- International stocks have long underperformed their US peers and may do so again.
- Michael Sheldon, the investing chief at RDM Financial Group, shares how to spot a reversal.
- These seven indicators, in addition to a peaceful resolution to the Russia-Ukraine war, are key.
It’s one of Wall Street’s favorite traditions: Predicting that this is the year international stocks finally beat their US counterparts.
But for the past nine years except 2017, foreign equities, as measured by the Vanguard Total International Stock
Index Fund
ETF (VXUS), have lagged behind the S&P 500. Since 2013, Vanguard’s international ETF has returned 27.6% — far worse than the S&P 500’s 214.1% gain.
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Buying low on international stocks hasn’t been a winning strategy for most of the past decade, and early indicators are that the S&P 500 will edge its foreign peers again — albeit slightly.
Stocks around the globe have been knocked around this year as investors worry about peaking economic growth, surging inflation, and the Russia-Ukraine war. The latter risk has hit especially close to home for European stocks, given the region’s reliance on Russian oil and coal.
That confluence of concerns means it’s still not yet time to dive into international stocks, but that may soon change, said Michael Sheldon, the chief investment officer at RDM Financial Group, in a recent interview with Insider. RDM Financial Group, a financial advisory firm based in Westport, Connecticut, serves high-net-worth clients primarily with $2 million to $5 million in assets.
“The US economy generally is doing better than many other parts of the world, but at some point, foreign markets will start to do better,” Sheldon told Insider. “And you need to consider — if you don’t have any foreign exposure — you will likely need to consider adding some foreign exposure at some point down the road.”
Though long unloved, international stocks still aren’t ready to shine
Sheldon’s bull case for international stocks centers around their alluringly cheap valuations, solid dividend payouts, and potential to be a strong alternative to domestic stocks if the US slips into a
recession
. Sheldon said an economic downturn isn’t his base case, but he expects weaker domestic growth.
Besides, that first point is probably the more compelling one: Vanguard’s international ETF has price-to-earnings, -book, and -sales ratios of 13.4, 1.7, and 1.2 that are dwarfed by that of the SPDR S&P 500 ETF Trust (SPY), which clock in at 26.5, 4.4, and 2.96, respectively.
“Foreign markets are more attractive on a valuation basis, and dividend yields are higher, and economic cycles perform differently overseas than they do here in the US,” Sheldon said. “So there’s some reasons to have some foreign exposure: to increase diversification and hopefully improve your investment returns.”
Sheldon continued: “But I think it’s a little early at this point, given what’s going on — especially in Ukraine and Russia — to get too excited about Europe or overseas markets just yet.”
7 changes needed for a foreign-stock recovery
Saying that it’s too early to pounce on foreign stocks begs the question: When will that change, and how will investors know that it’s time to rebalance their portfolios?
The precise timing is impossible to know, but Sheldon said that his firm has started to balance clients’ portfolios in the past six to 12 months by shifting away from the US and growth stocks that they’d long been overweight and toward value and international names.
Investors who are hoping to capitalize on foreign stocks’ long-awaited turnaround should keep their eye on seven signs, Sheldon said: the strength of the US dollar, a risk-on environment, monetary and fiscal policies, and trends for employment, manufacturing, consumer spending, and corporate profits. Monitor all instead of keying into one indicator, he said.
Currency movements can be confusing for less-experienced investors to follow, but they’re critical to determining whether domestic or international stocks outperform. When the US dollar index (DXY) rises and strengthens relative to the euro, meaning a dollar is worth more euros, US stocks tend to outperform. The inverse is true, as a weaker dollar lifts foreign stocks.
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“Historically, at least, when the dollar is depreciating or declining, that’s been a tailwind for US investors that invest overseas,” Sheldon said. “In recent months, the dollar has actually been strengthening because US Fed policy has been tightening, and interest rates here in the US are rising sharply.”
As Sheldon noted, a rising dollar is one reason why foreign stocks might not roar back soon.
International stocks also tend to fare better when investors are more comfortable with the global economic backdrop. US stocks are viewed as a safe haven and tend to outperform in times of crisis, like early in the pandemic and during the Russia-Ukraine war.
“When there’s a more risk-on environment around the world, people feel more willing to invest outside the safety of the US,” Sheldon said.
A resolution to the Russia-Ukraine war and a convincing drop in inflation would boost investor sentiment globally and, therefore, likely benefit international stocks disproportionately.
Monitoring the last five trends Sheldon mentioned in all the key countries outside the US may seem like a Herculean task, but investors can probably get a solid understanding of what’s going on by staying locked in to what’s happening in two critical economies: Europe and China.
In Europe, as in the US, inflation has surged to multi-decade highs, but monetary policy is still ultra-easy. Interest rates in the eurozone, as set by the European Central Bank (ECB) are in the cellar at 0%, and officials have said they won’t hike rates until its bond-buying program ends. UBS expects asset purchases to continue through the early fall, wrote Mark Haefele — the firm’s investment chief — in an April 8 note, adding that the first hike could come in December.
Tougher news for European Union members is that the unemployment rate for countries in the bloc is still far higher than in the US at 6.2%, manufacturing data is weakening again after a sharp rebound, and consumer spending is still below pre-pandemic levels.
But it’s not all bad news for Europe: Reuters reported in late February that Goldman Sachs called for European earnings to grow 6% per year through 2024 — the same rate as in the US. Matching or beating the US’s earnings growth could spur a recovery by European stocks.
Meanwhile, China is infamous for its unfriendly policies toward corporations because its authoritarian government punishes companies that get too powerful because it views them as a threat. However, the upside to having a seemingly almighty government is that it can — in theory — flip a switch and stop the falling knife that Chinese stocks have been for about a year.
China’s central bank vowed in late March to better support the economy and financial markets, Bloomberg reported. It also flooded markets with liquidity in December as its housing market continued to falter.
Investors are crossing their fingers that those policies will shake China’s economy out of the slump it’s been in. The nation’s unemployment rate has shot up from 4.9% in October to 5.5%, manufacturing data has softened, consumer spending has progressed steadily in recent years but may be weighed down by lackluster consumer confidence, and private sector profits fell by 1.7% in early 2022, according to FX Empire. That has all spelled trouble for Chinese stocks.
If the headwinds in Europe and China become tailwinds, international stocks will likely take the baton from their US peers. But investors may not want to hold their breath until that happens.
