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Will U.S. Equities Continue to Trounce Non-U.S. Equities? 2

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Will U.S. Equities Continue to Trounce Non-U.S. Equities? 2 January 2020 TINA BYLES WILLIAMS WILL U.S. EQUITIES CONTINUE TO PORTFOLIO MANAGER TROUNCE NON-U.S. EQUITIES? CIO & CEO For global equity investors, the decade ending on December 31, index for currency; and we evaluated the local currency per- 2019 was undoubtedly the American decade. The performance of formance variance of the equal weighted sector index vs. the U.S. equities more than doubled and in many cases tripled other actual index to determine the impact of sector variance. The countries and regions such as emerging markets, that dominated residual reflects performance that is unexplained by either cur- the prior decade (CHART 1). If their non-U.S. assets were unhedged, rency or sector composition. dollar-based allocators’ performance would have been further weakened by currency translation, as over the last decade, the U.S. Sector composition variance was responsible for a 4.3% aver- dollar appreciated by 28%. Consequently, some allocators are re- age annual performance advantage; whereas the greenback’s visiting the wisdom of their non-U.S. allocations. appreciation added 1.5%. While the contribution from currency varied over time; the U.S. index’s sector composition was the most consistent source of relative performance (CHART 2 and CHART Stock Market Returns By Country CHART 3). The residual factor tended to reflect country or re- 1 2010 to 2019, % Total Return, USD gional level idiosyncrasies. For example, U.S. equities experi- 300% enced positive residual effects in 2011 as a result of the Europe- 256 an debt crisis and in 2019 as a result of geopolitical uncertainty 250 associated with the trade war and Brexit. 200 150 CHART Attribution of the Relative Performance of U.S. vs. 94 Developed Non-U.S. Equities 76 2 100 72 2010 to 2019, % 49 46 50 Total Excess 10.0 0 U.S. Japan Europe China Emerging India Markets Currency 1.5 Source: FIS Professional Estimates and Factset Sector Variance 4.3 In this paper, we show that the past decade’s relative perfor- Residual 4.4 mance of U.S. vs. non. U.S. equities was driven by three main factors: sector, currency effects (as a result of the U.S. dollar’s 0 2 4 6 8 10 12% post-2011 bull run), and U.S. companies’ capital structure man- agement in an era of declining interest rates. While some of these contributions to returns may continue in the near-term, Source: FIS Professional Estimates and Factset the outlook for their persistence over the next decade looks in- creasingly suspect, and would likely defy substantial historical CHART Attribution of the Excess Return of U.S. vs. precedent. In looking out over the next decade, we are guided 3 Developed Non-U.S. Equities Over Time both by evidence that suggests that allocators would be wise to 2010 to 2019, % maintain a broad geographic diversification within their equity 20% portfolios that includes both passive and active components. 10 1. U.S. SECTOR COMPOSITION DROVE OUTPERFOR- MANCE 0 Over the last decade, U.S. equities outperformed developed non-U.S. equities by an average annual rate of 10%. In order -10 to gauge the impact of two major sources of variance, currency 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 and sector composition, we evaluated the difference between Sector Variance Currency the local currency and dollar-based return of each respective Total Excess Residual Source: FIS Professional Estimates and Factset Philadelphia | Chicago FIS GROUP | www.fisgroup.com | 215.567.1100 WILL U.S. EQUITIES CONTINUE TO TROUNCE NON-U.S. EQUITIES? 2 For emerging markets, the picture was similar, but because of CHART Attribution of the Relative Performance of U.S. vs. 4 Emerging Non-U.S. Equities the significance of residual effect, less clear. Over the last de- 2010 to 2019, % cade, emerging market equities underperformed U.S. equities by an average annual rate of 10.8% (CHART 4). Sector com- position variance was responsible for a 3.2% average annual Total Excess 10.8 performance advantage; whereas the greenback’s appreciation led to a 1.8% average annual performance edge. What renders Currency 1.8 these results more ambiguous is the size of the residual or un- explained factor. In addition to the sources of residual risk men- Sector Variance 3.2 tioned above, we believe that the higher residual for emerging markets stocks is attributable to two factors: 1. Lower correlation among emerging markets than among developing markets, Residual 5.9 which leads to greater idiosyncratic market risk at the country and currency levels; and 2. Higher stock-specific idiosyncratic 0 2 4 6 8 10 12% risk; neither of which would be well captured by our index level analysis. Source: FIS Professional Estimates and Factset For the attribution relative to Emerging Markets, the market de- cline prompted by the Fed Chairman’s 2013 announcement that CHART Attribution of the Excess Return of U.S. vs. QE was ending also generated a positive residual effect for U.S. Emerging Non-U.S. Equities Over Time 5 equities (CHART 5). At the security level, we also believe that 2010 to 2019, % U.S. companies’ capital structure and the impact of share buy 40% backs were another source of idiosyncratic risk relative to non- 30 U.S. companies that would not have been captured in our at- tribution analysis. This latter effect is discussed in greater detail 20 in SECTION 2. 