With the U.S. in the tenth year of a historic bull market, foreign stocks have been something of an afterthought for many investors.
It’s not hard to see why. China and other emerging economies have struggled with heavy debt and slowing growth, while in Europe populist politics threaten to upend a decades-long trend toward greater economic integration.
But according to investing pros, neglecting foreign markets may be a mistake. While these stocks have lagged U.S. peers seven out of the past 10 years, in the long run that pattern doesn’t hold. Going back to 2004, it’s effectively a toss-up—foreign stocks have led for seven years and the U.S. for eight.
“Performance—over long periods of time—actually tends to be pretty similar between the U.S. and international stocks,” says Kate Warne, investment strategist at brokerage Edward Jones. “But the leaders and laggards rotate.”
That mismatch may be frustrating when you log on to your account and look at your investment performance, but in the long term it’s good news. It means that by owning both U.S. and foreign stocks you can smooth your portfolio’s overall returns.
In fact, one recent study by fund firm Vanguard, which looked at different mixes of U.S. and foreign stocks over the past four decades, found that portfolios with roughly 30% to 40% in foreign stocks had the lowest overall volatility. If that seems like a lot, consider this: U.S. stocks account for only about 40% of the $79 trillion total value of all stocks worldwide, according to the World Bank.
If you own an all-in-one fund like a target date, chances are you already own some foreign stocks. But if not, or if you want to add exposure, you have several options. Fidelity International Index and Vanguard Emerging Markets Stock Index are among the funds Money recommends. You can also buy exchange-traded funds from firms such as BlackRock (for iShares ETFs) and WisdomTree to target single countries or regions.
Of course, when adding exposure to international markets, it’s worth knowing the idiosyncratic risks and rewards in each region. Here, then, is the 2019 world map for investors with itchy feet.
European markets enter 2019 on edge, in large part because of yet another threat to the continent’s common currency. This time around, the problems are emanating from Italy, where a populist government resisted calls from other European Union members to dramatically narrow its budget deficit. Then there’s the U.K., which voted to leave the EU in 2016 and has spent the past two-and-a-half years debating how to accomplish that.
But if there is a silver lining to all this political uncertainty, it’s that European stock prices already reflect it, leaving plenty of upside if the situation suddenly improves. The iShares Core MSCI Europe ETF trades at a relatively modest 14 times the past 12 months of corporate profits, far below the S&P 500’s 22 times. “Most investors are aware of the risks,” says Warne. “All you need is a little better news, and European stocks could do quite a bit better as investors get more optimistic.”
The weak euro—another by-product of political dysfunction—also offers hope to stock investors. It’s a big plus for European exporters, since their goods are cheaper to customers in the U.S. or anywhere else who want to pay in U.S. dollars. Export-oriented manufacturers, such as consumer goods companies, are a good group to consider for additions to European holdings, says BlackRock chief equity strategist Kate Moore.
The stocks Moore remains wary of, however, are those affected by Brexit. These include not just U.K. stocks, but Irish ones too, since Ireland’s economy is so closely tied to its larger neighbor.
The U.K. faces a March deadline to extricate itself from the 28-nation European Union. If separating its economy from the rest of Europe isn’t difficult enough, the uncertainty is compounded by the fact that, even in the U.K. itself, little consensus exists for what a post-Brexit Britain should look like. Politicians representing the roughly 50% of Britons who don’t want to leave at all have been pushing to keep as much of the status quo as possible, while hard-liners have been agitating for the U.K. to simply walk away from long-standing agreements that give British businesses tariff-free access to European markets.
While Moore thinks the worst-case scenario—a hard-line Brexit without any new trade deal—is unlikely, she says investors should remain skeptical: “It’s fair to ask the question, How long will the uncertainty last?”
Look to the Long Term
One of the first casualties of the U.S. trade war with China was confidence in China’s once-high-flying stock market. Just look at what happened to Chinese Internet giant Tencent Holdings. The company’s stock doubled in 2017—making it one of the world’s most valuable tech stocks—on the back of its popular WeChat app and wildly profitable online financial services business. But in 2018, fears that a trade war could slow Tencent’s plans to expand overseas sent it plunging by more than 30%. Overall, Chinese stocks were down 15% in 2018 and spent much of the year in bear-market territory, down more than 20% from their January peak.
Despite this and other headwinds—like a crackdown on the real estate speculation that had helped fuel the once-relentless pace of China’s GDP growth—the outlook remains bright in the long term, according to analysts. “Growth is slower, but it’s nothing to worry about,” says Taizo Ishida, portfolio manager at mutual fund firm Matthews Asia, citing strong corporate earnings reports: “Property and auto sales are a little bit weak, but if you look at other consumer demand, it’s still pretty resilient.”
Ishida says the sharp selloff in Chinese stocks was an emotional response to talk of a trade war rather than a realistic attempt to gauge the effects of tariffs on Chinese companies’ bottom lines. After all, he adds, companies like Tencent still do the vast majority of their business in China, so the direct impact of tariffs should be limited.
Of course, still more emotional selloffs could be in store for 2019. The effects of the trade war have not yet shown up in Chinese export data, and economists say it’s only a matter of time. What’s more, the Trump administration may make good on its threat to up the ante, slapping 25% tax on billions of Chinese imports, up from the current 10%. If so, the pace of Chinese GDP growth could take a more serious hit.
