Episode 35 – The Newfound Religion for International Diversification

Welcome to Market Perspectives, a Mercer Advisors podcast. Today, we’re gonna be talking about the newfound religion for international diversification. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors, and I’m joined today by Don Calcagni, our Chief Investment Officer. Don, thanks so much for being with us here.

Hey, Josh. Thank you. It’s great to be here again.

So, Don, the the title of this podcast comes from you were recently quoted in The Wall Street Journal. Let me just read this quote to sort of set the stage. This is what you told The Wall Street Journal. There’s some strong evidence, not necessarily for selling America, but for beginning to rebalance out of the United States and take a more equal weighted approach.

There’s probably a newfound religion investors may have found for international diversification. So, Don, regular listeners of the podcast will have heard us talk about international stocks, by which we mean non U.S. stocks. Right. But, Don, set the stage for us.

What’s happened with international stocks over the past year that has made this the focus of so much attention?

Well, I mean, the reality is is that, Josh, for a very long time, international stocks underperformed U.S. stocks for the better part of, I don’t know, maybe the past decade. But early last year with the incoming Trump administration, markets really began to rethink the primacy of U.S. stocks over non U.S. stocks. And that was because the administration clearly, from an economic policy perspective, had a very anti dollar or weak dollar, set of policies that they had wanted to implement. And so, naturally, April, I think it was April first or April second, President Trump, you know, his liberation day announcement, announced a slew of tariffs on virtually every country in the world.

And so, you know, that certainly negatively impacted the value of the US dollar, and that structurally has a very significant impact on the returns that we as non U.S. investors, U.S. investors investing in non U.S. assets, has a very significant impact on those returns. So, you know, last year, what we saw is international stocks outperformed U.S. stocks thirty two percent to eighteen percent for the S and P five hundred. Josh, just to be clear, I mean, eighteen percent returns for U.S. stocks still unbelievably attractive. I’ll take those returns all day long, but non U.S. stocks returned about thirty two to thirty four percent.

And that was the first year in probably eight or nine years that we saw U.S. stocks outperform.

And the outperformance of those non U.S. stocks has continued into twenty twenty six. I mean, the S and P is roughly flat so far this year, Josh, and non U.S. stocks are up anywhere from eight, nine to ten percent for the year. That’s a very significant outperformance.

What drove this performance for international stocks? I mean, you mentioned the actions of the Trump administration and what’s happened with the U.S. dollar. What are some of the other factors, though, that have been driving such a large divergence?

I think the Trump administration really turned on its head the global trading and economic order and military order that has persisted since the second World War. And so the Trump administration has been very hostile to our involvement with NATO, very hostile to our involvement with the UN. The Trump administration has shown a proclivity for Russian interests with respect to settlement of the Ukraine war. And so I think all of those things have led to a rearmament trend in Europe.

You know, in in Germany, if you look at the performance of German stocks, it is their defense companies that have had some of the very best returns. And so Germany has committed to investing a very significant percentage of its GDP in defense, and we’re seeing this trend throughout a number of European nations. And so that’s just one example is we are seeing a lot of fiscal stimulus from countries like Germany, like France, and others. We’re also, by the way, seeing it in Japan.

You know, Japan, there is concern about the rise of China. And so in Japan, we’re seeing a push there to rearm and actually make a change to their constitution so that they can actually invest in offensive weapons. And so things like that, you know, putting aside naturally the concerns that we have as global citizens around rearmament, this is a very powerful stimulus to the economies of those countries. And so stimulus combined with deficit spending in the United States, which has led to a weaker U.S. dollar combined with tariffs and things like that, there’s a number of tailwinds that have led to the outperformance of non U.S. stocks over U.S. stocks.

And another factor that we’ve kind of looked at a lot this past year has been what’s been going on with valuations. Obviously, in the U.S., valuations are pretty high by historical measures. What’s kind of the comparison to what’s happening internationally there?

Yeah. I mean, that that’s a great point. I mean, U.S. stocks currently trade at about twenty two times next year’s earnings, or I should say the earnings over the next two years. And what that really means is you have to pay twenty two dollars in share price for every one dollar’s worth of earnings.

Right? So that’s pretty expensive. I mean, historically, that number, that forward price to earnings ratio has been somewhere around sixteen or seventeen times forward earnings. So it’s at twenty two.

