Over the past six years, U.S. investors have been rewarded for staying close to home. U.S. equities have entered the seventh year of the bull market, one of the longest in history, and bond yields have remained contained thanks to massive central bank intervention, restrained growth and low inflation. A traditonal 60/40 blend of U.S. stocks and bonds has performed well relative to most other asset allocations.
However, with bond yields still near record lows and U.S. equity valuations stretched, this may not be the case going forward. Three arguments support the need for more international diversification, particularly in equities:
- Relative valuations. U.S. equities trade at a significant premium to the rest of the world. Longer term metrics, such as cyclically adjusted P/E ratios, suggest that U.S. stocks are likely to produce, at best, average to below-average returns over the next five years. In contrast, valuations are considerably lower in international markets, including developing countries.
- U.S. declining share of world GDP. While the United States is still arguably the world’s most dynamic economy, its relative share of the global economy is shrinking. Depending on the exact methodology, China is now the world’s largest economy or soon will be. Owning a predominately U.S. portfolio underweights the dominant and fastest-growing portion of the global economy.
- The basic tenets of portfolio construction. Finally, best practices in portfolio construction suggest that owning a portfolio solely focused on the United States may lead to suboptimal risk-adjusted returns. In other words, investors may be taking on risk that could otherwise be diversified away. This is a particularly important point today as stock correlations have fallen to their pre-crisis level, suggesting a greater benefit to diversification.