Why international stocks may be an ‘inexpensive hedge’ as S&P 500 outperforms rest of the world

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The S&P 500 has been beating the rest of the world for years, but diversifying geographically may now be “an inexpensive hedge” against a potential correction in U.S stocks, according to Morgan Stanley Wealth Management.

The S&P 500
a gauge of U.S. large-cap stocks, has climbed 6.4% this year based on Monday afternoon trading levels, surpassing the rest of the world’s gains year to date, FactSet data show. Shares of the iShares MSCI ACWI ex U.S. ETF
which invests in international stocks while excluding the U.S., are lagging with just a 1.7% rise so far this year.

“The S&P 500’s extraordinary outperformance of non-U.S. stocks over the past 15 years has convinced many investors that the U.S. is the only game in town,” Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said in a note Monday. 

“To be clear, we believe in the potential of capex-driven, AI-enabled innovation and what we have termed the next American productivity renaissance,” she said. “But valuations of non-U.S. equities versus the S&P 500 are at a 20-year low, and dividend yield differentials are also extreme.” 

Shalett said investors should consider “rebalancing extreme overweights” to U.S. equities with some exposure to Japan, Europe and emerging markets including Brazil, Mexico and India. 

“We see reason for optimism outside the U.S., given fiscal reform, stimulus and monetary accommodation that could catalyze profits in Europe, Japan and select EM countries,” she said.

Read: India is winning over investors as Chinese stocks struggle, these charts show

“With China in geopolitical isolation from the West, Japan’s leadership in Asia is being renewed,” according to her note. Although “China is particularly challenging for investors,” other emerging-market countries have growth catalysts including “structural drivers related to deglobalization of supply chains, constructive fiscal policies and stabilizing politics,” she said. 

Read: U.S. stock valuations stick out in ‘tremendous way’ as S&P 500 beats rest of world

U.S. stocks have much higher valuations compared to international equities, according to Shalett. While the S&P 500’s forward price-to-earnings ratio is over 20.4, the equivalent for the MSCI ACWI ex U.S. is around 13.5, her note shows. 

“That discount of nearly 35%, a 20-year low, is a two-standard-deviation event,” she wrote.  Also, “dividend yields for non-US equities are running above 3% — more than double that of the U.S. benchmark,” said Shalett.

Stocks in the U.S. represent more than 63% of the MSCI All Country World Index, “the country’s largest premium to its relative GDP weight in the history of the benchmark,” according to Shalett. Yet the U.S. has a smaller share of global gross domestic product at 24%, she said. 

While the U.S. may be heading for a “bright” economic future,” diversifying geographically may make sense as valuations of its stock market “suggest significant optimism is baked in” when considering monetary policy, according to her note.

“Over the next two years, U.S. growth and interest rates are likely to converge with global peers, just as relative valuations are extreme,” said Shalett. 

Meanwhile, the Federal Reserve has been holding its benchmark interest rate steady at 5.25% to 5.5% in an effort to bring inflation down toward its 2% target. Many investors anticipate the Fed will begin cutting rates this year, as U.S. inflation has dropped significantly from its 2022 high. 

Read: Should stock-market investors care more about Nvidia or the Fed? Inflation data will provide a test.

‘Hedge affordably’

The Morgan Stanley note also cited “the swelling U.S. deficit,” with Shalett expressing concern over U.S. politics and debt.

U.S. “political and debt sustainability problems may not seem urgent to many, but even modest foreign rebalancing back to home markets could foster volatility that U.S. investors may now hedge affordably,” she said.

Looking at different regions of the world, the iShares Europe ETF
has gained 1.8% so far this year based on afternoon trading levels on Monday. 

As for exchange-traded funds targeting stocks in individual countries, shares of the iShares MSCI Japan ETF
have jumped 7.6% so far this year as of Monday afternoon. 

Among ETFs focused on emerging markets, shares of the iShares MSCI India ETF
have climbed 5.6% year to date, while the iShares MSCI China ETF
have slid 2.8% over the same period, according to FactSet data, at last check. Shares of the iShares MSCI Brazil ETF
are down 4.6% so far in 2024 based on Monday afternoon trading, while the iShares MSCI Mexico ETF
has fallen 2.4% this year.

The U.S. stock market was trading mostly lower Monday afternoon, with the Dow Jones Industrial Average
off 0.1% while the S&P 500 shed 0.2% and the technology-heavy Nasdaq Composite
rose 0.1%, according to FactSet data, at last check. The S&P 500 was slipping after closing Friday at a record high.

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