Why today's shift to international stocks may signal the start of a longer-term trend

Investors are allocating more new assets overseas than to the United States for the first time in several years.

Net new investments in international equities reached nearly $70 billion in the first four months of 2017, versus $41 billion for U.S. equities.¹ Moreover, investors committed new assets to both actively and passively managed international strategies, whereas only passively managed U.S. equity funds received net new inflows. This is an encouraging sign from an asset allocation standpoint: International stocks today represent less than 17% of all ETF and mutual fund assets but more than 40% of the world's stock market capitalization—a clear imbalance.²

From an investment standpoint, the case for international stocks is even stronger. Developed international markets returned 10.20% for the year to date through April, versus 7.16% for the S&P 500 Index. Emerging markets did even better, returning 13.88%.³ The good news for investors is that there are several reasons to suggest we may be at the start of a prolonged period of international stock outperformance.

Investors are wise to have waited to return to international markets. Until recently, international equity returns had lagged U.S. stock returns for nearly a decade. In fact, this performance drought represents the longest stretch of international stock underperformance since the early 1970s. One contributing factor was the lack of potent monetary policy in the immediate aftermath of the 2008 financial crisis, which resulted in a tepid economic and earnings recovery, and a longer time for foreign capital markets to gain positive momentum. Another key factor was political uncertainty, particularly in Europe, where markets have endured numerous referenda, testing the strength of the European Union.

That's all changing. Central banks in Europe and Japan eventually stepped up their support, and political uncertainty has begun to wane. Today, we're seeing synchronized improvement across the global economy, along with a rebound in corporate earnings. As we observe in our latest update of Market Intelligence, equity valuations overseas are much more favorable than in the United States as a result of the multi-year performance imbalance. Closing this valuation gap won't happen overnight. In fact, the time involved in correcting valuation imbalances is one reason why the cycles of performance between international and U.S. stocks have historically been so long.

The relative inefficiency of international markets and uneven reporting of non-U.S. companies can give skilled international managers an edge over their U.S. counterparts. As Head of Investments Leo Zerilli recently noted, analysts' forecasts of future earnings results have been far less accurate for international stocks than for U.S. equities, creating opportunities for active managers. Some international equity managers also add value by actively managing currency risk through hedging techniques that convert the value of shares from the local currencies of overseas markets back to U.S. dollars. Meanwhile, strategic beta passive approaches have demonstrated the ability to limit downside volatility, versus some active strategies, owing to their disciplined approach.

Whether choosing active or passive strategies—or a combination of the two—investors are clearly training their sights on international equities to take advantage of the markets' improved performance prospects. Market fundamentals and historical precedent suggest this may be the beginning of a longer-term trend.

1 Strategic Insight, May 2017. Includes ETFs and mutual funds, using Morningstar asset categories.

2 Strategic Insight, MSCI, May 2017.

3 Standard & Poors, MSCI, as of 4/28/17.

Developed international markets are represented by MSCI Europe, Australasia, and Far East (EAFE) Index, which tracks the performance of publicly traded large- and mid-cap stocks of companies in those regions. Emerging markets are represented by MSCI Emerging Markets (EM) Index, which tracks the performance of publicly traded large- and mid-cap emerging-market stocks. It is not possible to invest directly in an index.