The MSCI EAFE index invests in the developed world’s stock market minus the US and Canada. Many popular international funds such as the TSP I fund and IEFA ETF track this index. It holds approximately 85% of the developed world’s market cap much like the SP500 holds about 80% of the US public stock market by capitalization. It does not invest in emerging markets.
The International fund’s relative performance compared to the SP500 index has been strong recently. Some investors are considering jumping in. It is important to understand what you are investing in so you know when to jump back out. Its long term performance has disappointed.
To understand why the international fund is outperforming today one only needs to ask which central bank is buying corporate bonds today (hint: the ECB – European Central Bank). It helps Europe’s economy is showing some signs of life, but the reduction of financial asset supply by central banks via QE has propelled the world’s equity markets to historically high valuations… and the ECB is up to bat.
When central banks create money out of thin air and buy assets from investors, those investors then have cash in search of another investment. They often buy more bonds but some of the funds flow into the stock market.
When the ECB announced their first QE program in late 2014, speculators front-ran the central bank buying. By the time the program was launched, Europe’s stock market had already priced in 65% of the gains. After Europe’s stock markets peaked in 2015, it rolled over.
Recently the ECB added corporate bonds to its list of purchases and the stock market is off to the races once again. The question today is how much of this QE program is already priced in to the market and how long will the central bank buying last. They supposedly plan to taper the program in 2018 – we will see.
Should US investors surf Europe’s QE via international funds? One of the problems is often when international stocks outperform so does the US dollar. Why is this a problem? Because the dollar’s gains are subtracted to determine your investment gains. Often it is awash or will become awash when the dollar surges.
International Fund (Blue) along with percentage of developed world markets
In the chart above it is strange to see the top three geographic weightings of the International fund outperform the fund itself. How can this be if the fund is made up of much of these indexes? The indexes plotted are not dollar adjusted. The International fund (IEFA ETF) is dollar adjusted. Those nice rallies in 2015 were mostly nullified by the rising US dollar exchange rate to the Yen and the Euro as seen in the next chart.
The challenge with investing in the international fund is you must understand what is going to happen to both the currencies and international equities. And more importantly today, what the central banks are going to do next. If you want exposure to international markets, you have it with the SP500 – 30% of the SP500 revenues come from international markets.
International Tech exposure
I am a big believer in the new economy stocks and most of them sit on the US exchanges – the SP500 is weighted with 26% tech compared to only 6% in the international fund. This alone has allowed the SP500 to outperform the international fund over the current market cycle.
The SP500 tech sector derives about 60% of its revenue from international markets. If you want international tech exposure you buy the SP500 index or better yet the Nasdaq-100.
The international fund is heavy in financials. As far as I am concerned, Japan and Europe’s financial sector is unstable, high risk and very dependent on central bank policy. Nothing has really been fixed since the financial crisis. Global interest rates being driven to 5000 year lows should tell you something – and it is not that stocks are relatively cheap.
Invest Smart
The central banks have given us a nice rally since February 2016. If you haven’t noticed all the conditions that were in place to drive the rally are reversing and I do not mean the economy or corporate profits. I talk more about the drivers of the stock market in my Spring summary if you are interested in learning more. I believe it is going to be an interesting summer.
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Categories: Perspectives, The Smart Bird