why international equities should be an important element of a diversified equity portfolio. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE 1
Reason #1: A Growing Opportunity Set Investors should consider the benefits of positioning their portfolios to benefit from the inevitable ebb and flow of the equity-market performance of nations. Maintaining an allocation to international equities ensures that equity investors have more options. As Figure 1 shows, the U.S. has not been among the world s leaders in equity-market performance over the past 15 years. That s because international companies maintain an outsized presence in global market capitalization. Figure 2 illustrates that of the 2,432 companies worldwide with market capitalization greater than $1 billion, 609 are located in the U.S. and 1,823 are located outside the U.S. If you aren t invested internationally, you may be missing out on compelling investment opportunities. This is changing the global growth picture. The U.S. now accounts for one-third of global growth. By 2030, that amount is estimated to dwindle to about onefifth, as shown in Figure 3. If you hope to reach your growth objectives, you should consider a strategy that takes international markets into account. The global economic recovery is powering the global recovery in equities. And while a rising tide does lift all boats, the rate of that tide s rise varies depending on its location. For example, Europe was considered to be no man s land by most equity investors during the depths of its sovereign-debt crisis. Today, though concerns in Europe remain, growth has turned from negative to positive there and signs of recovery are increasing. According to Nanette Abuhoff Jacobson, asset allocation strategist at Wellington Management and global investment strategist for Hartford Funds, Europe is now where the U.S. was in 2010. Meanwhile, after years of declining economic growth, Japanese equities soared in 2013, benefitting from the accommodative policy and extensive reforms implemented by Prime Minister Shinzo Abe. FIGURE 2 Most Companies With More Than $1 Billion Market Cap Are Outside the U.S. 1,823 Located Outside the U.S Source: Factset, as of 11/13. 1_ 3 of Global Growth Currently 609 Located in the U.S FIGURE 3 U.S. Portion of Global Growth Is Shrinking FIGURE 1 Focusing Exclusively on U.S. Equities May Lead to Missed Growth Opportunities Abroad Best 200% 1_ 5 of Global Growth by 2030 Equity Growth 150% 100% 50% 0% 50%- 100%- United States Finland Worst Norway Greece Austria Spain Finland New Belgium Greece Israel New Zealand Canada Sweden Zealand Ireland Finland nd Finland nd Ireland Japan Israel Israel Singapore Belgium Israel Ireland Greece Finland nd Germany Greece Greece Ireland 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: The Wall Street Journal, as of 4/12 FIGURE 4 Home-Country Bias 14% Average U.S. investor s allocation to international equities Source: ICI, as of 12/12. U.S. represented by S&P 500 Index, which is a market-capitalization-weighted price index composed of 500 widely held common stocks. All other countries are represented by the MSCI Index, which is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of 23 developed markets. Data source: Thompson Reuters, 1/14. Past performance is not indicative of future results. Indices are unmanaged and not available for direct investment. 2
Reason #2: Attractive Valuations A primary reason to consider international equities is their affordability relative to U.S. equities, which enjoyed a year of enviable performance in 2013. The S&P 500 Index rose more than 30% setting record highs, soundly outperforming most expectations, and defying the threats of political gridlock and lackluster economic growth. But this success has not come without a cost. As U.S. equities have risen, so have their prices as demonstrated by current price-to-earnings (P/E) ratios. Currently, the cyclically-adjusted P/E ratio for U.S. equities is 22.74, a bit higher than their historic median of 19.38. U.S. equities could be primed to continue their recent strong performance over the long term due to improving economic data and the long-term earnings potential of U.S. companies. But while domestic equities have turned heads during their recent rise, we think international equities appear even more attractive. Because valuations of domestic equities have increased at a faster rate than international equities, non-u.s. developed-market equities are trading at about a 14% discount to U.S. equities. Figure 5 shows that international equities are currently affordable relative to U.S. equities, based on their historical averages, making now an optimal time to consider