Investment Review №337. A shift toward hedging

U.S. investors have historically maintained an overweight allocation to domestic assets—a classic case of home bias, where portfolios are overweight in U.S. securities simply because they are convenient and familiar. In 2025, this bias proved costly: non-U.S. equities (MSCI ACWI Ex-U.S.) returned 33% in dollar terms versus 18% for the S&P 500. Even after stripping out currency effects—the weaker dollar added roughly 8 percentage points—foreign markets still rose about 25% in local-currency terms.  

Why could this trend persist going forward? Macroeconomic indicators abroad have improved: composite PMIs are in expansion territory. Europe is showing signs of recovery after a decade of stagnation, with unemployment at historic lows and inflation close to the ECB’s target. The key catalyst is that Germany—along with other countries—has begun to increase defense spending, effectively providing fiscal stimulus to the broader European economy. The U.K. economy is weaker, but inflation is falling steadily, and Bank of England easing should support London-listed equities. China has redirected its exports after a year of trade wars, halving its dependence on the U.S., with deliveries going to Asia and Europe. Japan is seeing growth regardless of tariffs, and moderate inflation after decades of deflation may help pull the economy out of prolonged stagnation.

The primary driver is likely to be the convergence of earnings growth rates. In 2026, we expect EPS growth of 15.5% for the S&P 500, 12.8% for Europe (ex U.K.), 11.4% for Japan, and 12.6% for China. The gap between U.S. and non-U.S. companies is narrowing, which should support non-U.S. assets. Valuation provides a second key tailwind. As of January 22, the S&P 500 traded at a forward P/E of 23.3x, versus materially lower valuation multiples abroad: FTSE 100 at 13.6x and TOPIX at 16.7x. Dividend yields are higher overseas, ranging from 2.2% in Japan to 3.3% in the U.K., compared to 1.05% in the U.S. For broad non-U.S. exposure, the Vanguard Total International Stock ETF (VXUS) is a leading vehicle; it rose more than 32% over the past year. If macro and earnings momentum remains supportive in 2026, non-U.S. equities should post solid gains on the back of economic recovery and converging earnings growth dynamics. Even in a choppier backdrop—geopolitical or economic—international equities start from significantly lower valuations and offer higher dividend yields than U.S. stocks. This provides a modest margin of safety for investors, making it difficult to find a better diversifier with a similar risk profile.