Foreign Stock Performance Not as Robust as U.S.

Posted by Larry Brundage on April 18, 2011

larry_f.jpegThe theme in the international markets for the first quarter has been the outperformance of cheap markets.  Investors seem to be overlooking economic growth and instead seeking value.  As a result, the top five country ETFs that we track were Russia, Spain, Italy, France and the Netherlands while the bottom five were Chile, Peru, Japan, Taiwan and the Philippines.  While this phenomenon did not work out perfectly in our list of 36 countries, a comparison of the extremes illustrates the point:

   Russia  Chile
 ETF 2011 Q1 Return  16.0%  -9.7%
 12/31/10 Market P/E  8.9  19.6
 GDP Growth Forecast  4.35%  6.10%


We should note as an aside that Japan’s position in the bottom five was due to the tragic earthquake and tsunami, a Black Swan event if ever there was one.  Yet the Nikkei’s reaction was likely exacerbated by overvaluation as it entered the tragedy.  On December 31st the Nikkei had a P/E ratio of 20.5, one of the highest in the world.

In aggregate, the international markets underperformed the S&P 500 with a return of 3.2% versus 5.9%.  It would be nice to jump up and down and say that this is what we forecast in the January newsletter, but the underlying causes for the underperformance were somewhat different from what we had expected and the year is still young.

At the time the dollar had been appreciating and we had expected it to continue to do so.  Yet it appears that with the Federal Reserve keeping short term interest rates near zero and federal deficits becoming increasingly worrisome, investors are in turn becoming increasingly wary of the dollar.  Thus during the quarter the dollar index fell about 4%.  It is unusual for the dollar to continue to fall as it did during an international crisis like the Japanese earthquake.  Historically, the dollar has been considered a safe haven that is attractive when global events create a flight to quality.  The continued decline of the dollar during this crisis may be indicative of its weakness and the likelihood that it will continue to fall.

A falling dollar helps the relative performance of international markets, both bond and stock.  However, even with a 4% drop in the dollar, international equity markets were not able to outperform the U.S.  On the fixed income side, the Citigroup World Government Bond Index had a 0.658% return, almost double the performance of the domestic index, the Citigroup Broad Investment Grade, 0.358%. 

We also expected Europe’s returns to be weak as the debt problems of Europe’s peripheral countries continued to worry investors and to provide a drag on their economic performance.  This may yet turn out to be the case as the year plays out, but for the first quarter, as we noted above, the relatively attractive stock prices in those markets were too enticing for investors to ignore.  An important element of that attractiveness was the improving European corporate earnings which were partially aided by a strengthening dollar during the fourth quarter, a situation which has now reversed.
Our concern about inflation, particularly in Southeast Asia and South America combined with high market valuations has, so far, played out as we thought with weak performance in most of those markets.  Much of that inflationary pressure has come from the rise in commodity prices, particularly (although not solely) in agricultural commodities.  This type of inflationary pressure has disproportionate effects among various countries due to the differences in the amount of income that has to be devoted to commodity purchases.  For example, the average family in India devotes a significantly higher amount of its income to food than the average American family.  Thus expenses for the average family in India are inflating much faster than they are for the average American family.
The disproportional effects are not only due to inflation within an economy but they are also due to the makeup of the industries in those economies.  Those countries that have a high proportion of commodity producers will have markets that perform well.  Russia, Canada and Australia are good examples of countries that we expect to continue to benefit from such conditions.

Putting it all together, we still expect a modest year in the international markets.  They will be helped more than we expected by the decline in the dollar, but continue to likely be hampered by excessive debt in Europe along with high valuations and inflation elsewhere.