Expanding (Investment) Horizons: The Case for Investing Globally

Executive summary:

  • U.S. equities have ruled the roost for the better part of the last decade, but another region may emerge as the leader if the business cycle changes.
  • The decision to allocate investments between the U.S. and international markets is not a binary choice. It's important to understand that there are opportunities in both.
  • We believe active management and skillful security selection are paramount for investors considering investing in global equities.

"The only constant is change" – Heraclitus.

Heraclitus, the Greek philosopher, famously stated that "the only constant is change," a maxim that may seem to contradict the prolonged dominance of U.S. equities in recent years. U.S. equities have consistently outperformed international and emerging markets over the past decade, as evidenced in Chart 1, which tracks 5-year annualized returns. However, a historical perspective reveals a different pattern. In the last 40-plus years, the chart shows that new leadership emerged after economic and market shocks. For instance, international equities reigned supreme in the 1980s; however, after the early 1990s recession, U.S. equities took the lead with the dot-com boom. Following the dot-com bubble burst in the early 2000s, emerging markets surged, led by China's economic expansion and rising commodity prices. The 2008 subprime crisis initially created uncertainty in leadership, but around 2012, U.S. equities regained their dominance.

U.S. equities have led the pack for the past decade. Is a change in market leadership possible?

Chart 1 demonstrates that major market shifts coincide with economic disruptions and tend to usher in new leaders. Despite the current era of U.S. equity strength, the cyclicality of markets suggests that change is inevitable. Aggressive central bank rate hikes may eventually trigger a recession and an equity market correction. While the timing remains uncertain, history indicates that a turning point in the business cycle is not a matter of if but when, which presumes a new leader could emerge.

Chart 1 Rolling 5 Years Annualized Returns

The conclusion, however, shouldn't be that the U.S. will necessarily underperform over the coming years. In the past few years, the equity markets in the U.S. have been dominated by a select few mega-cap technology-oriented stocks. More recently, the excitement has surrounded artificial intelligence and the magnificent-7 stocks. However, this concentrated leadership means plenty of reasonably valued stocks within U.S. equities remain.

Examining opportunities in U.S. equities outside the mega-cap space

For instance, while the S&P 500 Index's forward price-to-earnings (P/E) ratio stands at 18.5—slightly above the long-term average of about 16—when we exclude the dominant mega-cap technology stocks, it drops to a more reasonable 16.5,1 suggesting opportunities outside the mega-cap technology space. Additionally, dipping further down-market capitalization reveals that small-cap U.S. equities are trading at their widest discount to large-cap shares in the past decade, as Chart 2 demonstrates. Though small caps can be more volatile, and the short-term business cycle outlook remains uncertain, they hold significant untapped potential and an opportunity for superior returns relative to large-cap shares.

It's not about avoiding U.S. equities due to potential underperformance; instead, the key is to skillfully select securities within both large and small-cap U.S. equities that have the potential to outperform despite the overshadowing effect of the mega-cap tech giants.

Chart 2 Forward PE Differential (Small Cap Less Large Cap)