Economists are increasingly using the term “divergence” to signal the differing economic trajectories of the United States and the other important economies around the world. The U.S. economy is expected to grow faster in 2015 than at any other time since the recession of 2008-2009, while China is clearly slowing, and Europe is struggling to post any growth at all. The Federal Reserve is about to embark on a campaign to raise interest rates (which should increase the attractiveness of U.S. fixed income) while other central banks are aggressively easing monetary policy to stimulate growth. Market strategists are nearly uniform in their view that the U.S. dollar will continue to appreciate this year.
Investors that have followed conventional wisdom to diversify their equity portfolios outside of the U.S. have paid a significant price in recent years. In the five years ending in 2014, the S&P 500 Stock Index returned 15.5% (dividends reinvested), while the MSCI EAFE Index of developed economies (largely Europe and Japan) rose 5.3% (in USD), and the broad emerging market index (MSCI Emerging Markets) gained only 1.8% (in USD) – all figures are compounded annualized total return growth rates. Last year, the performance gap between the S&P 500 and the MSCI EAFE was the largest it has been since 1997.
As clients review their 2014 and prior year’s results, some are rightfully asking why they should bother with international diversification at all. With U.S. growth picking up while growth in the rest of the world slows, the U.S. dollar rising, and U.S. consumer spending likely to increase due to lower energy costs, why not just stay home?
At City National Rochdale, we have favored U.S. stocks over international stocks for the last several years. In fact, we recently lowered our recommended allocation to non-U.S. equities for a number of the reasons cited above. However, we have not abandoned, or do we intend to abandon the basic premise that broad geographic diversification is good for portfolios.
For one thing, U.S. companies represent only about half of the world’s equity market value. Why confine yourself to only half of the opportunities out there, when there are many great companies domiciled outside of the U.S. that compete successfully across the globe with U.S. companies? In fact, the strong dollar creates a large price advantage for those companies that are selling their products in euros or yen versus those selling in dollars. Good active managers can seek returns above the benchmark indices by factoring this and other variables into their security selection decisions.
An important principle of investing is to always consider the contrarian view. While the consensus is often right, it pays to consider what might happen if things do not turn out as planned. In most cases, the returns available to those who go against the grain are substantial, since market prices largely reflect the consensus. And let’s not forget how hard it is to forecast something as large and complex as the global economy.
We believe that making tactical investment bets at the margin by carefully analyzing the macroeconomic landscape can improve investment performance, but we are cognizant of the risks of making a big bet and getting it wrong. For that reason, we will always advocate a diversified approach across both geographies and asset classes.
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