Market Matters

Why Own Anything Other Than the US?

14 October 2024

8 Minute Read

Inigo Fraser Jenkins Investment Strategist

The US equity market has outperformed the rest of the developed world by more than 215% over the past decade, in common-currency terms. It’s also on track to lead this year. It would be understandable for investors to look at this impressive track record and ask: Why bother owning anything other than US equities? On the other hand, we’re unlikely to see such a dramatic winning margin in the future, so could this be a good time to rebalance portfolios away from the US?

As Of August 31 2024. Source: FactSet and AB

Highlights

US equities have outpaced non-US equities by a wide margin over the past decade, though US valuations are very high today.

US structural advantages include better profitability and favorable positioning with respect to long-term secular forces.

Non-US outperformance is likely to be smaller by historical standards, but allocating to other regions can enhance portfolio diversification.

Let’s take a closer look at the strategic asset allocation case for US versus non-US equities.

A high valuation multiple is the main argument against further US outperformance, because starting valuation is the biggest driver of expected return over long horizons, such as the next decade.

Right now, the US equity market trades at a 51% premium to the rest of the world—nearly an all-time high. US stocks are also trading at a premium of more than 29% versus their own historical average (See display).

However, higher absolute valuation multiples may be justified if investors think (as we do) that real yields are likely to stay low. Also, we believe the US equity market has structural advantages that justify a valuation premium and should help support future equity performance.

US Equity Evaluations are Near an All-Time High

Historical analysis does not guarantee future results.

As of 31 August 2024

Source: FactSet and AB

“

The US equity market trades at a 51% premium to the rest of the world—nearly an all-time high.

As Of August 31 2024. Source: FactSet and AB

US: More Profitable and Younger Population

US firms remain more profitable, with a return on equity of 16% versus 10.3% for EAFE. Near term, earnings growth is a much more important driver for equity returns than mean reversion in valuation, and can justify a premium.

Also, the US may be better positioned to weather secular forces that should pose growth headwinds, including two of the biggest economic and market challenges in the coming decade: aging societies and deglobalization.

United Nations (UN) projections call for the global working-age population to fall by 0.2% per year in the coming decade. If productivity were to stay constant, fewer workers implies slower economic growth. Labor shortages may empower workers to demand higher wages that could pressure corporate margins.

The US has a younger population profile than other developed markets and China. While this benefit will be lower in historical terms, the UN projects that the US working-age population should still be able to grow by 0.3% per year in the coming years (See Display).

US Companies Remain More Profitable

Return on Equity

Historical analysis does not guarantee future results.

As of 31 August 2024

Source: FactSet and AB

“

The US has a significantly younger population profile than other developed markets and China, which should bring a demographic benefit.

Deglobalization, Self-Sufficiency and the AI Effect

Deglobalization could also lean in favor of the US. This process will require companies to rethink supply chains and re-shore a significant portion of manufacturing capabilities. It will also reshape established trade relationships. Again, we think the US has an advantage, given its large domestic market that can compensate for a decline in exports. The proximity of the US to Mexico, with its well-established and cost-competitive manufacturing base, should also bring a benefit.

Also, the US is self-sufficient in energy production and rich in agricultural land and other natural resources. Other large developed economies, such as Germany, Japan and South Korea, rely much more on exports to drive growth while also depending much more on energy and other commodity inputs.

Finally, breakthroughs in AI technology, arguably the most important development of 2023, could play a role. It’s nearly impossible to forecast the full extent of AI’s impact, but it can be argued that the US and its formidable technology sector should be best-positioned to take advantage. Any AI-led productivity boost would translate directly into higher economic growth and profitability for US firms. Faster, more extensive automation could also help alleviate future labor shortages that stem from demographic change and the fragmenting of global labor markets.

Bringing It All Together

Traditionally, long-term market assumptions hold that non-US markets should outperform the US. The rationale is that they have more risk, so investors demand to be paid a higher return in exchange. However, these arguments only hold true in equilibrium, so it’s debatable how much they should drive allocations today given our view that investors face a new regime.

When constructing an equity return forecast from fundamental building blocks, it turns out that the relative benefits to the US from superior growth are smaller than the impact of any assumed mean-reversion in valuation multiples. This is despite the fact that earnings growth, not valuation, has determined relative regional performance in recent decades. The problem is that the timing and extent of any potential mean-reversion is highly uncertain. Mean-reversion is an important tool, but relying on it could risk being wrong for years.

The US enjoys structural advantages, including a more favorable demographic picture, greater resilience to deglobalization, and a sector composition that better enable it to capitalize on the potential productivity benefits of AI. These advantages justify a valuation premium, so we don’t expect the relative valuation of US versus global stocks to decline all the way back its historical average.

This is really about balancing different kinds of risk. There is more mean-reversion risk for US markets, but there is more growth risk for non-US markets. The bottom line is that we see other sources of risk that investors are better off taking, rather than a large position to overweight the US versus other markets. We would rather take risk elsewhere.

We’ve focused mainly on return here, but a hunt for diversification is likely to be more important to investors, because we don’t believe government bonds will be as effective a diversifier as in recent decades. That makes diversifying regionally within asset classes—including equities—more important in portfolios. Deglobalization is mainly bad for investors, but one slight advantage might be the ability to diversify more effectively across regions. The average correlation between regions has been rising for decades, making this technique less effective, but a retreat of globalization could reverse this trend. This could increase the benefit of diversifying across regions.

In Summary...

US equity valuations are high, but structural advantages include more favorable demographics and a better sector profile to exploit AI innovation.

As a result, we expect the relative outperformance of non-US stocks versus US stocks to be smaller than it has been historically, which warrants continued exposure to US stocks.

On the risk dimension, a hunt for better portfolio diversification will make diversifying regionally more important in equity portfolios.

Inigo Fraser Jenkins Investment Strategist

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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