Is international diversification worth it?

Christine Kashkari: Welcome to Better Vantage by Vanguard, a podcast series hosted by Custom Content from WSJ and Vanguard. In this podcast series, we'll be talking about the topics that are top of mind for financial advisors and investors today. In each episode, we'll be sharing market insights, data analysis, and strategies to help you invest with greater conviction.

And with me is our co-host, Joe Davis, Vanguard's global chief economist. Joe, hello.

Joe Davis: Hello again. Exciting.

Christine: And of course, our special guest today is Qian Wang, who is the chief economist for Asia Pacific and global head for capital markets research at Vanguard.

Qian, welcome.

Qian Wang: Great to be here.

Joe: Well, I'm really excited, Christine as well, as you know, I've had the pleasure of working with Qian for years. We work together in the investment strategy group. And I think the listeners should be really excited because, not very often we can talk to someone, an expert, that has both a deep macro background, but also really responsible for modeling, thinking about the risks, and the opportunities in the capital markets.

Certainly my job today for our podcast listeners is that they have a better understanding of what they could be getting into or if they're staying the course on their non-U.S. investments, which have trailed for some time.

Christine: So Qian, let's start there. So international stocks have been lagging U.S. stocks for pretty much since the GFC. Can you explain this long reign of U.S. stocks?

Qian: When you look at the past decade, right, from 2014 to 2024, the U.S. markets returned about 13.1% on average over the past decade. This would really outperform the international market by 7.7% every year in U.S. dollar terms.

Joe: That’s huge.

Qian: Yes, huge. So I want to say most of that is indeed driven by fundamentals, both at the macro level and micro level, right? So if we use the sum-of-parts approach to decompose the returns, right, you see that comes from strong earnings, strong valuation expansion, and also strong U.S. dollar, right? So we see that 13% annualized return.

Now I would say actually slightly over half of that came from stronger earning growth, right? So now of course at the macro level you could say, look, the U.S. really enjoyed pretty decent solid economic growth. The interest rate is low and the tax rate has been declining. But I think more importantly is actually at the micro level, the corporate fundamental is really strong. U.S. companies are just much more productive in value creation.

One measure we use is ROE, right, return on equity. That's a standard measure of corporate productivity. It's just to show how good a company is, generating profits from their capital. Now U.S. companies just do that so much better compared to their international peers. Now what's more is also those high ROE companies, they also retain and also reinvest their earnings more, even though that will lead to lower dividend yield for some investors. But then when you invest them in a high rate of return, then they could actually grow earnings even faster, for down the road.

Joe: So if I have it right, what you're saying is there's generally three broad buckets, right, that can contribute to, in this case, the U.S. and all other equity markets as a group, non-U.S. markets from outperforming or underperforming. One would be the earnings growth, the fundamentals you mentioned. There could be currency effects that could either make non-U.S. companies less valuable. It’s the value of the U.S. dollar.

And then the third one is the valuations, the price paid. So you're saying it's along all three dimensions the past decade, all have pushed in the U.S.’s favor versus the non-U.S.

Qian: Yes, I mean we talk about earnings, right? And the other part I think is just amazing to see is how valuation has expanded over the past decade. I know a lot of people are saying that the U.S. market is very expensive now and especially compared to historical average. Now to be frank, I think that's a wrong benchmark to use. I mean, in the long run, stock prices should converge to their business fundamentals rather than simple stats. We believe that valuation is actually time-varied and should be a function of both the macro and business fundamentals.

I would say a lot of the valuation expansion was justified by a low interest rate and low inflation environment. Now, even though we saw the Fed has been tightening monetary policy over the past several years, but you know what, U.S. companies, especially those large ones, they are able to lock in to low borrowing costs through the corporate bond market, what we call the rate lock effect.

Now I would say that's very different from a lot of other countries, like in Europe, where the financial system is primarily dominated by banks, and that they are able to adjust the interest rate much higher, much faster. I think the question is whether the expectation is reasonable or too high. We can discuss that later.

The other reason I think for valuation expansion is that, just as we mentioned earlier, when you have very productive companies generating earnings, now, it's reasonable for investors to expect that they are going to have higher earnings growth in the future.

Now Joe, you also mentioned about the U.S. dollar. Now, because I think we are now talking about returning U.S. dollar terms, right? So in fact, I would say the international market has pretty decent return, in their local currency terms. You know, take Japan as an example. Ever since 2012, the local currency return in the Japan market, guess what, 12.6%, you're like, oh, that's not much lower than the U.S.

Joe: That’s not much different than the U.S.

Qian: But in U.S. dollar terms, 7.6% only, right? So I think this U.S. outperformance really benefits from …

Joe: From what some call U.S. exceptionalism. I mean in investment circles, that's right. You know, some refer to U.S. exceptionalism, which means the U.S. has an outperform.

