Shifting To International Equities

The biggest recent shift has been a move from U.S. to international equities. At the end of last year, the U.S. accounted for 60% of the equity side of the portfolio, and developed international and emerging markets contributed 40%. By July 31 of this year, the international side had grown to 54%, while the U.S. share shrank to 46%.
“Investors have been rewarded handsomely by overweighting U.S. equities since the financial crisis, with a
cumulative excess return of 100% over developed ex-U.S. equities,” McDonald says. “We think this landscape is shifting, as economic momentum, political stability and currency valuations are starting to favor markets outside the U.S.”

He points out that earnings in the U.S. have fully rebounded from the global financial crisis and are near cycle highs. By contrast, the earnings across EAFE markets are still well below their highest levels. This is generally tied to the delayed economic cycle across Europe, where earnings are still roughly 40% below their prior peak. Despite the outperformance of overseas markets so far this year, fund flows into non-U.S. equity funds were weak in 2016 and only began picking up in April of this year. That trend could indicate that the shift to international securities has only recently begun, and has room to grow.

Equity valuations are also more attractive overseas, and European political risk is receding. “Client conversations around political risk have shifted noticeably over the last two years. After years of defending the European Union from the prospect of breakup, attention is now shifting to the political situation in the U.S.,” McDonald says.

U.S. bonds account for roughly 36% of his fund’s assets. Overseas, bonds offer skimpy yields and face looming currency risk, so the Northern Trust managers have avoided international exposure on the bond side of the portfolio. At 17% of total fund assets, investment grade represents the largest fixed-income sector, followed by high yield at 8%. The fund maintains an overweight position in the latter sector because default rates have been low, and low interest rates continue to help companies shore up their balance sheets.

Looking Ahead
Going forward, McDonald and his co- managers expect the aggregate of global economies to experience modest growth of 2.4% over the next five years. The constraints to global demand include high levels of government debt, especially in China, and aging populations in developed markets. Inflation will remain contained over the next five years, with most developed economies at or below central bank targets of 2%. With automation and increased efficiency keeping prices in check, the challenge ahead will be to maintain inflation, not control it.

In a slow economic recovery, the Federal Reserve might hike rates just once a year. Until other central banks can exit their monetary accommodation programs without too much disruption, the Fed will find it difficult to justify moving policy rates higher and more quickly.

In a nutshell, stocks have room to run, though expectations are that returns will be in the mid-to-upper single digits over the next five years. Economic expansion is likely to be constrained, which should help contain inflation. And given the tepid pace of economic growth, as well as the continued intervention by central banks, the threat of rising rates may not be as onerous as it seems at first glance.

Against this backdrop, McDonald says the best advice is to stay calm. He warns that investors who are planning investment moves in anticipation of the end of the economic expansion or pulling out of the stock market because of concerns about high valuations “will be missing the boat.”