investing internationally. FIGURE 5 Many Countries Have More Attractive Valuations Than the U.S. (as of 6/30/14) 40 Historical Median P/E Current P/E 30 P/E Ratio 20 10 0 Europe ex. U.K. Japan U.K. Austria Belgium France Germany Canada China Taiwan Italy U.S. Historical Median P/E Current P/E 19.8 38.7 14.7 29.7 14.3 19.6 17.9 19.3 19.0 19.2 22.2 19.4 15.5 22.5 12.5 8.4 13.8 14.5 16.9 19.9 14.1 19.4 10.1 23.2 Cyclically Adjusted Price-to-Earnings (CAPE) Ratio Source: Ned Davis Research, 3/31/14. Cyclically adjusted price-to-earnings ratio (CAPE) divides a market s price by 10-year average inflation-adjusted earnings to provide a smoother measure of current valuations. Price-to-earnings ratio is the ratio of a stock s price to its earnings per share. CAPE is measured by the MSCI Index for each region/country. Each MSCI Index measures the performance of stocks from the corresponding region/country. * Source: ICI, as of 12/12 3
Reason #3: Diversification Benefits It s an investing truism nearly as old as Wall Street itself: A portfolio diversified across multiple asset classes can help reduce risk and volatility. Today, investors should consider taking that advice a step further. It isn t enough to be diversified across different asset classes. Prudent investors should also be diversified within asset classes. Like a skyscraper that flexes in the wind to distribute force, being invested in multiple international markets can help blunt the impact of market fluctuations. If your equity portfolio consists almost entirely of domestic equities and the U.S. equity market suffers a correction, your losses could be greater than if your holdings were distributed globally. FIGURE 6 International Stocks Outperformed U.S. Stocks During the Lost Decade 1999-2009 Cumulative Returns 16.97% For example, investors who endured the lost decade for equities from 1999 to 2009 would have benefitted from an allocation to international equities. As Figure 6 shows, the MSCI EAFE Index of international equities rose 16.97%, while U.S. stocks declined by -9.10% during the same period. International U.S. -9.10% But allocating a percentage of your equity assets internationally can do more than just add diversification alone; it can also add growth. As Figure 7 illustrates, global GDP growth is projected to outpace U.S. GDP growth in the coming years. And with the growth of international companies shown in Figure 8, investors have an expanding multitude of choices. International stocks are represented by the MSCI EAFE Index, which tracks the equity market performance of developed markets outside of the U.S. and Canada. U.S. stocks are represented by the S&P 500, which tracks 500 of the largest companies in the United States. FIGURE 7 Global GDP is Projected to Rise More Quickly than U.S. GDP World United States 2014 FIGURE 8 Globalization: The Number of International Companies Has Exploded Since 1986 International U.S. 41,540 8,068 2015 6,475 4,720 1986 2013 2019 0% 1% 2% 3% 4% Annual Percent Change Data Source: Ned Davis Research, 1/14. U.S. companies includes all common stocks listed on the NYSE, AMEX, & NASDAQ exchanges. International companies includes all stocks in the Thomson Worldscope database listed on the different exchanges. Over-the-counter stocks are not included. Source: International Monetary Fund, 1/14. 4
Things to Consider: During the current bull market in equities, investors have favored domestic equities. But international equities offer benefits that make them critical to a balanced equity portfolio. Below are three reasons why now may be an optimal time to consider increasing your allocation to international equities: Opportunities in international equities are expanding, but the average U.S. investor has only a 14% allocation to international equities. International equities are attractively valued and many countries trade at a greater discount to their historical averages relative to U.S. equities. Diversifying a portfolio across domestic and international equities can help reduce risk and volatility. Hartford Funds International/Global Funds A C I R3 R4 R5 Y Emerging Markets Research HERAX HERCX HERIX HERRX HERSX HERTX HERYX Global Capital Appreciation HCTAX HFCCX HCTIX HCTRX HCTSX HCTTX HCTYX Global Equity Income Fund HLEAX HLECX HLEJX HLERX HLESX HLETX HLEYX International Capital Appreciation HDVAX HDVCX HDVIX HDVRX HDVSX HDVTX HDVYX International Growth HNCAX HNCCX HNCJX HNCRX HNCSX HNCTX HNCYX International Opportunities IHOAX HIOCX IHOIX IHORX IHOSX IHOTX HAOYX International Small Company HNSAX HNSCX HNSJX HNSRX HNSSX HNSTX HNSYX International Value HILAX HILCX HILIX HILRX HILSX HILTX HILYX 5
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