Qian: Exactly. So when you think about the U.S., number one, the U.S. dollar really started the last decade on the weak side. And then, you know, higher productivity that supports the stronger U.S. dollar. And also surprisingly we talk about low interest rate, right? But relative to the world, it's actually not that bad. Think about Europe and Japan where interest rate is zero or negative. So all those things support the U.S. dollar appreciation. And then the strong performance of the U.S. market actually attracts international capital and that further supports the U.S. dollar.

So it's kind of virtuous cycle between the U.S. asset market and the U.S. dollar.

Christine: International stocks are outperforming U.S. stocks. Is that all about the tariffs or are there market fundamentals overseas that are working in their favor?

Qian: I would say, Christine, there's a lot going on this year, other than tariffs. When you think about long term market returns, it really depends on how the secular macro outlook evolves and also how the business corporate profitability trend will evolve. I think at this moment our outlook for the next decade is that we will say the chance of risk is actually tilting towards international outperforming.

We use our model, a forecasting model called VCMM, Vanguard Capital Market Model. It's actually utilizing a probabilistic framework that our forecast is a distribution, not just a point forecast, it's a distribution based on 10,000 simulations of the future. Now I would say at this moment, out of every 10 simulations, international will outperform in seven.

So if you look at the median of the distribution, we are expecting the U.S. market to return about 4.3% every year over the next decade. Well, international will give you about 6.1% for the next decade on average.

Important: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of June 30, 2025. Results from the model may vary with each use and over time. For more information, please see the Notes section.

Joe: You're saying on average 1 or 2% return premium, potentially, for—this is for a U.S. investor-- for non-U.S. over U.S., but that's not a foregone conclusion.

Qian: No.

Joe: Roughly 70%.

Qian: We see a 70% chance that international will outperform in the next decade. Now of course that means, maybe you have a 30% chance that the U.S. could still outperform. But this is where we really want to emphasize on global diversification. If you have the right time horizon, risk appetite, you may want to slightly overweight international.

But diversification is always our first and foremost investment principle.

Joe: Full disclosure and just from a mea culpa perspective, we've been saying, Vanguard's been saying, our Investment Strategy Group has been saying that those odds, the 70% odds that she had mentioned, that we would have said --or did say-- the same thing four or five years ago.

So I'd say, those who want to be kind say, oh, we're early. Because of what you're saying Christine, right? You could also say we were wrong, but it's why we were wrong. And I think Qian, maybe you can talk a little bit about, what are some of the assumptions, or the conviction, right? You have a deep research team. You're looking at these things all the time.

Qian: Over the years, we actually have continued to build on our time varying fair value model. For the valuation in the past, we always say valuation is a function of the macro environment. Low interest rate, low inflation, and low volatility should support a high valuation.

Well, then later we actually improved the methodology. We realized that, no, it's not just macro, it's also the micro, business fundamentals. Like in the U.S., the growing weight of asset-light, high-ROE technology companies could actually sustain higher valuation. Because you are more effective in your value creation for investors. And you invest more, right. So you actually get a potentially higher earnings growth in the future.

Joe: Christine, where I'm going with this for listeners is, if you're going to do forecasts in markets, you got to hold yourself some way accountable both when you get it right or also when you get it wrong. But I'm really proud of the process, Qian, that you have. But I think I think good active managers do that because you learn from, you just want to make sure the process is stronger.

Qian: Totally. I think, Joe, the first step for improvement is really to admit that we were wrong, right? There's no denial here. But I think one thing is that we have to recognize forecasting is a very important tool for any household, for any individual business who needs to prepare and plan for the future, right? So it's that job we have, we must continue to do.

But then the thing is, how can we do better? I mean, when we talk about this, forecasting, this principle--valuation is the most important driver for long term return. That, we didn't change. We don't change that, because the driver for equity returns can be very different across different time horizons.

Joe: You know, the other thing. But keep me honest here, Qian, I also think about it from a risk management perspective and where I'm going with that for a moment. My macro background.

There's two things that, I would worry that if I had all of my eggs in the U.S. equity market. One would be, I think that's a bold assessment that all of the largest companies that may drive, I don't know, half of the returns over time. They're very small, Christine, there's what, 2,3,4 percent?

Christine: Yeah.

Joe: You could tell me what number, that they're all going to be based in the U.S. The other one is, what's not in the U.S. record, but it could be, and I'm not saying it will be in the future. And that is downward pressure on currency in part because of our fiscal issues. I would always worry if someone has 100% exposure to simply U.S., stock market returns are all denominating the U.S. currency that you were talking about. That's just from risk management.

If there's other fundamental reasons why from risk management, why you'd want some non-U.S. exposure.

