International Markets May Show Modest Gains

Posted by Larry Brundage on January 26, 2011

larry_f.jpeg2010 was not the year for international equity markets.  In fact, if you look at the list of equity indexes in the Current Markets Charts section of this newsletter, the international index, MSCI EAFE, is the worst with an 8.4% return.  Although, an 8.4% return in and of itself is not too shabby.  In fact it is above the bond market return of 6.4% (as measured by the Citigroup Broad Investment Grade Index) and just slightly below our expectations for the long term average annual return for the index of 10%.

That last place showing can’t be blamed on currency; the dollar index rose 1.5% during 2010, admittedly a drag on international stocks, but not nearly enough to bring the index’s home currency performance up to the S&P 500’s 15.1% showing.  (Note that the dollar index does not have the same country weighting as the MSCI EAFE so using it to convert MSCI EAFE dollar returns to domestic returns fits into the “best guess” category.)

Often when we look at indexes, we tend to forget that they are merely averages of their components.  So it would be unfair to look at the MSCI EAFE index and assume that each country outside of the United States had a mediocre equity market.  The range for the index was from +34.8% in Sweden to -44.7% in Greece.  Greece is a member of the high debt group of countries in Europe commonly referred to as the PIIGS (Portugal, Italy, Ireland, Greece and Spain), which as a group was largely responsible for the MSCI EAFE’s mediocrity.

Looking forward and trying to predict the performance of an index with the breadth of the MSCI EAFE is a dicey business.  That said, we certainly have a point of view and a few relevant (we hope) comments:

  • While the dollar did not appreciate much during 2010, there were certainly swings in its value during the year.  The fourth quarter of the year was particularly notable for the dollar’s strength.  We expect this trend to continue into 2011.  Several factors may contribute to this phenomenon including a continuation of the problems in the PIIGS countries with the resultant drag on European economic performance.  Also, the dollar may continue to benefit from the unwinding of the carry trade.  (The carry trade is an investment made by speculators in which they borrow in a low interest rate country like the U.S. and use the funds to buy bonds in a high interest rate country.  As the dollar has been rising, the value of the foreign bonds in dollar terms has been going down, creating losses for these speculators.  Thus they unwind the trade by selling their bonds, using the proceeds to buy dollars – causing the dollar to rise more – and repaying their debt.)
  • Weak European economic growth is also likely to be a drag on the performance of their equity markets.  It is necessary to tread a little lightly here though.  The correlation between economic growth and equity performance is far from perfect.  Also, already having corrected significantly, several European markets are looking attractive simply from a valuation standpoint.  As a side note, trying to pick the exact bottom of a market to begin investing more often leads to losses than it does profits.  This is frequent enough that it has generated an adage –“Don’t try to catch a falling knife.”  Well, maybe it didn’t create that adage, but it did lead to its application to investing.
  • Inflation has been picking up in several countries.  This may sound like a strange reason to be concerned because as an investment adviser HFM has often preached that equities, unlike bonds, have the ability to adjust for inflation.  Yet over the shorter term, inflation can act like a higher tax on a populace and slow economic performance.
  • While there are inexpensive markets in Europe, several markets are trading at price to earnings ratios that are significantly higher than the U.S.  One example is Japan, which trades at over 20 times 2010 earnings, compared to the S&P 500 which trades at less than 16 times 2010 earnings.

So where does this all lead us in 2011?  We believe that the international markets as a whole will have a modest year, with single digit growth.  That leads us to the question of what we should do about our international holdings.  We believe that international equity is an important part of a well diversified portfolio.  We do not think that any important asset class should be removed from a portfolio unless we have a strong opinion that it will experience severe losses.  Conversely, in a case like this in which we are not excited about a market, we would not increase a portfolio’s exposure to above its normal target.  Markets have a funny way of giving surprisingly great returns when you least expect it and you have to be invested to be the beneficiary of those returns.

Happy New Year!