First Eagle: Finding Balance In International Equity MarketsJacob Wolinsky
First Eagle Investment Management's new white paper, “Finding Balance in International Equity Markets.”
Q4 2020 hedge fund letters, conferences and more
The article looks at domestic returns and suggests the COVID-era bull market may have left some portfolio allocations out of balance. The key takeaways:
- Years of US equity market outperformance has left portfolios benchmarked to the S&P 500 highly concentrated and susceptible to risk
- The reflation leg of the new bull market appears driven by expectations that 2021 could feature a reopening of the economy and ample fiscal support
- The dollar has been trending lower. Periods in which the dollar has weakened have traditionally supported non-US equity markets and dollar-based portfolio typically get a boost from FX effects
- First Eagle leans on decades of global stock-picking experience and a flexible, benchmark-agnostic approach to build portfolios of companies that span industries, geographies and styles that offer differentiation from the primary indexes and the potential for risk-adjusted returns.
Finding Balance in International Equity Markets
While the outperformance of US stocks in the years that followed the global financial crisis already had been well established, the dominance of domestic equities—notably, mega-cap tech-related companies—during the nascent stages of the Covid-era bull market was the stuff of legend. However, we believe the domestic returns that enlarged the balances of US-heavy portfolios in many cases also increased the risks such portfolios face moving forward. The outsized market appreciation in certain popular stocks and sectors, if left unaddressed over the years, may have driven asset allocations off-kilter.
With US markets priced for perfection in a world that remains anything but, now may be a good time to review portfolio allocations to ensure adequate balance. Interest in foreign stocks appears to have been gaining traction in recent months in conjunction with a “reflation” trade distinguished by a pro-cyclical rotation away from mid-2020’s high-flyers and into some areas of the global equity markets that had been lagging, including non-US equities. This brief international renaissance has generally been particularly beneficial for overseas exposures held in US dollar-based portfolios, as a weakening greenback—in a steady downturn since late March 2020—has amplified the performance of such allocations.
Bull Markets and Their Dislocations
While the decade-plus bull market of the 2010s was a very fruitful period for US stocks—and tech-related US stocks, in particular—the initial stages of the post-pandemic rebound in 2020 represented a bumper crop. From the market bottom on March 23 through the end of August—a period of less than six months—the S&P 500 Index returned 58% compared to the 32% climb of the MSCI EAFE Index. The NYSE FANG+ Index, which has surpassed the Nasdaq Composite as the tech-stock bellwether in the eyes of many observers, spiked an unfathomable 111% during this time frame.1
Though one could argue about the magnitude, the bifurcation in performance between US and international stocks made a fair amount of sense given the nature of the economic turmoil that emerged as Covid-19 widened its spread. The pandemic provoked a near shutdown of the more mature, physical components of the economy—sectors like materials, industrials and real estate that account for a larger share of the MSCI EAFE Index than the S&P 500 Index.2 In contrast, the pandemic-driven shift online for both business and personal commerce accelerated preexisting trends and provided a significant boost to new-economy growth stocks with strong online presence, which is characteristic of some of the larger sectors within the domestic equity market.
While investors would be hard-pressed to complain about US market return trends—whether tracing back to 2009 or to the beginning of the more recent bull market—this outperformance has implications for investment expectations moving forward that warrant consideration.
Lofty prices and multiples for US equities. As shown in Exhibits 1 and 2, the post-crisis surge in US stocks has driven the price of the S&P 500 Index relative to the MSCI EAFE Index to levels far above those seen previously, while the relative valuation of these two indexes has gapped to multi-decade wides. While conclusions drawn from index-level metrics can sometimes be misleading, particularly for active investors focused on bottom-up portfolio construction, basic arithmetic suggests that expected future returns for today’s highfliers will be lower unless these companies can further improve upon their pandemic-fueled fundamentals or expand their already-high price multiples.