10 The key question for asset owners therefore is are there cycli- 0 cal, secular and/or fundamental factors that will challenge the -10 performance leadership of these companies? We argue that 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 there are. Moreover, the performance history of “hot” market segments in the subsequent decade should give investors fur- Sector Variance Currency ther caution. Total Excess Residual EVALUATING THE DURABILITY OF U.S. EQUITIES’ SECTOR Source: FIS Professional Estimates and Factset ADVANTAGE CHART MSCI USA vs MSCI EAFE Active Sector Weights U.S. equities’ materially larger exposure to companies in the 6 2010 to 2019 Technology, Consumer Discretionary, Healthcare sectors and more recently, the Communications Services sectors was the 20 most significant driver of their outperformance. Indeed the 15 only other decade in which U.S. equities outperformed an equally weighted country portfolio of major equity markets 10 was the 1990’s, which was also dominated by technology stocks. 5 CHART 6 and CHART 7 (on the next page) respectively evaluate the sector composition variance of the MSCI U.S. index vs. de- 0 veloped and emerging non-U.S. equity indices. -5 Relative to non-U.S. equity indices, U.S. equity indices have -10 significant active weights to healthcare, technology compa- 2000 2010 2020 nies and more recently, communication services (which houses Information Technology Financials erstwhile technology companies such as Alphabet and Netflix). Health Care Consumer Staples Non-U.S. equity indices have a much greater weight to compa- Real Estate Industrials nies that are classified in the financial, industrial and materials Utilities Energy sector. CHART 7 (on the next page) demonstrates similar vari- Materials Consumer Discretionary ances relative to emerging markets with the exception that the Communication Services U.S. index’s active weight to healthcare is more pronounced. Source: FIS Professional Estimates and Factset Philadelphia | Chicago FIS GROUP | www.fisgroup.com | 215.567.1100 WILL U.S. EQUITIES CONTINUE TO TROUNCE NON-U.S. EQUITIES? 3 For most of the post GFC period, cyclical growth has under- CHART MSCI USA vs MSCI EM Active Sector Weights whelmed and financial companies, particularly those outside of 7 2010 to 2019 the U.S., have battled to repair their balance sheets. Whereas defensive companies such as healthcare and organically grow- 15 ing companies with strong balance sheets such as technology 10 and consumer discretionary companies, have thrived (CHART 8). 5 It’s also worth noting that the growing utilization of passive ve- 0 hicles such as ETFs has further fueled fund flows into popular mega-cap growth stocks. Over that time, the investment en- -5 vironment has become more index, sector and factor focused, with new ETFs continually being launched to take advantage of -10 the ‘hot’ market segment of the time. The table below depicts 2000 2010 2020 the 10-year asset growth in the five largest ETFs today. These Information Technology Financials five comprise almost 30% of the almost 4 trillion dollar ETF mar- Health Care Consumer Staples Real Estate Industrials ket. Unsurprisingly, these ETFs are among the top holders of Utilities Energy the popular mega-cap stocks that drove U.S equity performance Materials Consumer Discretionary since 2010. And if you look at the top owners of the outstanding Communication Services shares of Facebook, Apple, Amazon or Alphabet today, the three ETF giants (Blackrock, Vanguard and State Street) own a whop- Source: FIS Professional Estimates and Factset ping 14 to 17% in their funds (TABLE 1). CHART Cumulative Performance of S&P Sectors over the TABLE Top 5 U.S. Equity ETFs by AUM 8 Last Decade 1 Information Technology 335 % of Fund in Consumer Discretionary 317 Share of Microsoft, Apple, Health Care 217 2010 2020 Total U.S. Alphabet, Industrials 170 Security AUM AUM AUM Equity ETF Amazon, Real Estate 159 Financials 154 Ticker Name ($B) ($B) Increase Market Facebook* Consumer Staples 133 SPY SPDR S&P $87 $317 364% 10% 17% Utilities 109 500 ETF Materials 89 IVV iShares $22 $208 945% 7% 17% Consumer Staples 69 Core S&P Energy 3 500 ETF 0 50 100 150 200 250 300 350 400% VTI Vanguard $13 $144 1075% 5% 14% Source: FIS Professional Estimates and Factset Total Stock Market VOO Vanguard $30 $135 455% 4% 17% S&P 500 ETF QQQ Invesco $19 $90 486% 3% 44% QQQ *13% of U.S.
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