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Still Reason to Pack Investment Suitcase
Non-US Markets Offer Buying Opportunities
By Ann Duncan
Portfolio Manager, Russell Investment Group
Global Leaders in Multi-Manager Investing
April 13, 2004
This article has been provided by our parent company, and any references to rates or returns are based in $US and specifically relate to US markets.
In the debate over the shrinking diversification capabilities derived from investing in international stocks, Russell's money managers have been of like mind. Au contraire!
While correlation between international and US market returns has risen over the past few years, this doesn't mean that investors should lessen the international component of their portfolios. There continues to be an excellent case for long-term investors to diversify assets both domestic and foreign. Not the least of which is that when you restrict your focus to domestic stocks, you may miss out on many of the world's best companies as well as situations where structural reforms or early-stage growth have the ability to produce benchmark-beating performance.
Yet this doesn't suggest throwing darts at a map; every country has not shared the rebound in the US economy. There are most definitely both bright spots and places to tread lightly. Let's take a journey overseas and review regional circumstances.
Talking Tech
At the start of 2004, technology issues continued to rally following the group's strong gain in 2003 (MSCI EAFE technology rose 48%), though a sizable part of the return came from currency gains. Some of the best news has come from Scandinavia, home of Nokia and Ericsson. These giants have propelled the overseas tech sector this year. However, Russell money managers are currently mixed on future prospects because technology companies, particularly in Europe, are starting to look expensive relative to historical norms.
The strong earnings shown by US tech stocks in January and February helped boost sentiment worldwide. Earnings have been generally solid among non-US companies as well, particularly in the communications equipment sector, though European managements have cited the negative impact of the strong euro.
At many overseas companies, the genesis for their renewed appeal has been cost cutting and other restructuring efforts in addition to improving sales — and more attractive valuation levels than their US peers. But it should be noted that when technology does well overseas, it is usually not reflected as much in market indexes as you would find in the US given the smaller weight of tech companies, particularly in Europe. For example, at the end of February, technology stocks made up over 17% of the S&P 500 Index compared to their 7% weight in MSCI EAFE and 5% weight in MSCI Europe.
Attention to Asia
Over the course of past year, a number of Russell managers have been shifting more assets into Japan, reversing the underweighting of previous years. China and other Asian emerging markets have also had renewed appeal, given the tremendous growth of the Chinese economy.
Though Japan has had several false starts during its extended slump, it has recently come back to life. The Japanese economy grew at a very strong rate (over 6%, annualized) in the fourth quarter of 2003 helped by rising sales to the US, and very robust demand from China. And though the US is expected to be the strongest of the developed markets in 2004, Japan's outlook is currently much more positive than that of the Euro zone.
While it's dangerous to say "this time it's different," Japan's recovery is unique relative to other upturns over the past decade: the banking system is healthier having made good progress in reducing non-performing loans, deflationary pressures are waning and, at last, consumer spending appears to be on the rise.
Japan's unemployment rate reached a record high in 2003, but has eased since then, and wages and salaries have also stabilized. Business conditions have been steadily improving, with a fall in the number of bankruptcies. Better profits, the prospect of higher employee bonuses, and rising real estate values are boosting consumer sentiment. The likely benefit of all this may be a rise in consumer spending, which has been depressed for some time.
The European Exception
On a comparative basis, the European economies remain fragile. A distinct exception within Europe, however, has been the UK where the robust property market and strong consumer spending supported the economy through the global downturn. Even so, Russell money managers have generally found the UK stock market to be relatively unappealing given its composition.
The UK has less exposure to the deep cyclicals and tech stocks that fared so well in 2003, and more exposure to energy, consumer staples and pharmaceuticals that tend not to be the major beneficiaries of recovery. Thus the UK has not been as leveraged to the global recovery as the Continental European markets. While its out- of-favor status in 2003 led to relatively attractive valuations for some of the UK's more stable large-cap growth companies, earnings forecasts are not overly compelling. Rising interest rates, high levels of consumer debt and a property bubble have also lessened the appeal of the United Kingdom.
Some Russell money managers have also underweighted Germany and France in favor of such peripheral markets as Spain and the previously mentioned Scandinavian countries. Italy has also been controversial of late due to the Parmalat bankruptcy, Europe's own accounting scandal. In general, Europe exhibited more corporate malfeasance last year than could be expected.
The combination of continued strength in the euro with a weakened dollar could put the European recovery at risk, as it cuts into the earnings of exporters. The European Central Bank has taken notice, and amid some political pressure, there is hope that later in the year it may ease monetary policy by cutting interest rates further. Structural reforms now evolving in Germany may also help the euro on a longer-term basis.
While lackluster economic growth last year did not keep stocks from soaring, MSCI Europe rose 39.1% in 2003, economic indicators have disappointed this year and 2004 growth forecasts are being eased down, particularly in Germany. In general, the Euro zone is highly dependent on its exporters as consumer spending has remained weak in the face of high unemployment. And while Europe's exporters have benefited from the global recovery, the strong euro has pressured their profit outlooks.
With the Japanese monetary authorities intervening aggressively in the currency markets to keep the yen low and exports competitive, the euro has been the major shock absorber of dollar weakness, gaining over 20% against the dollar in 2003. Despite pressures from rising euros, we could see a move back to greater interest in Europe later this year. By a number of measures — P/E ratios, price-to-book ratios and more — European stocks are exhibiting more attractive values relative to Japan. At the same time, the outlook for gains and earnings appears to be better for Europe than it is for the United States.
Despite the overall economic challenges of the region, and prominent terrorism issues such as the March 11 bombing in Madrid, Russell money managers are able to find attractive opportunities.
A Shift to Stability
Regardless of the country at hand, Russell money managers expect to see the consumer staples stocks overlooked in 2003 to perform better in 2004. The former favorites such as cyclicals, materials and industries are starting to look expensive to our managers relative to long-term norms.
This may not be the time to lessen one's commitment to international investing; in fact, as the pendulum swings back from extended outperformance by US markets, better opportunities may be developing abroad.
Copyright© Frank Russell Company 2004. All rights reserved. See Important Legal Information. Date of first use: 04/13/2004.
This is a publication of our parent, Frank Russell Company. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited.
Russell Investment Group is a registered trade name of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide. Frank Russell Company is a subsidiary of The Northwestern Mutual Life Insurance Company.
Non-US markets entail different risks than those typically associated with US markets, including currency fluctuations, political and economic instability, accounting changes, and foreign taxation. Securities may be less liquid and more volatile. If applicable, please see a Prospectus for further detail.
Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and to political systems which can be expected to have less stability than those of more developed countries. Securities may be less liquid and more volatile than US and longer-established non-US markets. If applicable, please see the Prospectus for further detail.
MSCI EAFE Index: An index, with dividends reinvested, representative of the securities markets of twenty developed market countries in Europe, Australasia, and the Far East.
MSCI Europe Index: A market capitalization-weighted index of over 550 stocks traded in 14 European markets.
S&P 500 Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the US large cap securities market (representative sample of leading companies in leading industries).
Frank Russell Company and Standard & Poor's Corporation are the owners of the trademarks, service marks, and copyrights related to their respective indexes.
Indexes and/or benchmarks are unmanaged and cannot be invested in directly.
RC 3821
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