For more than a decade, equity returns in international markets have trailed those of the US. There are various possible explanations, but a central one is that the US, after first staging a faster recovery from the global financial crisis, has tended to produce stronger earnings growth in the years since. Meanwhile, from an international perspective, everything from a strong dollar to geopolitical conflict to volatility in emerging markets to China’s economic slowdown have weighed on relative returns. It also doesn’t help that the arrival of ChatGPT, and the enthusiasm and competition it has inspired for generative artificial intelligence technology, has lately encouraged an almost singular focus on a handful of US tech stocks—a mere 0.2% of the companies in the MSCI ACWI Index.
Some investors look at the difference between international and US returns and, expecting that current conditions will persist, wonder what place non-US equities have in a portfolio today. But while it’s easy to fall into that line of thinking, history suggests it is likely wrong. The relative performance of US and non-US stocks has historically been a cyclical phenomenon, and as the chart below shows, their indexes have regularly swapped between leader and laggard over the past 50 years.
Source: Bloomberg, MSCI Inc. Data as of June 30, 2024.
The current period of US outperformance has already lasted twice as long as any prior cycle in the past 50 years, and that fact alone would seem to flash a warning. Investors also face many large and evolving risks—everything from elections and wars to potential economic upheaval from AI and the far-reaching effects of an increasingly less cooperative, multipolar world. All of this suggests that the next decade in equity markets is unlikely to look like the past one.
We are skeptical of our, or anyone’s, ability to predict market cycles, and the Harding Loevner investment process is structured to avoid attempts at timing them. We invest globally for the long term in stocks of high-quality businesses that can grow across economic cycles, and our research is devoted to understanding the enduring characteristics of companies and the competitive structure of their industries. As bottom-up investors, although we seek to understand how changes in the economic environment might impact our companies, we don’t believe in making investment decisions solely based on macroeconomic what-ifs. Still, it’s plain to see that there are certain elements of the recent investing environment that have been broadly unfavorable for international shareholders. Here are five possible changes in market conditions that could help pave the way for international markets—especially stocks of high-quality companies—to rise again:
1. The “Magnificent Seven” Stumble
Over the past couple of years, US stock-market outperformance has been dependent on a small subset of stocks—Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla, a group known colloquially as the Magnificent Seven. These seven stocks have been responsible for a third of the gains in the MSCI ACWI Index since the end of 2022, and all of its returns in the second quarter of 2024. If these stocks were to falter, international markets might become relatively interesting again. After all, the market capitalization of the global benchmark may be heavily weighted toward the US, but the majority of the most profitable and capital-efficient businesses in most sectors—as measured by cash flow return on investment—are located outside the US:
Data as of December 31, 2023.
Source: Harding Loevner, FactSet, HOLT database, MSCI Inc.
In the past 50 years, there have been two periods of sustained US underperformance, both of which were preceded by US valuation bubbles. One directly followed the Nifty-Fifty era of the late 1960s and early 1970s, when a very different-looking set of companies were held up as magnificent—including bygone brands such as Sears Roebuck and Polaroid. After the subsequent crash, the MSCI EAFE Index (the MSCI ACWI didn’t exist until 1990) dramatically outperformed the US index for eight years. Later, in the early 2000s, the bursting of the dot-com bubble and the liftoff of China’s growth led to another period of international outperformance that lasted until the beginning of the financial crisis.
From a macro perspective, what investors have had in the US for the last couple of years is a good economy despite high interest rates and roaring inflation. The market is now digesting the Federal Reserve’s decision in September to aggressively cut rates to support employment levels as inflation heads in the right direction. However, with a group of largely tech-oriented stocks dictating overall market returns, perhaps a more relevant consideration for investors is whether the revenue models forming around generative AI can live up to the high expectations for profit growth that are baked into those companies’ share prices. (There is a cautionary tale in Cisco Systems and the advent of the internet.)
2. China Gets Back Up
After three decades of breakneck growth, China’s economy is now sputtering, and comparisons are being drawn to Japan’s lost decades, a period of economic stagnation that began in the 1990s and continued into the 2020s. Add in rising geopolitical tensions and how they are causing companies to alter supply chains, and there appears to be a general apprehension toward Chinese stocks. Yet, even with possible deflation and an aging population, China remains one of the most populous countries in the world and a significant source of economic activity. It accounts for nearly a quarter of the value of the MSCI Emerging Markets Index—a larger weight than any other country. Because of China’s large manufacturing base and consumer population, the health of its economy is also important to companies in other international markets, especially Europe (Atlas Copco, for example, a Swedish industrial-equipment provider that has reported weaker demand from China for compressors and vacuums used in solar, battery, and electric-vehicle manufacturing). The last time that international markets outperformed, China played a key role, and given the size of its economy and index weight today, it is easy to imagine how receptive markets would be to better news there.