It’s pretty high. But when we look internationally, Josh, what we see is international developed countries somewhere around fifteen times next year’s earnings. And so if you do the arithmetic on that, that’s a pretty big discount if you will. That’s one way to look at that is gee, you know, I could pay fifteen dollars for every one dollar’s worth of earnings or I could pay twenty two dollars.

Logically, you’d wanna pay fifteen. Now there’s other things that and we’ll talk about those that have to go into that calculus into that consideration, but non U.S. stocks, emerging market stocks are trading at about thirteen times earnings. By any objective measure, non U.S. stocks are significantly less expensive than their U.S. counterparts.

Now I guess the other side of that equation is the earnings piece of it. Right? If you had just remarkably strong earnings growth in the future, then kind of those current valuations might end up being justified. Right? That’s the basic insight. And so what is sort of the outlook for earnings in the United States versus earnings internationally?

You’re absolutely right. Stock prices ultimately over time follow earnings. And it’s that earnings growth, that exceptionally strong earnings growth that we see in US companies that many argue justify that premium that investors have to pay to own U.S. stocks. And so if we look at earnings growth last year for U.S. stocks, it was thirteen percent.

If we look at earnings growth this year looking forward, it’s actually increasing to around fifteen percent. That is very strong earnings growth for U.S. stocks. And so I often tell folks that, yes, while it is absolutely true that U.S. stocks trade at a premium to their non U.S. counterparts, those valuations can be quote bought down over time through earnings growth. And so that fifteen percent earnings growth is pretty stellar, and that’s one of the powerful reasons why we still think owning U.S. stocks makes a lot of sense.

But with respect to non U.S. stocks, non U.S. stocks, their earnings growth forecasts going forward for twenty twenty six is thirteen percent. So that is also quite exceptional. Last year, was six percent. We’ve seen that more than double going forward.

And a lot of that goes back to that stimulus, that fiscal stimulus that we were discussing a few moments ago in terms of defense spending and and things like that. But when you look at the earnings growth going forward for U.S. stocks and non U.S. stocks, it’s quite attractive, and that’s that’s a pretty bullish case, at least in our view, for continuing to have a a strong allocation to to global equities.

Yeah. I mean, one of the takeaways if the proof is in the earnings, it’s that the U.S. economy still does have a lot going for it.

Absolutely. And, Josh, one of the things I often try to remind investors of is that when you’re looking at different investment opportunities like we are here, you know, U.S. stocks versus non U.S. stocks, it’s not an either or. Right? We shouldn’t look at these things as a binary choice. It’s an and. It’s a question around, okay, what’s the right weights between the two? And perhaps we’ll talk about that here in a moment.

But when we look at the U.S. economy, the U.S. economy remains the largest economy in the world. The U.S. economy is by far the most technologically innovative and dynamic. We have the world’s deepest capital markets. If we look at what’s happening with artificial intelligence, we have arguably the world’s leading AI companies.

AI investment in the United States is dramatic. Our financial markets, our capital markets are so deep. They’re so liquid. They’re so robust that that this still remains, I think, the world’s innovation lab when it comes to technology and finance and financial innovation.

And and, Roy, I should say, like, the financial investment that goes into these things. And these things naturally have a dramatic impact on the productivity of U.S. companies and their workforces. So again, large economy, deep capital markets, but also a favorable regulatory environment. I mean, to to the Trump administration’s credit, I think they have been pushing to simplify regulations so that it is easier to do business in the United States.

And I do think those things are important. But the other side of that coin is that U.S. financial markets are pretty well regulated. Right? They are highly regulated.

And I actually think those things are very beneficial. Capital flows here. Capital wants to continue to flow here because we have well structured, well regulated, and very large and deeply liquid capital markets. And that makes it a great place to innovate, makes it a great place to continue to do business.

You know, when we hear people talk about this trend toward wanting to invest a little more internationally, it’s sometimes called the the make Europe great again trade or the sell America trade. Like, there’s often a political tinge to that commentary. Right?

Should that make us a little bit nervous about jumping onboard that?

It absolutely should. Our clients have heard us say this many times for many, many years, and politics and investing don’t mix. I don’t believe in sound bite investing wisdom.