Christine: So Qian, you talk about U.S. stocks being overvalued in spite of all the calculations that you talked about, it is still overvalued. Is that enough to encourage people to diversify? It feels like there's a reluctance there, yes. Where is that coming from?

Qian: Valuation is not the only thing, right? And then when we think about return, Joe just said, you know, the U.S. dollar. We do think the U.S. dollar actually is coming back to our fair value estimate. So it's no longer a tailwind for U.S. investors. And then there could be still room for further depreciation if global investors decide to diversify away from U.S. dollar assets.

So to summarize that, our outlook is that we still expect international companies to have lower earnings growth, relative to the U.S., right? There is where you talk about business fundamental. I would say the U.S. companies are still enjoying that, stronger business fundamental.

But on the other hand international companies, they have more reasonable valuation, higher dividend yield as well as you know less, potentially some U.S. dollar depreciation becoming their tailwind.

Joe: Oh, interesting.

Qian: Now talking about Christine, where's the push back come from? Recency bias, right? But people still look at the past decade saying that the U.S. actually had such a stellar decade. Why would I want to bother to buy the non-U.S. international market? Now my point is that now, look, if you drag the history even longer, U.S. actually underperformed the non-U.S. developed markets in three out of the last five decades, 70,80, and then 2000.

Joe: I want you to put on your active manager hat. You got your macro hat and you got your capital markets research hat. So maybe if you'll stick with me here, just do a speed round. I'll ask you three quick questions. One or the other market, if you had to overweight them over the next three or five years, I'll pick some non-U.S. markets.

Qian: All right.

Joe: Europe or Asia?

Qian: Europe.

Joe: Developed or emerging?

Qian: Developed.

Joe: China or India?

Qian: How about I say neither?

Joe: Neither. *All panelists laugh.*

Qian: I have some serious reservations for both.

Christine: Why not China or India?

Qian: We talk about Europe defense spending. There is a way that you can use this to boost up long term productivity. Defense spending, you put that in a lot of public R&D and they can actually crowd in private investment rather than crowd out. So you just use that in the right way. So I think there could be some hope for the European market.

Japan, lost decade? No. Lost 3 decades? No. Well, to a certain extent, the last decade was pretty good for equity investors, especially in local currency terms. But I think when you look at Japan, I think what we have is our return to normal inflation. I'm not even saying high inflation, just 2% inflation.

Joe: Listen, you sold me. Wait, wait, wait. I don't need to be sold. But for the listeners, so you're talking developed markets—Europe and Japan or Asia, right? They may be a little bit surprised if in terms of what could lift the equity markets outside the U.S. What about AI in that front? Because a lot of those countries actually lag there.

Qian: We are slightly optimistic, more optimistic that AI could be this transformative. If that's the case, it's going to lift up, generate broad economic gains across all sectors and all countries, right?

Joe: Gotcha. So, if you're outside U.S., it could be banking sector, or...

Qian: Exactly, right. So, you know, Joe, I think this is sometimes people always confused about innovation and they narrowly defy innovation in the scientific breakthrough. Optimization is also innovation. Application is also innovation.

Joe: Particularly if it's transformational. I agree with you, Qian.

Qian: So then in that case, I would say actually AI is a reason that we believe other than the catalyst we just mentioned, defense spending or corporate governance reform in Japan. I actually think AI is the reason we believe international would outperform, right? U.S. may actually live up to the high expectation.

Joe: Boom. I love it.

Qian: That's fine, but international will catch up because of AI.

Christine: I'm not sure where I'm going to bet, but this has been really great. I love Joe's lightning round, so I want to extend that as we wrap this episode, what would be the key takeaways?

Qian: If anything, I would take away, is remember the diversification, right? Skipping international is not safe. It's really just a concentrated gamble. So diversification always makes sense. They make sense any time, any environment. But, probably particularly important at this moment, especially when we are, seeing a better chance for international performance. So I know a lot of investors have recency bias. They have home bias. Buy what you use right is what the people are saying. But I think that may not be a rational decision when your objective is to maximize your risk- adjusted  return.

So I would just say having some international exposure starting with the global bench, capital market weight benchmark 60/40. I think that would be a good start.

Christine: Are we debating 60/40 again?

Joe: No, no, I think what you're saying, Qian, I think you've given the audience a lot in terms of, if you do have simple U.S. exposure, it's really gone in the favor and that's been fantastic. But let's get off the zero bound, right? And let's hedge some of those bets.

Qian: Yeah, I think I'm going to say 60/40. That's not the stop on the mix.

Christine: Yeah, I know, right. But thank you so much, Qian. Thank you for making such a powerful case for international diversification.

And definitely the message is keep your one foot in the U.S. door, but definitely explore. There are a lot of opportunities out there. Thank you for joining us.

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