Offshoring: Increasing International Exposure

Higher Asset Allocation Weighting in Portfolios

Phil Diamond, CFA | Nov. 23, 2009

In a similar vein to Silicon Valley companies outsourcing information technology (IT) operations to India, so too should investors consider making such a move by shifting their asset allocation to a higher international weighting in both stocks and bonds, a move we have continually called for in client portfolios. A reminder of why we are doing this seems appropriate.

We have a whole bunch of reasons for making this shift. Probably highest on that list would be not putting so many of our precious eggs in the US basket. Especially since the US market is no longer the only highly liquid, highly regulated and highly transparent market in the world. Several of the developed markets would argue that they are better regulated or more transparent and just about as liquid. Some of the emerging markets are closing fast on one or more of those criteria. So, the US is not the only game in town. That is reason number one.

We think that the outlook for a lot of the globe is more amenable to investors than here at home. The outlook for the US economy and US corporate profits (and so US stock markets) isn't as favorable as it once was. The demographic argument that we just aren't creating as many highly skilled, highly motivated and highly productive workers as we once did is a big piece of this. We used to grow by 3% or more a year in population. Now, we grow barely 1% and largely due to immigration (legal and illegal). Productivity adds to that and gives us a potential, long-term GDP that is lower than our history and lower than many, more promising opportunities. That is reason two.

Workers in many other countries earn less than their US counterparts. Availability of land without harsh environmental and other regulatory hurdles means faster development. Capital is cheaper in some other places, though that is not a universal point. Many governments are welcoming of industry and jobs, while the environment in the US (California) and many other developed countries isn't so welcoming. Taxes and other costs are generally lower in developing nations. So, if you were a business executive wondering where you would build your next plant, would you choose Muncie, Indiana or Mumbai, India? Peoria, Illinois or Guangzhou, China? Los Angeles or Sao Paulo, Brazil? We think you know the answer to all those questions and it isn't favorable to the US outlook. That is reason number three through about six.

On the back of that last bunch, there is the virtuous cycle that develops once a China or India or Turkey wins that new plant and the concomitant jobs. Those jobs raise living standards in the community where they start. The higher living standards work their way into neighboring towns and cities as shopkeepers and service providers benefit from the factory workers' spending. We get an emerging middle class in one country after another and those middle class people spawn whole new industries to service them. As these middle classes swell, they demand more and more products and services, helping the employment, productivity and incomes in these countries one by one. They are going to see the same benefit to development that showed up on our shores from about the end of the Great Depression through the '70s. This will go on for a long time and it is something that the US won't enjoy because we've already had this phase of development. That is reason seven and maybe even reason eight.

After these reasons there are several minor ones: like access to specific companies in specific industries that will bring obvious benefits over time; many resources are more available overseas than at home; riding a wave of interest in these markets and companies now. But these benefits are more tactical in nature rather than the strategic benefits above. The last reason is more abstract. We will get far more diversification from investing a little bit in some emerging markets than we get from investing a lot in developed markets. The correlation between US and European and Japanese markets has risen inexorably over time. That may become the case with the major developing markets, but not for a while we hope. That adds up to reason nine through twelve or so.

There are also risks. Probably the one we are most familiar with is volatility in many foreign markets. That is both a good thing and a bad thing. As we are accustomed to say, only half of volatility is bad, the part that means going down (the other part we call performance). Foreign markets have different economic cycles, different fiscal and monetary policies, different interest rate regimes and different currency impacts. All those present risks and opportunities. They are also why we get diversification as noted above. As the developed economies begin to act more in concert, this difference will become even more important.

Please do not frame this move in terms of a tactical play against the dollar or against the current administration (even though those may help in making the case) but as a reminder of how different the world is today versus the '60s or '70s. The real reason is above in those first few big issues. The risk-return relationship between US investors and foreign markets is different today than it has ever been before. We think this is a big opportunity for our clients, not a tactical move that appeals to the idea that the US is declining or that we fear the socialist tendencies that many see. We will still have a lot of dollars invested in America. If we feared some of the scenarios painted by the "end of empire" crowd (that the US is doomed to ultimate decline), we wouldn't stop at 40% of equities and 20-25% of the bonds. We'd go 80%/20% and cut and run from this great land. We are simply recognizing a real opportunity that does not exist here and riding it for a long time. We are not likely to go back to the old US-centric model, ever.

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