That said, plenty of investors think the U.S. and China will settle their differences, especially after Donald Trump and Xi Jinping agreed to a 90-day reprieve on new tariffs at their December meeting in Argentina. The trade war is “a headwind,” says Salvatore Bruno, chief investment officer at ETF firm IndexIQ. But, he adds, “to the extent that it gets positively resolved, that could be a huge tailwind.”
Historically, it hasn’t paid off to bet against China. U.S. investors who left Chinese markets for dead after the 1997 Asian currency crisis and 2008 financial crisis lived to regret it. Chinese stocks rose nearly five-fold from 1998 to 2008 and, while down substantially from 2015 highs, remain more than 50% above financial-crisis lows.
One advantage of China’s more centrally planned economy is that policymakers have a powerful array of fiscal-stimulus options they can deploy at short notice to jump-start growth, including construction projects like highways and train lines associated with the New Silk Road, aiming to link China more closely with the nations of Central Asia and Europe.
President Xi will “do whatever it takes” to keep the Chinese economy growing, predicts Quincy Krosby, chief market strategist at Prudential Financial.
Other Emerging Markets
Picking Up the Slack
If the U.S.-China trade war continues, China’s loss could be others’ gain. India’s tea industry was born during the Opium Wars of the 19th century, when Britain had to replace Chinese supplies of the beverage. Today’s trade spat could help China’s smaller Asian economic rivals, including Thailand, Vietnam, Indonesia, and Cambodia, chip away at its dominant place in the global supply chain, says Ishida.
To be sure, some goods—like electronics and computer components—require expensive factories that can take years to build. But production for other less complicated goods like clothing can be moved much more quickly.
There is evidence that is already happening. Jean-Jacques Ruest, chief executive of freight railroad Canadian National, which carries many imported goods from Asia to points in North America, told investors in late October the company was already seeing customers moving their business from China to Vietnam and other Asian nations.
It’s not just Americans, of course, who will stop buying goods because of the trade war. China could also stop buying American products. That could help Brazil, which has already seen soybean production increase after China slapped retaliatory tariffs on exports by U.S. farmers.
Another plus: Brazil’s far-right leader, Jair Bolsonaro, has also promised to reform a pension system seen as disastrous for the nation’s budget. Those reforms and interest rate cuts could set in motion a “supercycle” of growth for Brazil’s banking sector, said strategists at brokerage Morgan Stanley in a recent note to clients.
As ever with emerging markets, there are caveats. The International Monetary Fund has warned that global growth is set to slow in 2019, partly because of new trade barriers. Emerging-markets stocks are more responsive to changes in the economic outlook than their more stable developed-market peers because they borrow money at higher interest rates and because their extraction-heavy economies depend heavily on volatile energy and materials markets.
These nations are also vulnerable to a strong dollar, because they frequently borrow in dollars, then have to convert their local currencies to pay the loans back. That’s especially true for heavily indebted countries like Argentina and Turkey, says Bruno. The dollar is likely to continue rising as long as the Federal Reserve hikes rates more aggressively than other global central banks.
All that said, after struggling through much of 2018, emerging markets’ potential rewards outweigh the risks, according to Edward Jones’s Warne. The average price-to-earnings ratio on the MSCI Emerging Markets Index is 12, compared with 18 for the MSCI World Index, which tracks stocks in 23 developed markets.
A Rising Sun
It’s been five years since Prime Minister Shinzo Abe rode into office on promises to reinvigorate the Japanese economy. After nudging the Bank of Japan to cut interest rates, changing labor laws thought to hamper business, signing trade agreements, and spending billions on stimulus, his efforts are finally starting to bear fruit. Japan is shaking off three decades of a sluggish economy and should reach a more respectable 2.2% growth rate by 2021, said strategists at brokerage Morgan Stanley.
Despite these optimistic signs, the Japanese stock market has continued to lag. An 8% decline in 2018 was not the worst among developed markets, but Morgan Stanley argues that Japanese stocks still do not reflect Abe’s successful battle against long-standing problems like deflation. Japanese stocks trade at 1.35 times their book value, meaning the market prices corporations at only a small premium to their assets. Based on Abe’s reforms, Morgan Stanley puts them at 2.15 times.
A key growth area is Japan’s tech sector. The last time American investors plowed money into Japanese stocks, during a speculative bubble in the 1980s, Japan was at the forefront of technological innovation. Recently Japan has rediscovered this cutting edge, says Matthews Asia’s Ishida.
SoftBank Group, controlled by Japanese billionaire Masayoshi Son, has moved beyond its legacy cell phone business to become one of the world’s largest tech investors with the Vision Fund. Small and midsize Japanese companies are among the leaders in the promising niches of artificial intelligence and robotics.
The shift back to a tech-centered economy could help with a traditionally thorny issue for U.S. investors interested in Japan—the yen. For years there was an inverse correlation between stock performance and the yen. The traditionally strong yen has been a bane to Japanese exporters because it makes Japanese goods more expensive for consumers in other nations to buy. More recently, says Ishida, this relationship has broken down as the new generation of Japanese tech companies has managed to grow regardless of fluctuations in the currency.
An earlier version of the story misstated the new, higher tax rate the U.S. is considering for Chinese imports.