Moreover, there are scores of Chinese companies that remain solid despite the overarching environment, which is why it’s important to understand not just what is happening at a country level but also at an industry and company level. High-quality companies—those with strong balance sheets and consistent free-cash-flow generation—are better equipped to withstand, or even expand, during difficult times such as China is encountering. With the share prices of so many quality growth companies in China failing to reflect the strength of the underlying businesses, valuations in China are more compelling than at any point over the past 30 years.
3. India Continues Its Ascent
As one of the world’s fastest-growing economies, India’s profile has been rising among US consumers and investors alike. A “Made in India” tag is something shoppers now encounter quite a lot, while investors increasingly wonder about India’s potential to stand as a substitute for China’s stock market. But investing in India is also full of challenges. For starters, it is the most expensive market in the world, and much of the market’s recent gains have come from cheap stocks, which tend to be those of lower quality. These include many state-owned enterprises (SOEs) benefiting from government spending. Finding companies that can deliver long-term profitable growth and whose stocks can be purchased at reasonable prices is difficult. However, as India’s market develops further, and the fundamental weakness of SOEs becomes apparent, high-quality growth businesses should be rewarded for their superior fundamentals, and more of them may emerge over time. And while it remains unclear whether India’s infrastructure, policies, and other features of its economy are built to support global manufacturing and trade on the order of China, its population and potential purchasing power can’t be ignored, and the country’s rising global competitiveness is likely to present opportunities for investors over the long run.
4. Peace Breaks Out
Between the wars in Ukraine and Gaza and the rising tensions in the Middle East and South China Sea, fears of international conflict continue to be an inescapable theme of markets, and one in which investors are at the largest information disadvantage. Although uncertainty alone can be enough to topple stock prices, companies around the world have also had to contend with the tangible effects of geopolitical instability, such as the dangerous disruptions to vital trade routes along the Red Sea, as well as, at one point in the Russia-Ukraine war, the prospect of a European winter natural-gas shortage. And while investors cannot reasonably predict the likelihood of China’s aggression toward Taiwan escalating to an invasion, it is one of the risks that complicates the picture for AI beneficiaries such as TSMC, whose factories are situated on the northern coast of Taiwan and supply the chips used by the market’s favorite semiconductor company, NVIDIA. The absence of any more significant destabilizing developments doesn’t mean that global tensions will simply fizzle; however, wars, like market cycles, generally do end, which would alleviate at least some of the pressure on international stocks and call attention to their relatively attractive valuations.
5. AI Goes International
As AI begins to ripple through the economy, investors—including us—are trying to determine which industries and companies will be disintermediated by advances in the technology and which are impervious to the coming change. But many investors seem to be certain very early on about which companies will be the biggest long-term winners from AI. The Magnificent Seven, or more specifically, the six tech and communications-services companies that are part of the Magnificent Seven, aren’t the only businesses with revenue models tied to AI. Dutch lithography machine manufacturer ASML, French energy-management solutions provider Schneider Electric, and German software provider SAP are just some of the high-quality, non-US companies playing a key role in the transition to the AI era by either supporting the chip-production process, powering AI data centers, or allowing businesses to add AI productivity tools to their digital systems.
These are all potential factors that could reverse international performance, and there are others that they could help set in motion. For example, the persistent strength of the US dollar has hindered the returns of US dollar-denominated investors in international markets, but as international risks dissipate, the dollar may also reverse. A weaker dollar would provide an additional tailwind to investing overseas—just as it did when international markets outperformed throughout the early ’00s. For all these reasons, international markets are a rich hunting ground for high-quality companies with attractive long-term growth prospects and, because of how unloved they have been lately, enticing valuations. No one can say when or how the market inflection will occur, only that history shows it is likely to do so. If that day were to arrive tomorrow, it would be too late for investors with low allocations to non-US equities to reposition their portfolios effectively. And so, for the question we are so frequently asked—“Why international?”—the most succinct answer is this: Because nothing lasts forever.
