Foreign stocks have underperformed US stocks significantly since 2009. From January 2014 to December 2016, for example, the MSCI EAFE, a foreign stock index, declined 10% while the S&P 500, a US stock index, increased 20%. However, this trend appears to be reversing in 2017, with foreign stocks posting stronger returns that US stocks for the first time in seven years.
Source: Yahoo! Finance
In fact, so far in 2017 the MSCI EAFE has doubled the performance of the US stock, increasing more than 12% year-to-date. This has caused many investors to take note and explore the possibility of increasing their allocation to foreign stocks. However, before taking action it is important to look at the drivers of the recent foreign stock outperformance in an attempt to assess whether this trend may be sustainable.
One of the factors that has aided US stock outperformance in recent years in the increase in the value of the US dollar. From January 2014 to present, the US dollar increased over 23% against other major currencies. Therefore, US investors who invested in foreign assets that are denominated in foreign currencies experienced a 23% loss on the currency conversion. In 2017 the value of the US dollar has decreased 1.5%, creating a tail-wind for foreign investments. Given the current high value of the US dollar compared to other currencies, this trend may continue.
Second, economic data outside the US has improved in recent months. Both European countries as well as Emerging Market countries, such as China and Brazil, have reported better economic growth recently. This may be a sign that those economies are reaccelerating after several years of fairly stagnant growth.
Third, political risk appears to be waning outside the US. The European elections held this year both in the Netherlands and France have signaled a commitment to remain in the European Union and a willingness to continue to embrace globalization and open borders. This may reduce the perceived increase in risk that resulted from the Brexit vote in mid-2016. Reduced political risk may allow the companies based in the countries in question to attract capital from foreign investors.
Many foreign countries may be in an earlier stage of the economic cycle than the US. In the US the Federal Reserve is actively increasing interest rates, a sign that the US is in the late growth stage of the economic cycle. Many foreign central banks have continued to hold interest rates low as economic growth starts to rebound. This may be a sign that many foreign countries are in the early or middle stage of the economic growth cycle. This may be a sign that foreign economies have a longer period of economic growth ahead.
Investing in foreign stocks comes with increased risks when compared to investing in domestic stocks. However, foreign stocks can also be an important risk management tool as they can increase diversification. It is important to balance these factors when weighing the economic and financial trends that may influence foreign stock performance in the future.