The Case for International Equities

by Wayne Ferbert on November 13th, 2013

If you follow this blog, you know we have increased our International equity allocation several times in the last year. Our rationale has been that International was due for a recovery and the US Equity market was due to level off.
That view hasn’t helped our portfolio when compared to just staying invested in the S&P500 so far in 2013: S&P 500 + 24% / Emerging Markets – 7% / Developed Markets +15%.
But call us contrarian as we still believe its time to rotate more money out of the winners like US Equities and in to the International laggards. Let’s remember that a regular re-balance shifts from winners to losers anyway – so US Equity is by far and away the big winner.  You can take some profits and rotate to a laggard like International.
But what is the foundational reason that we like International. Here is some of the data that makes us like it so much:
  1. The US is 19% of the world GDP but almost 48% of the world’s market capitalization. This skew always exists – but not usually this skewed. It is due to correct and it will correct with either a US Pullback or an International rally.
  2. International markets continue to trade at a forward PE multiple that is considerably lower than the US market. The S&P500 trades at 14.5X while the EAFE Index of Developed countries trades at 13.2. Of the world’s largest developed economies, the US and Mexico are the only ones that trade at a premium to its historical PE and at a premium to the world’s average PE valuation.
  3. In the emerging markets space, the discount on PE is even more pronounced when compared to the developed markets and the US. The Emerging Markets Index trades at 10.4 forward PE. While we expect this kind of discount given the risk premium that investors want from this category, it is still below the historical average.
  4. Emerging markets have attractive forward GDP growth prospects around +4% with materially lower debt to GDP than Developed markets. But these countries trade at a material discount and have much higher interest rates on their debt. As a long term investor, I like the higher growth prospects and the lower debt.
  5. International equity markets are still well off their 2007 highs – while the US market has already recovered. The Emerging markets are still 22% below their all-time highs and the Developed markets are still 37% below their all time highs. These markets still have room to run.
What worries me about International markets?
  1. A strengthening dollar in a rising interest rate environment. To invest in International, we need to purchase it in US Dollars. As rates rise – which seems likely in the long-term view – the dollar will strengthen. That will cause the investment we make in International to lose value – even if the International market moves sideways when measured in its own currency.
  2. Risk assets like emerging markets could be the first to lose a bid in a rising interest rate market. As interest rates in the US go up, the risk premium that investors expect will need to increase. The riskiest categories tend to lose a bid first in that scenario.
In the end, I hate the idea that the US markets are the only place for my equity allocation – and a good portfolio needs diversification anyway. Think about re-balancing AGAIN and rolling the US Equity winners over to International.

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