Intrigue Overseas: Reasons to Let Your Money Travel

This year’s tech surge has left Canada on the sidelines, letting domestic equities languish in mediocrity. While Canadian investors might be tempted by eye watering returns from a small group of U.S. mega-caps, you don’t want to get caught in a riptide for fear of missing the wave.

Yes – American tech giants are on a tear. But FOMO has never been a sound investment strategy. So where can Canadians look for a healthier kind of growth based on sound fundamentals?

It turns out, developed international markets have quietly shown a more holistic growth balanced across a broader range of sectors. With more opportunities to diversify at more appealing valuations, it might be time to allocate overseas.

In search of diversity, Canadians have commonly looked to the U.S. equity market which has been dominant since the Great Financial Crisis, as led by mega-cap growth stocks like Apple, Microsoft, Alphabet, and Amazon.

The top seven stocks from the U.S. market now make up over 25% of the weight in the Index.  When considering these names, concentration in both weight and performance have renewed interest in other areas of the market for investors seeking to diversify their equity portfolios.

Top S&P 500 Weightings
(as of May 2023)

Source: Bloomberg L.P., as of May 31^st, 2023 based on the S&P 500 Index.

Several major markets in the developed international space hit all-time highs this year, with stellar performance across many areas from the region. Valuations are still relatively attractive compared to historical levels, while providing an appealing point of entry for long-term investors.

In this article, we’ll explore opportunities in the developed international market by examining valuations, portfolio allocation, performance, and flows.

Valuations

Valuations are broadly more attractive for the developed international markets compared to the U.S. on a relative basis when looking at the ten years of history. We see this as a better entry for investors seeking to diversify their portfolio away from the U.S. equity market.

The following chart includes historical forward P/E of various markets, and where it currently trades. Many of the Eurozone countries are trading below ten-year median figure.

Portfolio Allocation

Developed international markets provide great diversification based on sector allocation, offering less concentration into one area.

Financials, energy, industrials, and materials make up close to 70% of the Canadian equity market. There’s a lack of diversity when it comes to opportunities in other industries and sectors.

The U.S. equity market has approximately 60% of its weight in information technology, health care, consumer discretionary, and communication services. The technology sector has exhibited outsized returns along with consumer discretionary and communication services sectors year-to-date.

Sector Weightings by Region

Source: Bloomberg L.P., as of May 31st, 2023. Canada is represented by the S&P/TSX Composite Index. U.S. is represented by the S&P 500 Index. The Developed International markets is represented by the Solactive GBS Developed Markets ex North America Large & Mid Cap CAD Index. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Past performance does not predict future returns.

In contrast, there is less concentration in top names in the International Index, and returns aren’t contingent on a narrow band of stocks or a limited range of sectors. The top five stocks for both Canada and the U.S. based on market-cap makes up over 20% weight compared to developed international market, where it’s less than 10%.

Weightings in Top Market Cap Stocks

Source: Bloomberg L.P., as of May 31st, 2023. Canada is represented by the S&P/TSX Composite Index. U.S. is represented by the S&P 500 Index. The Developed International markets is represented by the Solactive GBS Developed Markets Ex North America Large & Mid Cap CAD Index. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Past performance does not predict future returns.

Relative to the U.S. and Canadian markets, the developed international market is well diversified across multiple dimensions from a regional, currency, and sector perspective. Hence, we see the benefit of including exposure for clients seeking to diversify outside of North America.

Performance

Positive returns year-to-date for the region have been much broader compared to the U.S., showing better overall breadth of performance.

The developed international market had a stellar fourth quarter 2022 return, and has also led major regions during the first quarter:

Quarterly Returns by Region

Source: Morningstar Research Inc., as of May 31st, 2023. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Past performance does not predict future returns.

There have been notable milestones in a number of developed international markets this year. Major European indices like DAX (Germany), CAC 40 (France), and the FTSE 100 (U.K.) have hit all-time highs this year, demonstrating relative strength from these key markets. Sentiment has been positive in the region since the fourth quarter of 2022.

In May, the Nikkei 225 Index (Japan) rose to its highest level since July 1990 and has been one of the best markets year-to-date in the local currency.

The developed international market has benefited from a broad source of areas  with better breadth in performance as compared to the U.S. market.

Notable performers are from luxury goods companies like Hermes International, Moncler, and LVMH Moet Hennessy Louis Vuitton. Moreover, auto makers like Rolls-Royce, Mercedes Benz Group, BMW, Honda Motors, and Ferrari have exhibited strong performance this year. ASML Holdings, which provides chipmakers with the power to mass produce patterns on silicon, has also been a stand-out contributor.
 

Flows

The recent performances of various developed international markets have caught the attention of Canadian investors. As compared to previous years, we’ve seen strong ETF flows towards the space in Canada.

The following shows the proportion of flow in various regions based on calendar year. The 2023 flow is as of May 31^st, and thus far the developed market has garnered the highest weight:

Annual Flows by Region

Source: NBF ETF Research, Bloomberg. Data as of May 31st, 2023. * Data since 2019 are adjusted for ETF cross-holdings.

We feel prudent investors stand to benefit over the long term by taking a closer look at international developed markets, where growth is more broad, and valuations are more reasonable.

FLUR - Franklin International Equity Index ETF has the lowest management cost at 9-bps for developed international markets indices based on the Solactive GBS Developed Markets ex North America Large & Mid Cap CAD Index in Canada.

As we begin the second half of the year, early growth drivers seem to be slowing down in local markets. If you find yourself wondering where to turn to next, don’t limit yourself. When it comes to investing, it’s never been easier to cast a wide net! So don’t feel like you’re stuck fishing local waters.

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