Going Global - Part 1
Over the past year economic turmoil in the Eurozone has taken its toll on US investors in international stocks. Here are some figures. The S&P 500’s annual return over the last three years has averaged 25.34%, and has added 4.08% over the 12 months ending 2/29/2012, while the MSCI EAFE index, a measure of developed market performance outside the US, averaged 19.8 % annually over the last three years, but lost 8.38% over the last year. Emerging markets indices averaged 29.9% annually over the past three years, handily outperforming the S&P 500, but lost 6.3% over the past 12 months.
Should a diversified portfolio of stock and bond investment go global, or is it safer to stick to the US? US investors have typically gotten away with underweighting foreign securities when compared to investors in other countries; this is understandable in light of our enormous and diverse economy. But the world has changed.
The case for international investment we believe, is still compelling. Correlations of international markets with US stock returns have risen of late, but still vary enough to offer the benefits of diversification and lower volatility. Another important consideration; many major companies, particularly in sectors such as manufacturing, clothing, mining and basic materials, and in some cases entire industries, are located outside our borders; an all US portfolio would lack important representation in these areas.
There’s no getting around the fact that global markets have undergone a profound shift. In 1985 the US represented about 50% of the global stock market capitalization; by 2010 that had dropped to 31%. During the same time period emerging markets’ share of the total had grown from 3% to 28%. The US bond market made up 52% of global bond capitalization in 1985; that share has fallen to less than 30%.
The size and resources of the middle class, that defines itself in terms of product and service consumption, have exploded in the developing world. Population in this segment, counted at 2.6 billion in 2000, grew to 3.3 billion in 2006, and is projected to increase to over 5.1 billion by 2025. The debt load of developing countries as a percentage of their GDP, an important measure of economic prowess, has fallen dramatically, from 49% in 2000 to 35% in 2010. Auto sales in India and China are projected to grow between 2-6 times faster than in the US.
Companies like Nike, Apple, Coca-Cola and Heinz, to name a few, generate over 50% of their revenue overseas, and their investors have reaped the benefits as well. Over the twenty years ending 06/30/2011 the stocks of companies with more than half of their pre-tax profits coming from global sales strongly outperformed those with less than 50%.
Evaluating the risks
You should be aware of some special risk factors that impact global portfolios. Three of the most important are exchange rate risk, regulatory risk, and political risk. Exchange rate risk involves the changing relationship of US dollars to other global currencies. It’s relevant because returns on international stocks and bonds are first earned in local currency, and must be translated into dollars before you can count your gains or losses. For example, you make a $10,000 investment in shares of a Japanese company. Over the next year, the stock price does absolutely nothing; however, over that time period the US dollar loses value against the yen. Now, your initial investment will buy a greater number of dollars when you sell the stock, and you will have made a gain, despite the fact that the stock price was flat. Of course, this can work in reverse; currency translation can wipe out the gains and create a loss in what was otherwise a successful investment in local currency.
In part two of this blogpost we will explore regulatory and political risk, and consider the types of investments you can use when adding international diversification to your portfolio.