Amid a Gloomy Outlook, Don’t Abandon International Diversification

Diversification, as an investment concept, is easy to understand: By spreading dollars into investments that span a variety of industries, geographies and asset types, you can help reduce your overall risk because all your “eggs” aren’t in one basket. In practice, however, adhering to the wisdom of diversification isn’t always easy.

Take, for example, the struggles of international and emerging markets thus far in 2018. Brexit, trade tensions, sanctions, rising interest rates, struggles in Italy, Turkey and Argentina, growth slowing in China … this year has brewed a perfect storm of bad news for equities outside of the United States and valuations have followed suit. U.S. equities have vastly outperformed their international peers not only this year, but over the past five to seven years.

Investors who own a mix of U.S. and international stocks or funds may be looking at their portfolios and asking, “Why bother holding onto these struggling international and emerging market equities when U.S. stocks are winners?” As such, it may be tempting to dump those international losers and embrace U.S. stocks. However, Brent Schutte, chief investment strategist at Northwestern Mutual, says you should resist this temptation.

NARRATIVES VS. FUNDAMENTALS

“Twenty-three years of watching market trends and vast sentiment shifts have taught me that remaining centered is a strong foundation for long-term success. Diversification doesn’t matter until it does, and then you’ll be thankful that you have it,” says Schutte, chief investment strategist at Northwestern Mutual. “On the other side of the coin, people think they want diversification until they get it, because by definition it means they own something that isn’t performing as well as the rest of their portfolio.”

In the short-term, popular narratives and emotional sentiment can drive the valuations of stocks in specific industries or different parts of the world. Over the long run, however, the underlying fundamentals tend to outweigh short-lived market moods. And beneath the gloomy narrative currently enveloping international equities, Schutte says there’s a rosier fundamental story.

“The world has been turned on its head in the past few months as concerns abound that the Federal Reserve is tightening too quickly, and tariff worries have driven international assets lower. However, we continue to believe that normality will return and that in the coming months a new path forward on trade will be hashed out. The Fed will tighten with a velvet touch and err on the accommodative side. These short-term concerns aren’t enough to override the attractiveness of international stocks,” says Schutte. “We continue to believe that emerging markets and international developed stocks will recover their relative underperformance to their U.S. counterparts.”

In other words, price performance might be bleak outside of U.S. equities, but the fundamentals are still intact. Sooner or later, sentiment is bound to shift. The trouble is there’s no telling when that might happen; thus, the wisdom of remaining diversified. It’s a long-term investment strategy that has repeatedly been shown to work in the past.

SENTIMENT SEE-SAW

Schutte says he’s seen this movie play out too often in his career. From June 30, 1994 to August 31, 2000, the S&P 500 returned 212 percent more than international developed stocks, and 281 percent more than emerging market stocks cumulatively. By the year 2000, Schutte recalls investors asking him why they would bother with international stocks at all.

Then, from August 2000 to October 2007, the S&P 500 returned 1.99 percent annually, while similar indexes tracking international developed and emerging markets equities rose 8.34 percent and 20.44 percent on an annual basis, respectively. Those investors who turned their backs on the rest of the world in 2000 may have missed those gains. When international stocks were trendy again, much of that growth was in the rear-view mirror. Of course, by that time, Schutte says investors flipped the script entirely and asked him why they didn’t own more international stocks.

“The most critical component of being a successful long-term investor is knowing when to avoid short-term emotional decisions based upon thematic trades that are not rooted in fundamentals,” says Schutte. “Do not fall prey to abandoning diversification and prudent investment strategies.”

By the time a trendy narrative gains critical mass in the market, odds are you’ve already missed the biggest gains. Rather than attempting to position yourself on the “right” side of the sentiment see-saw, a disciplined approach to diversification will allow you to be on both sides at the same time.

[The opinions expressed are those of Northwestern Mutual as of the date stated and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security

All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.]