But does the recent rebound of the greenback spell an end to their run?
With international markets outperforming the U.S. market since early 2003, investors might recall the bull run in foreign equities from the late-1980s through 1993 that was fueled by soaring emerging markets. Depending on their own experience, they might also recall getting burned by joining the party too late.
Indeed, the biggest money flows into mutual funds geared toward non-U.S. markets came in 1994, when those stocks were overvalued and economic cycles had already peaked. International markets gradually deteriorated over the next few years, before getting hammered by assorted financial crisis in the Far East, Russia and Brazil in the late 1990s. Meanwhile, U.S. stocks were soaring, and international investing became an afterthought for many investors.
But for the two-and-a-half-year period from the start of 2003 through June 30, the MSCI EAFE index (Morgan Stanley Capital International Europe Australasia Far East) of 21 developed market economies gained 66.6% versus 41.5% for the S&P 500. That includes dividends, and results are in dollar terms. For Americans investing overseas, the weak dollar during much of this period meant foreign profits were worth more when converted back into dollars, much as it did 15 years ago.
And various emerging markets did particularly well during this time frame, highlighted by skyrocketing returns of 170% for the Latin America index, 136% for Eastern Europe and 101% for Asia (excluding Japan, which is generally its own category). Such explosive returns make for inviting alternatives to the recently plodding U.S. market. For investors without a crystal ball, the obvious question is how long will the good times last in overseas markets?
Certain trends-from structural economic reforms to the state of the dollar to cheaper valuations outside the U.S.-could bode well for the near term and beyond. Thomas Melendez, an international portfolio manager as MFS Investment Management, says that as of late June the MSCI EAFE index traded at a 31% discount to the S&P 500 on a price-to-cash flow basis, the second-widest discount in roughly 30 years. And both Europe and Asia (excluding Japan) are trading at lower price-to-earnings and price-to-book multiples to the U.S., while also sporting larger dividend yields.
At the same time, forecasters expect economic growth in emerging markets to outstrip the developed world-including the U.S.-over the next two to three years. GDP growth doesn't always translate into gonzo stock market performance in a particular country, but the point is that nondeveloped nations potentially pack the most dynamic economic punch in coming years.
And then there's the dollar, which surprised many analysts by gaining strength this year against the euro, especially after France and The Netherlands voted down the proposed EU constitution and some countries questioned the viability of the euro itself. That cut into returns in dollar terms, but many observers think the dollar inevitably will fall again due to huge U.S. trade and budget deficits.
"There's very little in the U.S. that's not either fairly valued or overvalued," says Ronald Roge of R.W. Roge & Co., a financial advisory firm in Bohemia, N.Y. "The better valuations are overseas." He also believes the dollar will fall against international currencies, particularly if China lets it currency float and appreciate beyond current artificially low levels.
Roge is putting his money where his analysis is by gradually shifting half of his equity portfolio into international mutual funds, or double his global stake from late 2004. More than 30% of his equities were in overseas funds at mid-year, with a preference for small- to mid-cap companies he thinks offer the best value.
Roge did well with three funds now closed to new investors-the First Eagle Overseas, Julius Baer International Equity and Artisan International Small Cap funds. One of Roge's new favorites is the Dodge & Cox International Stock fund.
The global economy is more integrated than ever, and certain macroeconomic conditions could bolster overseas markets. "The world is flushed with excess capital and that will find its way to higher-growth opportunities with better value," says Mark Madden, portfolio manager of the Oppenheimer Developing Markets fund. "Basically, we're talking about the emerging market countries."
Madden expects gross domestic product growth rates of 4% to 9% in many emerging market economies through 2006, versus 3% to 3.5% in the U.S. and 1% to 2% in Western Europe and Japan. He also cites structural changes in recent years that could help sustain emerging-market growth, such as the break up of cabals between governments and big business cronies after old-guard ruling parties fell from power in Taiwan, South Korea, Mexico and elsewhere. New regimes reduced red tape, increased economic freedoms and created conditions that foster economic growth.
Additionally, the emerging-market financial crisis of the late 1990s wiped out existing banking systems in many countries, and ushered in recapitalizations that enabled foreigners to buy stakes in formerly off-limit banks in Asia and Mexico. As a result, credit is now doled out more prudently based on credit risk and potential profit. Under the crony system that prevailed in many emerging nations, low-interest-rate credit flowed easily to well-connected, highly leveraged companies, creating tons of bad loans and excess corporate debt that fed the aforementioned debacle.
The upshot is that banks are now lending more to consumers and smaller businesses. Home-building markets are flourishing in Mexico, Brazil, South Korea, Thailand and Taiwan because people can get mortgages, and Madden says more capital is being allocated to the small- to mid-sized companies that generate jobs and provide a foundation for healthy economies.
After the late '90s tumble in emerging markets, countries such as South Korea and Taiwan rebounded earlier by exporting their way out of the slump. Other countries in Southeast Asia and Latin America have recovered only in the past 18 months or so. "By and large, I think we're probably halfway through this bull market in emerging markets," offers Madden.
But that's predicated on market returns in coming years. If market indexes gain 15% to 20% this year and next, Madden believes the rally could have another four years to run. Faster growth rates would shorten the rally. "We've gone from cheap valuations and depressed margins to middling margins on average, and multiples are anywhere from single digits to 15," he says. "I think over the next two or three years we'll see additional capacity, top-line growth and the rest of the margins coming through. Valuations will go from reasonable to extreme on the high end."
