In recent years, the S&P 500 has consistently outperformed global markets, leading many investors to believe that the U.S. is the only game in town. However, according to Morgan Stanley Wealth Management, diversifying geographically may now be a wise move to hedge against a potential correction in U.S. stocks.
The S&P 500, which represents U.S. large-cap stocks, has risen 6.4% this year, surpassing the gains of global markets. On the other hand, the iShares MSCI ACWI ex U.S. ETF, which invests in international stocks excluding the U.S., has only seen a 1.7% rise so far this year.
Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, suggests that investors should consider rebalancing their portfolios by reducing their overweight exposure to U.S. equities and adding exposure to Japan, Europe, and emerging markets such as Brazil, Mexico, and India. She points out that valuations of non-U.S. equities compared to the S&P 500 are at a 20-year low and dividend yield differentials are also extreme.
Shalett highlights various reasons for optimism outside the U.S., including fiscal reform, stimulus, and monetary accommodation in Europe, Japan, and select emerging market countries. She also notes that China’s geopolitical isolation from the West has renewed Japan’s leadership in Asia. While China poses challenges for investors, other emerging market countries offer growth catalysts due to factors such as deglobalization of supply chains, constructive fiscal policies, and stabilizing politics.
One of the key reasons to consider diversifying internationally is the valuation discrepancy between U.S. stocks and international equities. The S&P 500’s forward price-to-earnings ratio is over 20.4, while the equivalent for the MSCI ACWI ex U.S. is around 13.5. This nearly 35% discount, which represents a 20-year low, suggests significant potential upside for international stocks. Additionally, dividend yields for non-U.S. equities are running above 3%, more than double that of the U.S. benchmark.
Despite the U.S. representing over 63% of the MSCI All Country World Index, its share of global gross domestic product is only 24%. This imbalance suggests that the U.S. stock market may be overvalued, and diversifying geographically could make sense.
Shalett believes that over the next two years, U.S. growth and interest rates are likely to converge with global peers, making international stocks more attractive. The Federal Reserve’s efforts to bring inflation down toward its 2% target may lead to rate cuts, further impacting U.S. stocks. Additionally, concerns over U.S. politics and debt sustainability could foster volatility that investors can hedge against through international diversification.
Looking at different regions and individual countries, European stocks have gained 1.8% this year, while Japanese stocks have jumped 7.6%. Among emerging markets, Indian stocks have climbed 5.6%, while Chinese stocks have slid 2.8%. Brazilian stocks are down 4.6% and Mexican stocks have fallen 2.4% so far this year.
In conclusion, while the S&P 500 has been outperforming global markets for years, now may be a good time for investors to consider diversifying geographically. Valuation differentials, along with fiscal reform, stimulus, and monetary accommodation in various regions, suggest potential opportunities outside of the U.S. By rebalancing their portfolios and adding exposure to international stocks, investors can hedge against a potential correction in U.S. equities and potentially capture higher returns in undervalued markets.
