Performance
At the top level, both stocks and bonds moved higher in the second quarter. However, in a reflection of the uncertainty affecting the U.S. economy at large, variance among sub-asset class styles and sectors was high. Large-cap technology companies continued to provide an outsize portion of U.S. stock market growth, while small- and mid-sized stocks fared more poorly. The divergence extended to international stocks; developed markets stocks lost ground while emerging markets posted healthy results. Bonds overall navigated the topsy-turvy interest rate environment well enough to eke out a positive return, but municipal bonds suffered slight losses over the quarter. Alternative assets followed suit: real estate and natural resources stocks posted declines, while commodities rallied higher.
Stocks
The theme of concentration in U.S. stocks (Russell 3000) persisted through the second quarter; an significant amount of year-to-date return has been provided by NVIDIA and other mega-cap tech companies. This phenomenon allowed U.S. stocks to outpace international stocks (MSCI All Country World Index ex-U.S.) over the three months, although both categories advanced. Large-sized (S&P 500) U.S. company stocks were the only cap-weighted portion of the market to move higher over the quarter; their small-sized (S&P SmallCap 600) and mid-sized (S&P MidCap 400) counterparts suffered moderate losses. Internationally, emerging markets (MSCI EM) companies expanded broadly, while developed markets (MSCI EAFE) stocks wheezed to a slight loss.
Bonds
Both short- and long-term interest rates oscillated in the second quarter. No true consensus on the timing and scope of Federal Reserve monetary policy action emerged, which caused bellwether Treasury rates like the 2- and 10-year to bounce up and down several times. Inflation readings and economic growth projections also varied, which led longer-term rates to also fluctuate. Overall, bonds (Bloomberg US Aggregate Bond Index) withstood all the machinations regarding rates to move fractionally higher. If rate cuts from the Fed eventually materialize, the medium-term outlook for the total return of bonds (interest plus capital appreciation) remains positive. But even if rates stay “higher for longer,” the higher current interest component of bond returns should persist.
Alternatives
A significant increase in commodities (Bloomberg Commodity) was not enough to overcome declines in natural resources stocks (S&P Global Natural Resources) and global real estate (FTSE EPRA/NAREIT Developed). As a result, overall alternative assets drifted lower in the second quarter.
Source: Planning Alternatives
Perspective
“The only investors who shouldn’t diversify are those who are right 100% of the time.” – Sir John Templeton
“Diversification is your buddy.” – Merton Miller
Spoiler alert: No investment team on earth, including the team at Planning Alternatives, is right 100% of the time. As a result, following legendary investor Sir John Templeton’s advice, we practice diversification as one of the key disciplines in building client portfolios. U.S. economist Merton Miller didn’t discover (or popularize) the concept of diversification in investing, but he did articulate its benefits in a pithy manner!
The rationale for spreading funds across more than one type of investment is not difficult to understand, but the benefits of diversification can sometimes be challenging to appreciate. Episodes such as the recent sky-high returns of a select group of large-cap technology stocks (see: NVIDIA) can often raise questions about why diversification is a prudent approach. Why not just put all your chips on the hottest company and be done with it?
The short answer is that there are two sides to any investment discussion: what return you expect to achieve, and what level of risk you’re willing to accept in pursuit of that return. Diversification is a time-tested method to mitigate the risk of a multi-asset portfolio, or a suite of stock or bond funds. While diversifying leads to returns never as high as the best performing component, it also avoids tracking as low as the most poorly performing one. Diversification remains the most widely accepted way of seeking the investment performance necessary to meet your financial goals while attempting to stay away from the drastic downturn that can accompany a concentrated strategy.
This diversification primer helps answer an often-asked question: Why invest in international stocks, when the U.S. has outperformed?
