For what has felt like a lifetime, large cap U.S. stocks represented by the S&P 500 have dominated their foreign counterparts. Since the start of 2013, the S&P 500 has notably outperformed both international and emerging markets:

While somewhat surprising that it’s lasted this long, a backdrop of low interest rates, massive stimulus, and steady economic growth makes a big difference. Plus, valuations of these markets were similar in 2011, and much of the performance gap has taken place the last four years.

Fast-forward to mid-April and the tables have turned as the S&P 500 has been a laggard:

Now, I don’t recommend reading too much into 5 ½ months, but it could be a turning point as it hasn’t occurred in a long time. Several reasons explain why this is happening and what it will take to continue.

Valuation

It’s no secret the U.S. is more expensive on nearly every metric compared to foreign markets. As of July 31, the P/E ratio of the S&P 500 was 23.84, compared to 18.57 for the MSCI World ex-USA and 15.84 for MSCI Emerging Markets Indexes.

A “cheap” market alone does not necessarily mean it’s worth owning. Other factors must emerge for a sustained period of outperformance to take hold. There are a few positives trends for foreign economies:

COVID-19: A majority of foreign developed nations are much further along in re-emerging from COVID-19 lockdowns, which puts them in a stronger position for economic growth over the coming years and less reliant on more government stimulus (debt).
Growth: Given the above, the International Monetary Fund (IMF) predicts a faster and bigger recovery in both the eurozone and emerging markets compared to the U.S. This needs to be factored in when assessing stock market valuations over the coming years.
Youth: Emerging market countries have a much younger population compared to developed nations. Countries such as India, South Korea, Indonesia, Nigeria, and Pakistan have less than 8% of their population age 65 or older, while the U.S. sits at 16%. This matters because a younger population provides fuel for economic growth and development.

The looming risk, of course, is if a second wave of COVID-19 cases leads to another partial shutdown. In this case, valuations and growth outlook would need to be adjusted lower, which would have a negative impact.

U.S. Dollar

The dollar’s strength has been on full display this past decade as expectations of strong economic growth and a gradual increase in interest rates bolstered the dollar’s value. Typically, a strong dollar has negative consequences on foreign markets for a plethora of reasons:

It weakens countries who rely heavily on exports (i.e., commodities) as purchasing power significantly diminishes. Many foreign countries borrow in U.S. dollars but repay in their own currency. Under these terms, a stronger dollar means an even further depreciation of their currency, which makes it harder to not only service debt but also attract new capital investment.
It has a negative impact on emerging markets debt investments. If an investor can earn a comparable yield on AAA-rated U.S. Treasuries as a BB-rated emerging market bond, they have no incentive to take additional risk. This, in turn, leads to less capital investment, which can hinder economic growth/output.
It increases the production costs for multinationals, which has a negative impact on profits. Anywhere from 40% to 60% of the S&P 500’s revenue comes from abroad. With globalization on the rise, this should continue.

The likelihood of a strong dollar took a hit when the Federal Reserve vowed to keep interest rates near zero until at least 2023. In addition, with the U.S. budget deficit at $3.3 trillion, not including any additional stimulus package(s), it remains unlikely that the dollar will significantly rally in the foreseeable future.

Concentration

As mentioned last month, the top five holdings in the S&P 500 make up ~25% of the index, and all are in the “technology” space. For years, the Emerging Market index mainly comprised energy, financial, and material companies. Many of these countries were commodity-dependent for decades, but as their economies have evolved, so has their composition.

As illustrated by BlackRock, things have drastically changed since 2007:

Energy, financials, and material accounted for ~51% of the index vs. 31% today.
Information technology has increased from 13% to 19%, making it the biggest sector in the index.
Consumer discretionary went from a measly 3% to 18% of the index.

What this illustrates is that emerging markets are no longer reliant on a few sectors, and as their economies expand, so do their opportunities.

Ironically, the sector percentage breakdown today of the S&P 500 and emerging markets is very similar. On the other hand, the MSCI World ex-USA Index has a higher weighting in financials and industrials at ~32%, compared to ~18.5% in the S&P 500.

Unlike the U.S., though, no single sector makes up over 20% of the index, so the case could be made that it is more “balanced” and less reliant on any single sector.

Bottom line, it’s too soon to claim victory but seeing underlying strength is a welcome sight. For this to continue, there will need to be further follow-through and patience.

The irony is, from 2000 to 2010, foreign investments considerably outperformed and were the talk of the town. Fast-forward to today and very few want to own them. And at the end of the day, this is what makes markets … markets.

Discuss your situation with a fee-only financial advisor.

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