May 13, 2017

With so much news and commentary these days focused on politics, some people might not realize that there's been a noticeable strengthening of the global economy.

Below are a couple of charts to support this point. The first shows global manufacturing Purchasing Managers' Index (PMI), an economic indicator which you can see from the chart correlates well with economic growth. Global PMI has increased pretty steadily over the past year, and now sits at a 6-year high:
 


The next looks at a similar PMI measure for Europe. This one looks especially interesting, as it has broken rather decisively out of recent doldrums and is now nearing pre-Euro crisis levels:
 

A year ago, the mainstream press and most investors were negative on international economies and wanted nothing to do with their stock markets. But since that time, there's been clear improvement in those economies, and international stocks have done very well in response.

It's further reinforcement that neither the latest headlines nor the rear-view mirror are reliable sources of information about what's going to happen next.

So, we can't say what lies immediately ahead. Maybe the global economy will continue to improve, and maybe that will be a catalyst for further "catch-up" gains in international stocks. But we don't know — so as plausible an idea as that is, we wouldn't want to depend on it, because catalysts and timing are basically impossible to reliably predict. We are in these investments for the likely long-term returns, and the best way to predict those is not with near-term economic forecasts, but with valuations.
Long-term return prospects look good for international stocks, less so for US
Fortunately, despite recent gains in international stocks, their valuations still look reasonable — especially when compared to US stocks.

We've often shared the return forecasts published by Research Affiliates (RA), an institutional asset manager that employs a highly effective valuation-based methodology to estimate long-term returns. Here are their latest inflation-adjusted return estimates for stocks in the decade to come:
 

(We should note that we factor multiple return forecasts into our investing process, not just RA's. But for the purposes of this letter, RA's are a good representative example: they are based on reasonable and well-defined assumptions, they take valuations into account, and they have a very solid long-term record of forecasting accuracy.1)

RA's research projects a pretty stark difference in the outlook for US and non-US stocks. Based on their estimates, foreign stocks are likely to provide long-term returns between roughly 5%-7% before inflation, while US stocks are poised to barely outpace inflation.

If US investors are hoping for help from the bond side of the market, they may be disappointed. RA estimates that with valuations and yields where they are now, the "classic" US-based passive mix of 60% stocks/40% bonds is likely to return less than 1% per year above inflation over the next decade. (RA puts the probability of this portfolio achieving a 5% real return — which many investors use as a default assumption — at just above 0%).2
Yet, investors are loaded to the gills with US investments
Based on the much more favorable return prospects for foreign stocks, it seems prudent to emphasize international investment exposure. But US-based investors are doing exactly the opposite.

The chart below shows that the US accounts for 22% of global economic activity and 36% of global stock and bond market value. By comparison, US investors have 74% of their investments in US assets.
 
Source: J.P. Morgan Asset Management, Openfolio, IMF, ICI

In other words, US investors are heavily overweighting US investments, compared to both market capitalization and economic influence.3 If the RA forecasts described above are on the mark (and historically, they have been1), the average US investor will be facing pretty dismal returns over the next decade.

But for people who are willing to do something different, and to seek out the more reasonably valued areas of the markets even if they've been out of favor, the prospects look a lot brighter.


1 - A description of RA's methodology can be found here; figure 4 of this paper summarizes the long-term accuracy of their forecasting methodology.
2 - Source: RA's 10-Year Expected Portfolio Returns
3 - At least, they were as of 2014, which seems to be the latest available data — but given how markets have done since then, the disparity has probably gotten even worse.