This asset class is outperforming U.S. stocks in 2023, and you may be missing out

If you’re a long-term investor and you don’t own any international stocks in your portfolio, now might time to add some.

“International stocks are set up quite well,” says Ross Mayfield, an investment strategy analyst at Baird Private Wealth Management. “If you’re heavily [allocated] to U.S. stocks, you may want to revisit why that is, and whether a more diversified approach would be appropriate.”

So far this year, the MSCI EAFE index, which tracks the performance of foreign stocks from developed economies, is off to a hot start. The index has returned about 6.6%, compared with a 1.8% return in the S&P 500 index. It’s a continuation of a relatively strong 2022 in which foreign stocks shed 14.5% compared with an 18% loss for U.S. names.

Here’s why experts say it’s worth holding some international names this year and beyond.   

Why international stocks have been good recently

Investing experts point to a handful of factors that have boosted the performance of international stocks of late.

1. A slowdown in the U.S. dollar

Because the greenback is the dominant currency of international commerce, its strength generally coincides with difficult economic conditions abroad. A strong dollar saps returns that U.S. investors receive from foreign investments, since whatever profits those companies earn in local currencies are converted into fewer dollars.

That was the story for much of 2022, with the dollar growing stronger against a basket of foreign currencies, peaking in late September. But amid U.S. economic uncertainty and hikes to interest rates, the dollar has receded in value since.

“The dollar went on a run of historic proportions earlier in 2022,” says Keith Buchanan, senior portfolio manager at GLOBALT Investments. “Now that it’s come back down, it’s relieved a lot of the pressure on international stocks.”

2. A warmer-than-expected winter

Russia’s invasion of Ukraine early last year had international market watchers fearing the worst. Not only could the geopolitical situation sow chaos in the region, but a shortage of Russian oil and natural gas exports could spark an energy crisis for a continent trying to heat homes during a harsh winter, analysts said.

This winter isn’t over, but so far, it’s been warmer than expected, taking some pressure off European energy infrastructure.

“The idea became widespread that Europe wasn’t heading into a recession but a depression,” says Liz Young, head of investment strategy at SoFi. “It hasn’t been as bad as expected. The Armageddon situation we feared no longer needed to be priced in.”

3. A favorable mix of stocks

U.S. stocks have enjoyed a prolonged period of outperformance, but that allowed certain segments of the U.S. market to become overvalued, says Young. “International valuations were lower. They had less to lose,” she says. “They didn’t experience that same froth in the aftermath of Covid.”

Among U.S. stocks, the biggest losers of the current downturn have been some of the market’s most growth-oriented stocks, such as those in the technology and consumer discretionary sectors.

“The sector mix for international stocks is more compatible with the economy we’ve seen,” says Mayfield. “It’s a little more defensive. It’s a lot of what’s worked recently.”

Why foreign stocks are worth holding going forward

This wouldn’t be the first time foreign stocks took the lead over their American counterparts.

“In the early 2000s, international outperformed the U.S. It was a lost decade for U.S. stocks following the dotcom bubble,” Mayfield says. “These tend to be longer, sweeping cycles.”

Saying that the market is at the beginning of another long cycle of international outperformance is premature, but many of the factors that contributed to foreign stocks’ recent outperformance are still in place, says Young.

And emerging markets — foreign stocks that are generally considered risky, but that are thought to come with more promising growth prospects — may be the biggest beneficiaries.

But just because analysts think international stocks are in a good position isn’t reason enough to buy. Rather, it makes sense to hold an allocation to foreign stocks because they provide valuable diversification to your portfolio.

International stocks can give a lift to your stock portfolio when U.S. stocks are stuck in the mud. Over the long term, this should smooth out volatility in your stock market returns, investing experts say.

“It’s hard to justify a position in an asset class that’s been underperforming,” says Mayfield. “But there is always a benefit in diversification.”

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