To say 2022 was a chaotic year is an understatement!  A lot of market history was made last year; most of it was forgettable.  However, in a year that saw dual bear markets in stocks and bonds, inflation at 40-year highs, and the most aggressive Federal Reserve in years, there was one lone bright spot:  International stocks outperformed domestic stocks for the first time in years!

The final report is in; the S&P 500 Index finished 2022 down 18.11%, while the MSCI All Country World Index (ACWI) ex USA IMI was down 16.58%.   It was the first time foreign stocks outperformed domestic stocks in some time, but as the table shows below, the annualized returns over three, five, and ten years, their returns remain dismal compared to U.S. stocks.

After reviewing the above table, it’s not surprising investors have soured on foreign stocks and tend to avoid them.  However, there are many reasons foreign stocks have underperformed, including a strong U.S. dollar, weak global growth, and the past financial crises in Italy, Spain, Portugal, and, more recently, the U.K. (Brexit) and China (COVID-19 outbreaks) over the past dozen years.

Nevertheless, despite the performance issues international stocks have experienced, investors shouldn’t ignore them as a viable part of their long-term investment portfolio.  Our Investment Committee comes to this conclusion each time we discuss the value of foreign stocks in portfolios.  The reasons include the following:

Diversification benefit(s)

Historically, owning foreign and domestic stocks helped long-term returns and reduced a portfolio’s overall risk.  More recently, however, some of these dynamics changed.  The advent of globalization since the late 1990s married these two regions and moved their markets closer.  However, I’m not sure this is a long-term trend we can count on continuing, especially with the supply chain problems experienced during COVID.

In simple terms, markets outside the U.S. don’t always rise and fall at the same time and depths as our market, so owning parts of both international and domestic securities can level out some of the volatility in a portfolio.  As a result, international stocks can spread out your portfolio’s risk more than if you owned just domestic securities.

When I think about foreign stocks, I break them down into developed and developing.  The developed regions include Europe, the U.K., Canada, and Japan.  These are areas with established industries, extensive infrastructure, stable economies, and a generally high level of living that are home to developed markets.

The developing areas, typically called emerging markets, include China, Brazil, India, Eastern Europe, and other parts of Asia.  Emerging markets are typically nations with less stable economies and emerging capital markets.  However, they generally have faster economic growth as they eventually migrate into mature markets.

Both areas deserve a place in long-term portfolios because they work well together and may not move in sync over time.

Expanded opportunities

The global equity market capitalization is approximately 60% U.S. and 40% foreign.  However, until the past five years or so, it was closer to 50/50.  The bull market in U.S. stocks, particularly in larger companies, increased the U.S. equity percentage.

Therefore, if an investor omits foreign stocks from their portfolio, thinking U.S. stocks are the only attractive area to own, they are missing tremendous opportunities outside our borders.  The U.S. has the world’s largest stock market and economy, but some countries are home to dynamic companies in technology and healthcare.  As a result, this means excellent growth opportunities exist in non-U.S. companies and foreign markets.

Improved Returns

It may not seem logical for foreign stocks to deliver higher returns than what we’ve experienced over the past ten+ years, given the problems mentioned above.  However, several tailwinds are working in their favor:

Performance cycles – The long U.S. outperformance cycle since 2010 won’t last forever and may eventually reverse course when we least expect it.   As the graphic below shows, there have been four multi-year periods when foreign equities outperformed the U.S. in the last 50 years.

I am a big believer that long term there is a reversion to the mean.  The long-term historical return for foreign stocks is near 8 to 9%, so by that statistical logic, the future upside appears compelling based on their past ten years.

Currency – At a high level, the relative strength of foreign currencies to the dollar has the potential to help or hurt returns.  The U.S. dollar has been a significant headwind for foreign equities priced in U.S. dollars (USD) since 2009.  Since 2009, the USD has appreciated about 60% against the Euro, Yen, and Pound.  Since foreign equities are priced in USDs, a strengthening dollar hurts foreign stocks, while a weakening dollar helps returns.  While it is difficult to know which way currencies move due to various factors, the USD may likely be headed lower in the coming years because of higher budget deficits, lower interest rates, and slower economic growth.

Compelling valuations – Lower expectations for foreign stocks translate into lower equity valuations.  However, cheaper equity valuations do not guarantee higher future returns, but starting points matter.  Despite foreign equities outperforming domestic stocks last year, their valuations remain cheap as the graphic below displays.  As the new year unfolds, foreign stocks across developed and emerging markets look cheap based on long-term historical trends compared to U.S. stocks, even after U.S. stocks declined by 20% last year!

At some point, even a slight change in investor sentiment toward foreign markets may be the impetus for better returns in the future.

Key Takeaway

Adding foreign stocks to a long-term portfolio has historically yielded positive returns with slightly less risk than excluding them entirely.  However, that has not been the case over the past dozen years.  As mentioned above, there were various reasons for the lack of diversification benefits, but some may begin to dissipate.

Most notable is the undervaluation of foreign stocks and currencies.  At Bloom Advisors, our team does not attempt to predict currency movements, but we think the long-term strength of the U.S. dollar may soften in the coming years.  A weaker dollar may become a significant tailwind for domestic investors holding foreign securities.  In addition, positive investor sentiment can be a considerable force that helps push up prices, particularly if the overseas economic picture brightens.

In the end, adding foreign stocks to your portfolio may help reduce risk over the long term.  It may take time, and there are no guarantees we will see trend reversals.  Moreover, there are risks, such as international assets tend to be more volatile.  These swings can be to the upside or the downside.  And just as the unique elements of investing overseas (like foreign exchange rates or sector exposure) can sometimes help investors, they can also hurt U.S. investors in other circumstances.

As with anything involving investing, global diversification isn’t a magic bullet.  However, if you add international exposure to your portfolio, size the position appropriately to meet your needs.