First, we cannot predict the future with any consistency. While gauging what sector of the stock market will outperform is sometimes achievable on a one-off basis, it is virtually impossible for anyone to do so with regularity. Therefore, including investments from multiple geographic areas potentially mitigates the risk of poor performance from concentrated positions that often affect market timers. By lowering overall portfolio volatility by using funds that do not perform in lockstep with each other, diversified portfolios can help save investors from the deleterious effects of a wrong decision. As international stocks comprise 57.5% of the worldwide stock market (as measured by global market capitalization), purposefully excluding that much of the globe’s businesses unnecessarily excludes areas that may flourish whenever the next U.S. downturn occurs. Another consideration: although international companies may have their headquarters outside the U.S., some derive a majority of their revenue from sales within our own borders. Excluding them from consideration eliminates the ability to benefit from great businesses that serve American consumers.
Second, U.S. versus International performance tends to alternate in cycles. The chart below shows that Europe, Australasia, and Far East (EAFE) stock performance compared to that of U.S. stocks results in differing cycles of outperformance. Some investors may be surprised to learn that there was a period of more than a year post-pandemic in which EAFE performance outpaced the U.S., even though the trend since the Great Financial Crisis has generally favored U.S. stocks. Aside from the post-GFC era, the last 50 years have demonstrated periods of alternating leadership between domestic and international stock, often lasting for periods of five years or longer. Allowing recency bias to serve as rationale to pull away entirely from international investing runs the risk of missing the inevitable next period of international outperformance.
Third, certain current fundamentals of international stocks appear more attractive than domestic stocks. While we’ve acknowledged that nobody can predict the future, the next chart below shows two reasons why international stocks could be poised for attractive returns moving forward. Both valuations (expressed by the price to earnings ratio) and the dividend yield (total dividends of constituent companies divided by the value of the index) are approaching two standard deviations in favor of international stocks. While one or both data series might revert towards long-term averages, they are signaling a potentially advantageous time for international stocks.
Positioning
While we’ve covered the general benefits of including investments from more than one country in an investment portfolio, there are innumerable ways to implement a globally diversified approach to fund selection. Planning Alternatives remains committed to utilizing international options, while allowing for flexibility to alter our exposure depending on our analysis.
In selecting our core lineup of international stock funds, we rely on a combination of both passive (attempting to match performance of an index) and active (seeking to outperform an index) strategies. This approach results in the use of three main building blocks: passive exposure to developed markets, an emerging markets fund that tracks stocks in developing markets excluding China, and an international active mutual fund that invests in companies across the globe.
For the past two years, we have excluded China from our core emerging markets exposure, primarily due to concerns about the veracity of economic data reported by the Chinese government. Additionally, the often-controlling government influence on both the Chinese stock market in general and certain specific companies does not describe a freely and independently functioning market. This does not mean that we would never entertain resuming a position in China, but the current environment makes it imprudent at this time. We feel that we can achieve a well-rounded cross section of emerging markets companies and countries through our ex-China fund, which in turn helps add to overall diversification.
Our active international selection – Goldman Sachs GQG Partners International Opportunities Fund – has a unique process for vetting stocks. By employing both traditional financial analysts alongside those with non-traditional pedigrees (e.g. former investigative journalists, forensic accountants, etc.), GQG seeks to exploit market inefficiencies to capture the upside of international investing while protecting against sizable downside losses, which they have a sustained track record of accomplishing.
Our baseline ratio of U.S. to international stocks is 75% – 25%, which reflects a sizable home country bias compared to the makeup of the worldwide stock market (see “Perspective” section). As the U.S. market is the largest in the world, with long-standing corporate governance guidelines in place, we are comfortable with an outsized portion of our allocation apportioned here. However, a meaningful allocation to international stocks is warranted for both diversification benefits as well as potential return prospects. We can slide our international exposure higher and lower from the 25% benchmark as conditions warrant.
Including international stocks as part of a globally diversified approach to asset allocation is a hallmark of how we invest money for clients at Planning Alternatives. By using a focused approach comprising both indexed and active strategies, we seek to capture the diversification and return enhancements of international investing while reducing overall portfolio volatility.
Please contact us with questions, or just to chat!