May 4, 2023

Diversification matters – making the case for international equities

MFS Investment Management is the sub-advisor to the Sun Life MFS mutual funds.

In a recent interview with Nicholas J. Paul, CFA, Institutional Portfolio Manager, MFS Investment Management, we discussed the case for international equities. Since the global financial crisis of 2008, U.S. equity market returns beat those in Europe, Japan and emerging Asia. But as the U.S. Federal Reserve began fighting a 40-year high inflation with aggressive interest hikes in 2022, the conditions that favoured U.S. equities markets seem to be fading. Read more to find out why some time-tested investing lessons such as diversifying across international markets are now getting more attention.

American equities largely overshadowed international equities since 2008. Going forward – what’s the case for investing in equities outside the U.S.?

Nicholas J. Paul: I wouldn’t frame the question as making the case for international equities. It is not pounding the table and saying, ‘now is the time to buy international because they are going to outperform U.S. over the next decade.’ I am not saying that because that may not necessarily be the case. But as we think about the next decade, it is going to be significantly different than the one before. Almost every imaginable investment characteristic – monetary, fiscal, inflation, globalization, defense and security, energy transition, and capital allocation – is likely to be very different from the past 10 years.

In the period after the financial crisis, we had record stimulus, quantitative easing and massive liquidity. All of these were also revisited during the pandemic. These factors are now going away.

In a world of higher inflation and higher interest rates, relative to the past decade, return expectations for equities are likely to come down. If you went back a little over the past decade, U.S. equities rose well north of 300% during that time. That is probably not happening again over a similar timeframe. This will probably not happen with non-U.S. equities either; that they are going to rise by a similar amount over the next decade. Investors are not likely to pay extremely high multiples that drove equity performance in the last decade.

Now, it is really about diversification within equities that is going to matter for the next decade. Diversification simply didn’t matter in the last 10 years. All you had to buy was the right factor – mega-cap technology companies. This is essentially what the U.S. had become because of the poor methodology around cap-weighted benchmarks. As U.S. technology companies benefited from trends like digitization and post-pandemic policies, they grew to occupy a disproportionate weight amongst U.S. equities. The U.S. essentially became a growth benchmark. But now that the conditions are changing with higher interest rates, diversification matters, and it is in that context we see the importance of international equities.

What conditions favour international equities?

Nicholas J. Paul: The last decade in markets was dominated by factors such as massive liquidity, stimulus from central banks, and globalizing supply chains through lower trade barriers. These conditions that helped U.S. technology companies gain a lead over international equities are already looking meaningfully different now. Central banks don’t seem to have any more appetite to put more liquidity in the marketplace. Just-in-case localized supply chains are getting a second look after an era dominated by globalized just-in-time supply chains. Defense and national security expenditure is another factor that could influence how governments invest. Especially in Europe, given what is happening in Ukraine, a transition to alternative sources of energy and decarbonization is gathering pace. These trends could create opportunities for international equities.

What’s next for U.S. equity valuations?

Nicholas J. Paul: From a valuation point, in the period between 2012 and 2021, the S&P 500 traded at higher multiples between 11.5x and 21.3x on a forward price-to-earnings compared to a range of 10.9x and 14.3x for the MSCI All Country World index ex USA (MSCI ACWI ex USA). U.S. equities derived some of these valuations due to balance sheet financialization and share buybacks in the wake of ultra-low interest rates. Now that the period of ultra-low interest rates seems behind us, richly-valued U.S. equities could cede some ground and converge with that of international equities as return expectations come down. ?

Finally, international mid- and small-cap equities could also benefit from a cycle of increased capital expenditure in the areas of green energy and defense spending. This is also true for U.S. mid- and small-cap equities. A combination of both international and U.S. equities is likely to produce strong diversification benefits.

Given the push to localization and spending in areas like green-spending and defense, can Europe or Asia produce the next trillion-dollar company like the U.S. did in the past decade?

Nicholas J. Paul: Probably not. The U.S. produced some of the trillion-dollar companies that went on to dominate cap-weighted indices. But over the past two decades, in any typical calendar year, over 80% of the top-performing companies were from outside the U.S. But the massive size of U.S. companies dwarfed the performance of non-U.S. companies in cap-weighted indices. Some of the themes such as cloud computing and mobile technology that were behind the rise of trillion-dollar U.S. companies are probably also transitioning.

While Europe or Asia may or may not produce the next green or defense trillion-dollar company, the spending towards green energy will help a range of international companies in these regions. For example, the drive to decarbonize could help European industrial gas companies. Asian companies that provide heating, ventilation, and air conditioning (HVAC) companies to buildings could also benefit. So, such spending will matter more to performance of international companies and equities than whether they turn into trillion-dollar companies. ?

How does the MFS Investment Management team approach global investing?

Nicholas J. Paul: The high level of integration and collaboration among our fundamental research team across geographic regions and across the capital markets spectrum is one of the most unique characteristics of the research efforts at MFS as compared to the industry. It is a critical factor that has helped us to make better investment decisions for our clients by leveraging all of the research done by MFS' global research platform.?

We believe that having analysts based in specific regions around the world, working collaboratively together enhances our ability to conduct first-hand, global equity research. Based on this philosophy, we have developed a globally integrated research platform with fundamental equity, quantitative and fixed income research analysts covering companies all over the world from our investment offices located in Boston, Hong Kong, London, Mexico City, S?o Paulo, Singapore, Sydney, Tokyo and Toronto. Our research team is organized into eight global sector teams that allow our research analysts, although domiciled in different regions, to share information broadly about companies and industries, to evaluate regional trends, comparative growth rates, business characteristics and relative valuations of companies competing in the same sector from a global perspective.

Additionally, the participation of our fixed income and quantitative analysts within the sector teams also enables MFS to fully understand and evaluate the capital markets implications of all potential investment opportunities. These teams operate in a collaborative environment so that members are able to fully leverage their specialized areas of expertise in order to enhance the quality of each other's research and to help identify the most attractive investment opportunities globally for the benefit of all our clients.

MFS Investment Management or MFS refers to MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc. MFS Investment Management Canada Limited is the sub-advisor to the Sun Life MFS Funds; SLGI Asset Management Inc. is the registered portfolio manager. MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc. have entered into a sub-advisory agreement.

Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any mutual funds managed by SLGI Asset Management Inc. These views are subject to change at any time and are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Sun Life Global Investments is a trade name of SLGI Asset Management Inc., Sun Life Assurance Company of Canada, and Sun Life Financial Trust Inc., all of which are members of the Sun Life group of companies. SLGI Asset Management Inc. is the investment manager of the Sun Life family of mutual funds; Sun Life Assurance Company of Canada is the issuer of guaranteed insurance contracts including Annuities, and Segregated Funds. Sun Life Financial Trust Inc. is the issuer of Guaranteed Investment Certificates. ? SLGI Asset Management Inc., Sun Life Assurance Company of Canada, and their licensors. All rights reserved.