I don’t like sound bites. They’re too simplistic. And I said this to The Wall Street Journal the other day, Josh. I said, if indeed last year was the, quote, sell America trade, and I still earned eighteen percent on U.S. stocks, I love that trade.

Right? I’ll take that trade all day long.

And so, you know, so I would just be careful. I encourage investors, stay away from politics and investing.

Stay away from this sound bite meme sort of approach to investing. I don’t think it ends well, and I say stay focused on the basics. Stay focused on global diversification and things like that. But you definitely wanna keep politics out of your investing. They don’t mix.

So in that case, how do we figure out the right amount to invest internationally?

Yeah. And like I said a few moments ago, it’s not an either or, it’s an and. Right? So we wanna own both U.S. and non U.S. equities.

The question is ultimately, well, what’s the right ratio? Right. And and I think a really great starting point, Josh, is just look at the global market capitalization of all of the world’s stock markets, which is a real fancy way of just saying, well, okay. How big is the U.S. stock market relative to the rest of the planet?

Well, if you look at all the stocks, all the stock markets in in the world, the US makes up about sixty five percent of the global stock investment opportunity based on market capitalization. Market capitalization is just the size of the company. It’s the number of shares outstanding, basically, times the share price. So it just gives you a sense of how big these companies are and how big the U.S. financial market is.

But we’re about sixty five percent of the total and the rest of the world’s about thirty five percent. And again, that’s just when you’re looking at the global stock market. And that’s actually a really good place to start. Right?

If you had a sixty five thirty five split between U.S. and non U.S., you own the whole planet. You have exposure to basically everything. And that’s a really good place to start. It it’s also a very difficult allocation to outperform through any sort of timing or anything along those lines.

And so my advice to investors is, hey. Start there. You know, can do a lot worse. And and what what we see is some investors, especially our clients, will take a little bit of an overweight to the U.S.

And so if you look at Mercer portfolios, we’re about thirty two percent non U.S. and the balance sixty eight percent would be U.S. And I think that’s totally fine. We are American citizens. We live our lives in the United States.

We earn our dollars in the United States. We spend our dollars in the United States. So I think having a U.S. tilt in the portfolio, I think is totally totally fine. I think if you start going a lot lower than that, I think that could be that would be detrimental.

Right? I see too many clients come to us from other advisory firms, Josh, for example, that only have maybe five, ten, or fifteen percent in non U.S. stocks. I actually think that’s a big mistake. So we we strongly recommend somewhere around thirty, thirty two, thirty five percent is a is a good starting point.

So, Don, sum this all up for us. I mean, what are sort of the key takeaways that someone should take away thinking about this international outlook and how they ought to approach it?

Well, I think number one is that diversification works. Right? And and it works when you least expect it to work. If you could time returns on these asset classes, then there would be no need to diversify.

You would just constantly move in and out, but you can’t. And so, you know, we believe that the best approach is build a globally diversified portfolio, keep it low cost, and and things like that. That’s number one. Number two is that the investment case for U.S. and non U.S. stocks, both of those investment cases are strong.

And so I I would resist making it an either or discussion and instead focus on what’s the right balance between U.S. and non U.S. stocks that you want in your stock portfolio. Now, of course, you should also have allocations to cash and bonds and real estate and other things. Right? So right now, this conversation is just focused on global stocks.

So, again, those investment cases are strong. We touched on earnings. We talked about the dollar and valuations. And I think finally, Josh, and I already touched on this, but I’m gonna hit it again, is market leadership changes.

And it’s impossible to predict from year to year. Coming into twenty twenty five, most investors had no idea that non US stocks were gonna utterly trounce U.S. stocks. Right? Nobody would have predicted that.

Nobody did. I know because I read all of the forecasts.

And I I can tell you that, you know, there’s a classic example. Right? And thirty two percent versus eighteen percent, that was pretty dramatic outperformance last year. So final point is don’t try to pick winners and losers. Just try to, like, invest in all of these different countries through a well diversified, low cost portfolio.

Don, thanks so much for being here to share the overview of this topic.

Thank you, Josh.

If you’re already a Mercer Advisors client, don’t hesitate to reach out to your advisor and talk about kind of how you’re set up in terms of international diversification. And if you’re not a Mercer Advisors client but you’d like more information, visit our website, mercer advisors dot com. It starts with setting up a phone call. This has been Market Perspectives. Thank you so much for being with us today.