A top-heavy domestic market. Despite the success of the US market since 2009, there has been a stark divide between the haves and have-nots over this period. Though the S&P 500 Index appreciated more than 500% during the bull market that emerged from the ashes of the global financial crisis—officially, from March 9, 2009, through February 19, 2020—the aggregate price appreciation of the information technology, consumer discretionary and financial sectors was greater than that of the other eight sectors of the index combined.3
Similar division could be found following the Covid-related selloff, and the domestic market’s recovery from its bear-market bottom was notable for its lack of breadth. While the S&P 500 Index as a whole reclaimed its high a mere 106 trading days after its March 23 low, only 40% of the names within the index could make the same claim; this compares with a 60% rate following the 2007–09 bear market, over a recovery period of more than 1,000 days. On a market-cap-weighted basis, 59% of the S&P 500 Index recovered during the post-Covid period, driven primarily by FANG+, information technology and health care stocks; the bull market that began in 2009 saw 75% of the index by market cap recover, with broad-based participation across sectors.4
These dynamics have culminated in an extremely top-heavy US equity market. As shown in Exhibit 3, the five largest stocks in the S&P 500 Index—Apple, Microsoft, Amazon, Google (Alphabet Class A and Class C combined) and Facebook—comprised 22% of its market capitalization as of year-end 2020 after years of steady growth. Excluding the contribution of these five names from the S&P 500 Index’s 2020 performance would slash the index’s return by about 760 basis points.5 The MSCI EAFE Index, in contrast, has seen only minimal change in its leaders’ share of the market over the years.
Many S&P 500 Index-benchmarked vehicles—passive investments in particular—designed to provide diversified exposure to the US equity market, in our view, bear both significant single-stock and sector risk as a result of these changes to the index’s composition. For example, information technology represents 28% of the S&P 500 Index, a percentage that doesn’t include companies like Amazon, Facebook and Google that are bucketed in other Global Industry Classification Standard (GICS)6 sectors but have tech embedded deep within their DNA.7 High concentration within indexes makes true diversification more difficult for traditional benchmarked portfolios and in our view leaves them more susceptible to idiosyncratic risks. On the other hand, selective portfolios with flexible, go-anywhere mandates may be able to identify differentiated sources of risk and return.
Strategy drift. The substantial outperformance of US equities over the past 12 years may have skewed geographic portfolio exposures that were established to leverage the benefits—including potentially better risk-adjusted returns over the long term—historically available through foreign markets subject to varying economic fundamentals, interest rate regimes, political conditions, risk factors and other endogenous performance drivers. By virtue of nothing other than index performance, investors who entered the post-financial crisis bull market with an equity allocation consisting of 70% domestic stocks and 30% international stocks would have ended 2020 with a ratio closer to 85/15, undermining the pursuit of global diversification and leaving investors with the outsized risk exposures mentioned above.8
“Reflation” Trade Fuels Market Rotation and Pressures US Dollar, to the Benefit of International Stocks
Post-financial crisis trends can make it easy to forget that the relative performance of domestic and international equity markets historically has been cyclical. For example, while the 2010s were dominated by the US, the MSCI EAFE Index outperformed the S&P 500 Index in the 2000s on a total return basis, 12.38% versus -9.1%. It’s also worth noting that the MSCI Emerging Market Index, which does not overlap with the MSCI EAFE Index but whose stocks often fall within the investment scope of many global and international equity mandates, delivered a total return of 162% during the first 10 years of the new century, crushing both developed market indexes.9
We do not attempt to time or predict the direction of markets, but ample historical precedent suggests it’s reasonable to believe that the recent run of US dominance will end at some point and international equities will again assume leadership. In fact, signs of a nascent market transition—not just from US stocks to international stocks, but also from growth to value and from large caps to smaller names—emerged in September 2020 as reflation expectations took hold of investor sentiment and fueled the next leg higher in equity markets.
