For the past five years there were reasonable arguments for keeping money in the United States. While the United States endured a brutal recession and is still suffering through an anemic recovery, on a relative basis the economy has been a bright spot, particularly compared to Europe and Japan. Since the end of the recession corporations have churned out record profits, the dollar has been stable, and interest rates remain near historic lows.
In the past few years, having a strong US focus has been a good trade. Since exiting the recession in mid-2009, US stocks have significantly outperformed international markets.
But this trend is starting to break. Since the summer, US stocks have trailed stocks overseas. In the three months between the end of August and the end of November, US stocks gained less than 1% as measured by the S&P 500 versus a 5.5% advance for the MSCI ACWI-ex US Index.
I believe this trend is likely to continue. While US stocks still appear reasonably priced, and downright cheap compared to fixed-income alternatives, they are relatively expensive compared with other countries. US large caps trade for 2.1 times book value compared with 1.45 for the rest of the world. This represents a 47% premium, which is well above the five-year average. US stocks look particularly pricey compared to Europe, which has a price-to-book ratio of 1.16; Japan with a P/B ratio of 0.96, and emerging markets with a P/B ratio of 1.56.
Some of the premium is justified. As I mentioned, US companies maintain near-record profitability. Assuming the fiscal cliff is avoided, the United States is almost certain to grow significantly faster in 2013 than either Europe or Japan.
But with the fiscal cliff looming, the size of the premium is becoming harder to rationalize.
Should the full brunt of the fiscal cliff hit and remain in place, a prolonged period of fiscal tightening would dramatically alter the US growth picture. The United States would likely go from an environment of 2% growth to a modest recession. Under this scenario, Japan and perhaps even Europe are likely to grow faster in 2013.
Even if most of the fiscal cliff can be avoided, the United States is still likely to experience some fiscal drag in 2013, probably on the order of magnitude of 1% to 2%. For an economy only growing by 2%, this will represent a significant headwind and will lower the differential between US growth and other developed countries.
Beyond the fiscal cliff, the current value differential between the United States and emerging markets appears particularly rich. We are cautiously optimistic that emerging market countries will re-accelerate in 2013. While they are unlikely to match the glory days of 2010, lower relative valuations and faster growth suggest that this is a good time to overweight this asset class.
Finally, apart from the return opportunity, there is a risk argument favoring a higher weight to international stocks.
Since 2010, stock market risk - measured using the volatility of daily returns - was roughly equal in and outside the United States. Since November 1 that has changed. Over the past five weeks, the volatility of the US market has been roughly 30% higher than the volatility of markets outside the United States.
With both the fiscal cliff and debt ceiling looming, it is getting difficult to argue that the United States is still the "safe port" in a storm. Given the changing dynamic, we continue to believe that this is a good time for investors to consider lowering their overweight position in US equities while raising the allocation to international stocks.