Despite current favorable overseas valuations on the whole, not all sectors are valued equally. Raymond Mills, portfolio manager of the T. Rowe Price International Growth & Income fund, is finding fewer attractively priced options for his fund, primarily a large-cap vehicle with more emphasis on value than growth.
Two areas that he likes are energy and financials. He believes energy stocks are reasonably priced, and he likes the fat dividend yields of 4% or more paid out by some of the major oil companies. Among his top picks are British Petroleum and Total, a French company. Regarding financials, Mills likes certain European banks, such as Royal Bank of Scotland, because of better valuations and dividend yields compared with U.S. banks.
Mills believes the best the mid- to long-term growth prospects are in the Pacific region (excluding Japan). "The economies are growing faster, the valuations are solid, and it's the most dynamic part of the world."
And no country has generated more buzz than China, a foreign capital magnet that's now shopping for American assets. Despite the country's white-hot growth, some fund managers aren't crazy about China.
For starters, China's high-single-digit economic growth rate doesn't translate into a booming stock market. The Shanghai Composite has lost roughly 45% in the past five years, and some investors see yellow flags in China's shaky banking system and its inefficient capital spending. Chinese investors are angrily blaming their Communist government for the stock market's poor performance and suspected price rigging. Madden from Oppenheimer estimates that recapitalization of Chinese banks could cost more than 30% of the country's GDP. In comparison, it cost 3% of GDP to fix the savings and loan banking crisis in the U.S.
Additionally, most publicly-traded Chinese companies are 50% to 70% government owned. "The government doesn't care about wealth creation or shareholder returns," says Madden. "What they care about is accessing public markets to commandeer financial resources to build a modern China."
With enormous sums of foreign capital to play with, the government is throwing money into an infrastructure-building blitzkrieg of roads, bridges and other projects ranging from factories to technology "cities." At times, cost-benefit analysis doesn't seem to be part of the equation.
Brett Gallagher, portfolio manager of the Julius Baer Global Equity fund, recounts stories of thousands of tractors sitting end-to-end because there's no market for them, and of a fabulous machining factory filled with state-of-the-art German machine tools sitting idle because it was built too far away from any supporting infrastructure.
Some investors believe that many Chinese companies are poorly run and would suffer from foreign competition if and when the country unpegged its currency from the U.S. dollar, causing currency appreciation and making its goods more expensive. Madden, for one, sees China as a bubble waiting to burst.
But Madden likes Asia as a whole, and he's also bullish on Latin America, particularly Mexico and Brazil. Despite a brewing bribery scandal involving Brazil's current government, Madden credits the administration of President Luiz Inacio Lula da Silva for getting Brazil's financial house in order by stabilizing the currency and aggressively attacking inflation.
The country's commodity-based exports such as metals, iron ore and soybeans have done well, and pent-up consumer demand could potentially give the economy a further boost. Madden sees opportunities in Brazilian banks, telecoms and retailers over the next two or three years. Like many South American nations, Brazilian exports have benefited from China's insatiable appetite for raw materials.
In Europe, there's been talk over the euro's fate, if not perhaps the European Union itself, after French and Dutch voters rejected the EU constitution in the spring. Some investors see that as a political rather than economic problem. "A lot of companies are doing the right things even if some countries aren't," says Mills from T. Rowe Price, adding that many leading companies there are interwoven into the global economy. "There's a heavy export component, so they're not as heavily tied to top-line European growth as one might think."
Gallagher from Julius Baer is particularly bullish on Central and Eastern European countries on the cusp of joining the EU, which he doesn't think will unravel. His premise is twofold. First, countries aspiring to EU status need by whip their budgets and inflation rates into shape and to enact political reforms to get on equal footing with existing members. As interest and inflation rates fall in these countries, it's generally a boon for their stock markets and certain sectors that benefit from improved macro conditions, such as banking.
The now-closed Julius Baer International Equity fund profited by investing in Poland and the Czech Republic in the years before they joined the EU, and now Gallagher's Global Equity fund hopes to do the same by investing in select Romanian and Bulgarian banks before those countries' hoped-for EU entry in 2007. Another positive for the region is a low-cost labor pool that encourages established European manufacturers to invest in plants and equipment there, laying the foundation for sustainable economic growth in those countries.
Gallagher expects GDP in Europe's emerging economies to grow 4% to 10% over the next several years, or essentially double what he forecasts for Western Europe. But such economies are volatile, and playing the "EU game" isn't a sure thing. Although Turkey's EU bid remains an iffy and long-term proposition, Gallagher invests there because it's undergoing structural reforms that helped tame inflation and attract more foreign investment. Nonetheless, the Turkish market plummeted 25% last year before recovering for a sizable gain by year-end.
Despite tantalizing prospects overseas, some investors and advisors are content staying by the home fires. Jeff Swantkowski, a principal at Patriot Wealth Management in Houston, allocates no more than 10% of his equity portfolio to purely international investments, either through mutual funds or exchange-traded funds. "We have strong markets here in the U.S., and this is where people run to when they feel frightened."
Nonetheless, continued boring returns in the U.S. will make overseas investing hard to resist. Although Gallagher expects the wealth transfer from the developed world to the emerging markets to play out over many years, he's realistic about the long-term picture. "You won't see another 100% gain in some of these markets over the next three years," he says.