Asset Class in Focus: International vs. U.S. Equities

April 2021

Domestic stocks have outperformed international stocks by a wide margin for the past several years, but many market commentators suggest that the tide may be turning in favor of international equities. The BDO investment team provides perspective on the merits of international vs. U.S. equities, including the benefits of emerging markets equities as part of a diversified portfolio.
 

What defines international vs. U.S. equity investing? How have international equities performed relative to domestic equities over the past several years?

Domestic stocks, which by definition are domiciled in the United States, have been strong performers for the past several years. Technology stocks—such as Facebook, Apple, Netflix, and Google—have been key to domestic equities’ success relative to international equities. The strong performance of these companies has been a major reason that domestic equity indices, such as the S&P 500 Index, have risen so strongly over the past decade—a trend that accelerated in 2020 when the pandemic struck.
 
On the flip side, international equity indices generally comprise fewer technology companies. Therefore, international equity indices haven’t benefited from the recent strength of technology and other growth sectors of the economy as much as U.S. equity indices. This is particularly true of developed international markets, such as Europe and Japan, and less so in the case of emerging markets, like China and India. This trend of domestic stock outperformance may be shifting.
 

How do you compare the relative attractiveness of international vs. U.S. equities?

When comparing the relative attractiveness of public equity investments, we generally start by looking at valuations. When reviewing traditional valuation multiples, international stocks appear relatively inexpensive today relative to their U.S. peers.
 
We feel that some level of discount makes sense for international equities due to the relative strength of the U.S. economy and risk factors abroad. However, the discount appears to be a bit high today. Additionally, the diversification benefits of international securities are often overlooked by many U.S.-based investors, particularly in light of rising U.S. debt levels and easy-money policies that have been adopted by central banks not only in the United States, but also in Europe, Japan, and other markets. A critical part of portfolio management is reaping the long-term benefits of risk-factor diversification. Generally speaking, international equities provide a good source of such diversification.
 

How do you define emerging markets (EM)? What role do EM equities play in a portfolio?

The term emerging markets refers to economies of developing nations that are expected to exhibit strong growth as they continue to become more integrated with global developed markets. Generally, emerging markets attract significant foreign and local investment and use this capital to fuel their growth. This eventually leads to higher levels of employment and a rising standard of living as more people enter the middle class, driving further growth.
 
We feel that emerging markets are an essential part of well-diversified portfolios. EM equities are valuable from a portfolio construction perspective because, as mentioned earlier, they provide exposure to a diverse set of risk factors relative to developed markets equities. One key trade-off in emerging markets is a higher level of uncertainty, or risk, for investors. Typical risks of EM countries include political instability, potential supply or demand shocks, lack of proper infrastructure, immature regulation, exchange rate risk, and credit risk.
 
Demographic factors are one of the key variables to the relative attractiveness of EM equities. For example, China and India each have approximately 1.4 billion citizens, and they together represent around one-third of the global population. Both countries are expected to grow their middle classes substantially over the coming years. In China alone, experts estimate that anywhere from 300 million to 500 million citizens will enter the middle class during the next 15 years. That is more than the entire population of the United States today (approximately 330 million people). These demographic factors point to strong consumption and investment growth in India and China as well as a variety of other emerging markets around the world.

For more information on BDO Wealth Advisors’ investment approach, see our recent articles on alternative investments and “growth” vs. “value” investing, or feel free to contact us to schedule a conversation with an advisor.