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US investors should get some international exposure

Only 45 percent of American citizens have a passport, which implies that 55 percent of Americans only travel domestically. Slowly, however, Americans are warming up to the virtues of international travel, as 2016 was a record year for Americans traveling overseas.

Similarly, many U.S. investors are disinclined to look outside of the United States for investment opportunities. The U.S. economy is the single largest economy in the world, which makes investors believe there is little to gain from venturing elsewhere. However, there are three crucial reasons why investors should ensure they have a meaningful allocation to international equities in their portfolios.

1. The world is a big place. The share of the global economy found outside of the United States has been steadily rising, from 78 percent in 1990 to 85 percent in 2016. The ability to invest in that overseas growth has also increased, with international markets now representing 60 percent of global public capital markets, compared to 53 percent in 1990. This trend is set to continue, yet international equities and bonds represent only 21 percent of U.S. investors’ portfolios.

2. Protection is key. Investing internationally helps to diversify a portfolio. Overseas markets move up or down based on local developments that affect domestic company fundamentals; what may affect a U.S.-based company may not be relevant to a Brazil-based company, for example. As a result, the correlation between U.S. and international equities tends to be fairly low outside of crises.

It’s important to remember that while investing in U.S. companies that have a significant portion of their revenues coming from abroad may sound like a solution, the only way to truly be insulated from U.S.-specific fluctuations is by investing in international directly.

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3. Variety is the spice of life. An equity portfolio that has both U.S. and international should have a better risk-and-return profile than a U.S.-only portfolio because it taps into a wider opportunity set and has lower correlations between assets. However, over the past 15 years the result was not particularly encouraging, with the addition of international equities not providing enough additional return to justify the higher volatility. This was due to the poor performance of developed markets ex-U.S. during this time.

Over the next 10 to 15 years, U.S. equity returns will likely be lower than in the past, given a continued low-growth environment and current elevated valuations. A possible way for investors to achieve similar returns to those provided by U.S. equities in the past is to have a meaningful allocation to international.

Oftentimes, common fears get in the way of larger, international exposure. So why would international actually deliver? Investors may wonder whether the future will look different for international investing or whether it is a tourist trap. Three factors suggest that international equities are actually a hidden gem: growth, earnings, valuations and currencies.

Investors have gotten used to thinking that the United States is the only worthwhile place to visit. Indeed, the U.S. economy has seen steady growth for eight years since the global financial crisis, while other regions were beset by issues such as a double-dip recession in Europe caused by the sovereign debt crisis and a slowdown in emerging markets as a result of the commodity price collapse. However, after several improvements many regions are now attractive places to visit once again. In fact, the greatest acceleration in growth is happening abroad in regions in earlier stages of their expansion relative to the United States.

From 2011 to 2016, the challenges faced by other economies resulted in U.S. earnings growing faster than international ones. However, with the improvement in global growth beginning in early 2016, international earnings are now starting to grow faster than those in the United States. While U.S. companies have been reporting record-high earnings since 2011, emerging market earnings are still 32 percent below their previous peak, and euro zone earnings are still 74 percent below theirs. With the encouraging acceleration in economic growth, we can expect these gaps to continue to close.

With the U.S. bull market now well into its ninth year, U.S. equities are no longer cheap, both in absolute terms as well as relative to other equity markets. In general, overseas markets tend to trade at lower valuations, but international is close to the cheapest it has been relative to the United States in 15 years.

From mid-2011 to late 2016, the U.S. dollar strengthened close to 30 percent against developed and emerging currencies. For U.S.-based investors, this meant that converting their foreign returns into U.S. dollars resulted in lower numbers because the foreign currency had gotten weaker. Looking forward, we believe we are at the beginning stages of a long move down for the dollar as a result of better global growth, narrowing interest-rate differentials, more stable commodity prices and a persistent U.S. current account deficit. This weaker-dollar environment would provide a boost to international returns.

The strong run in international markets over the past year may leave investors wondering if they are too late. We believe we are still in the early stages of international equity outperformance. Comparing U.S. and international equity performance since the global financial crisis, it is clear that the recent move up in international is still only a drop in the bucket. U.S. equities have returned more than 150 percentage points more than their international counterparts during this time, with international not yet having recovered to its pre-crisis peak.

The feeling may be that everyone is talking about international now, so isn’t it already packed? Increasingly, positive international developments are receiving the attention they deserve. As a result, investors worry that international equities are already a “consensus trade,” but U.S. investor equity positioning has barely changed, meaning investors have yet to take action.

While opportunities still exist in U.S. equities, investors should ensure they have enough exposure to international equities. Over the next decade, a meaningful allocation to international will be crucial to improve overall equity returns. Many investors still underestimate the strength of the global economy and overestimate their exposure to international. U.S. portfolios are still overly concentrated in U.S. equities at a moment when international economic and earnings growth is accelerating, valuations are cheaper abroad, and the currency may provide a tailwind to returns.

Fundamentals suggest that the euro zone and emerging markets, specifically cyclical sectors within these regions, look particularly attractive.

— By Gabriela Santos, global market strategist at J.P. Morgan Asset Management

Source: Investment Cnbc
US investors should get some international exposure

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