Is U.S. Outperformance Sustainable?
MODERNIST’S ASSET CLASS INVESTING PORTFOLIOS ARE STRATEGICALLY INVESTED WITH A FOCUS ON LONG-TERM PERFORMANCE OBJECTIVES. PORTFOLIO ALLOCATIONS AND INVESTMENTS ARE NOT ADJUSTED IN RESPONSE TO MARKET NEWS OR ECONOMIC EVENTS; HOWEVER, OUR INVESTMENT COMMITTEE EVALUATES AND REPORTS ON MARKET AND ECONOMIC CONDITIONS TO PROVIDE OUR INVESTORS WITH PERSPECTIVE AND TO PUT PORTFOLIO PERFORMANCE IN PROPER CONTEXT.
Investors entered 2024 anxious. Pundits wondered whether the economy would stall or continue to grow while having to endure higher interest rates. It did not stall, and for now it looks like Chairman Powell orchestrated an elusive soft-to-no landing. As a result, the S&P 500 posted its second consecutive year of greater than 20% returns, a feat only accomplished four other times and for the first time since 1991.
Performance over the last decade plus has some investors questioning the merits of investing internationally. U.S. equity market returns have significantly outperformed their international counterparts by an unprecedented magnitude. As a result, a term has moved into the investment lexicon, American Exceptionalism, an expression that promotes the belief that U.S. stock-market outperformance is a function of its superiority.
We are deeply wary of a financial industry that blithely uses supremacist ideological terms like “American Exceptionalism” in any context, especially as America’s capitalist and extractive history has come at an extraordinary cost to so many, all while exacerbating economic inequality globally.
We absolutely believe in the strength and resilience of a globally diversified portfolio. Read on for why an investment portfolio that purports to center “American Exceptionalism” has minimal evidence to support future outperformance compared to a globally diversified portfolio.
What is American Exceptionalism?
Equity investors are acutely aware that the U.S. has outperformed most other countries and regions by a wide margin over the past decade plus. They should also understand that stocks have gone through several cycles throughout history with different segments moving in and out of favor. The last meaningful cycle of outperformance for international stocks occurred from the early 2000s through 2008, following China’s admission into the World Trade Organization.
In fact, this has been one of the longest periods of outperformance between domestic and international stocks in history, pushing the U.S. to a jaw-dropping 66% of the world’s total stock market capitalization, its largest share ever. For some context, the U.S. comprises only 4% of the world’s population and 26% of the world’s economic output as measured by GDP.
(Those numbers should be your common sense clue as to why this out performance won’t last.)
In aggregate, U.S. companies have typically generated stronger earnings growth, are more profitable, have stronger balance sheets, and generate more cash flow than their foreign counterparts. Indeed, U.S. public companies have generated meaningfully higher returns on invested capital relative to most other developed regions, including Europe, Japan, the U.K., and Canada, of approximately 15% versus 10% for the next highest country (Japan).
This could partly be a reflection of a history of a stronger rule of law (now in calamitous decline) and lighter regulatory environment (with long term implications for domestic and global citizens).
Another factor driving stronger performance is that the U.S. equity market is more concentrated in growth sectors, such as technology and communication services, while other countries’ stock markets have higher exposure to the more mature natural resource and utility sectors.
Is U.S. market dominance at risk?
Some signs suggest that U.S. market outperformance is not be sustainable. For starters, nearly one-third of U.S. stock market outperformance since 2010 was driven by multiple expansion (Narayan and Greene 2024), an industry term that essentially means that the valuation of U.S. stocks grew more rapidly than their foreign peers. Stronger growth rates certainly support richer valuations but there are limits to how much more an investor will pay for each dollar of earnings. Moreover, growth rates are starting to converge, with earnings forecasts expecting a more level playing field in 2025.
Another concern involves the U.S. budget deficit, which is expected to grow to $1.9 trillion (6.2% of GDP) at the end of 2025 and debt-to-GDP is projected to reach 120% by 2034. Economists question what the ultimate impact will be of unfettered indebtedness, but we are certain it cannot go on forever.
Finally, the status of the U.S. dollar as the world’s reserve currency is tenuous. BRIC countries (Brazil, Russia, India, China, and South Africa) recently announced a payment system called BRICS Pay to compete with the U.S.’s Society for Worldwide Interbank Financial Telecommunications (SWIFT) system, and the dollar has been losing share of the foreign reserves held by central banks, which has fallen to below 59% from more than 72% at the start of the millennium.
What does this mean for investors?
A look back in history reveals distinct cycles between the performance of U.S. and non-U.S. equities. While U.S. dominance has appeared unassailable until recently, many said the same of Japan in the 1980s or China in the early 2000s. These examples are reminders that long cycles often shift rapidly.
And the winds of change appear to be blowing harder today than ever before. There is friction on multiple fronts. Seldom seen shifts in trade, geopolitics, technology, and innovation support the notion that there could be a new world order. In fact, this is arguably the greatest combination of transformative events since the end of the Cold War.
As much as recent trends could point toward continued U.S. market outperformance, it does not seem timely for an investor to put all their eggs in one basket.
How can investors stay protected?
The recoveries from both the Global Financial Crisis and pandemic produced a period of strong growth and low interest rates. It is not always this easy. Investing environments like today are fertile ground for a change in the status quo. That change is generally uncomfortable but navigable with the right advice. Leaning out too far in any one direction is never a good idea because global markets don’t move in perfect lockstep. Correlations between domestic and international markets vary over time, providing a natural hedge against country-specific economic downturns.
By holding international stocks, investors can spread risk across different economies, monetary policies, and geopolitical environments. This diversification enhances risk-adjusted returns. Global diversification protects against the uncertainty of which economies will outperform in the future. Bottom line: a globally diversified portfolio is a more resilient portfolio, in our view.