Exhibit 4 overlays the S&P 500 Index price level with the size of the Federal Reserve balance sheet. As depicted, unprecedented central bank intervention in March—which was complemented by significant fiscal commitments from federal governments and other forms of support for markets, economies, businesses and individuals—brought the pandemic-driven freefall in stocks to a halt and served as the spark for a new bull market. By summer, however, the monetary and fiscal impulse had begun to level off, and markets, seeking direction, traded sideways in volatile fashion for several months. Equities appeared to find their orientation in September, however, as upbeat news on vaccine progress and a potential “blue wave” in November’s elections had markets hopeful that 2021 would feature both a reopening of the economy and ample fiscal support.
This optimism was manifest across financial markets. While global stock markets rotated into the more cyclically sensitive areas mentioned above, the bond market saw inflation expectations—as reflected by the 10-year TIPS/Treasury breakeven rate—approach and ultimately push through the Fed’s 2% target while the Treasury curve steepened to its highest level since 2017.
These renewed inflation expectations put further downward pressure on the US dollar, which has seen its fortunes change markedly over the past year. The greenback strengthened through the early dislocations of the pandemic as investors sought perceived currency “safe havens” but has trended lower since. This has been due at least in part to the Fed slashing its policy rate to near zero in March 2020, which narrowed interest rate differentials between the US and other economies and diminished the appeal of the dollar carry trade.
While we don’t maintain a specific forecast for the dollar or any other currencies, there are reasons beyond the loss of the dollar carry trade to believe that the dollar’s recent weakness may not be transitory. The country’s already large “twin deficits”—its budget and current account deficits— ballooned as a percentage of GDP with the monetary and fiscal stimulus enacted in response to the Covid-19 pandemic and seem unlikely to contract meaningfully anytime soon given current policy rhetoric.10 In addition, the US money supply has been growing at a much faster rate compared to other developed markets, further debasing the value of man-made money; M2 money supply in the US grew 25.8% in the 12 months through end-January 2021, while the broad monetary aggregates for Japan and the euro area grew 9.4% and 12.3%, respectively.11 Though these measures, in conjunction with an efficient vaccine rollout, may support US economic outperformance in 2021, we know there’s no free lunch in economics.
A historical perspective, meanwhile, suggests that currency cycles tend to be durable in nature. As shown in Exhibit 5, the last six periods of prolonged dollar weakness or strength have lasted an average of 8 years (or 96 months). Also evident in this graph is the inverse relationship between the dollar and international equity performance, with the latter leading during periods of dollar weakness and lagging during period of dollar strength.
While relative market performance is influenced by a multitude of factors beyond currency movements, a weakening greenback serves as a tailwind for US dollar-based investors in foreign equities. The potential benefits of this dynamic have been plain in the young bull market. From the March 24, 2020, market bottom through the end of February 2021, the MSCI EAFE Index delivered a dollar-denominated total return of 63% compared to a local-currency return of 45%—an 18% pickup—as depicted in Exhibit 6. This result compares quite favorably with the S&P 500 Index gain of 73% during the period, despite the large head start ceded to the domestic index. Since September 1, the MSCI EAFE Index in dollar terms has easily outpaced the gain of the S&P 500 Index, 14.3% to 9.7%. A similar currency effect can be seen in the performance of the MSCI Emerging Markets Index, but to a lesser degree.
The recent pro-cyclical rotation into previously unloved areas of global equity markets may represent the start of a broader reversion to long-term means—or it may not. Regardless, at First Eagle we will continue to invest our clients’ assets as we always have, with our true north oriented around the construction of all-weather portfolios that seek to create resilient wealth and mitigate the permanent impairment of capital in the face of complexity and uncertainty.
First Eagle has long held that the US does not have a monopoly on good companies, and for more than 40 years we have actively sought to establish and maintain strategic allocations to high-quality businesses worldwide.12 We cast a wide net to identify individual companies—independent of domicile—with scarce, durable assets that we believe have the potential to generate persistent earnings power over time, and we seek to acquire these businesses only when available at a market price that represents a “margin of safety,” or discount to our estimate of intrinsic value.