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.
Soft Dollar Buoys Foreign Equities
August 1, 2005
« Previous Article
| Next Article »
Login in order to post a comment