For most of the past five years, U.S. investors in international stock funds enjoyed both a powerful surge in stock prices and favorable currency translation from a weakening dollar. Since the beginning of last year, plunging international markets, weighed down by a stronger greenback, have decimated those gains.

Yet the case for international diversification remains solid says Barnaby Wiener, who manages the MFS International Value Fund from his office in London. "Some of the best companies in the world are located outside the U.S., so imposing geographic barriers places significant limits on your investment universe," he contends.

Wiener admits the global synchronization of world economies in this latest downturn has drastically muted the benefits of diversifying internationally. But at the same time, he says, the economies and stock markets of different countries will recover at different speeds. That means global diversification could be a more compelling strategy when all the boats aren't sinking. "Certain countries," he says, "are facing short-term cyclical concerns rather than deeper structural issues, and will likely recover much more quickly."

Key To A Turnaround
Even in a best-case scenario, such a recovery will take time. Last year, gross domestic production in the euro zone-the 16 nations that use the euro as their common currency-fell by 1.2%, while it fell by 0.20% in the U.S. The U.K. saw a drop of 1.8%, while Japan's GDP plunged 4.6% for the year. As demand for exports plummeted, factory production for everything from cars to computer chips fell at the fastest pace in decades. Export-dependent countries such as Germany and Japan were especially hard hit.

But traditionally conservative lending standards kept some countries out of the worst of the subprime mess and could give them a head start for an economic turnaround. While the lending practices in countries such as the U.S., Spain and Ireland led to a credit binge that will likely take years to unwind, banks in Germany, France and Japan, by contrast, managed to keep a tighter rein on their loan portfolios and thus far have managed to avoid the worst of the credit morass. "These countries were once characterized as basket cases by many investors because their economies were growing more slowly than those of other developed countries," says Wiener. "Now, they are not facing the same structural headwinds as countries where above-average growth was fueled by rampant lending."

Wiener's optimism about Japan, whose companies account for about one-quarter of his fund's assets, is a contrarian stance in light of the country's well-publicized stock market problems and its recent string of economic woes. In January, the International Monetary Fund said Japan's economy will contract 2.6% this year, after having shrunk at an annualized rate of 11.7% in the fourth quarter of 2008. In December, exports plunged a record 35%. In March, the Nikkei closed at its lowest level in 26 years.

But the economic devastation could force a much-needed change in corporate and government practices, which have long focused on preserving employment and maintaining the status quo. Japanese companies have been forced to fire thousands of workers, driving the nation's unemployment rate to 4.4% in December. Companies such as Panasonic, Hitachi, Nissan and NEC have all announced job cuts in recent weeks. "The pain Japan is feeling is positive if it can expedite restructuring. There is huge latent potential there," says Wiener.

Although a sustained economic recovery in Japan and elsewhere could take years to materialize, Wiener says stock markets around the world are likely to recover sooner. "Corporate profits are not entirely linked to GDP growth, so there is some decoupling between what is going on in the economy and the stock market," he says. "Over the next three years, there will be attractive investment opportunities in companies with a strong market position and a tangible competitive advantage." With markets down nearly 50% from peak levels in some countries, he believes valuations are compelling, particularly for those with a five-to-ten-year investment time frame. He believes stock prices will begin to hit bottom sometime in the second half of this year.

Investors in the U.S. making decisions about international allocations must weigh those positive signs against the possibility of a stronger dollar and the accompanying negative impact of currency translation on foreign stock prices. Wiener sees the dollar rally as a relatively temporary phenomenon and points out that the greenback faces headwinds such as a growing U.S. budget deficit and rampant government spending that could keep further strengthening in check.

And if the dollar continues to rise, he says, many of the foreign companies in the portfolio that do business in the U.S. will see a boost in revenue.

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