Perspectives

International Stocks: Waiting for Risk-Taking to Return

 In 2012, international market investors sought greater certainty, even if they ended up finding it in Europe, a region racked by a sovereign financial crisis and the possibility of recession.

 They weren’t comfortable with the Japanese market or in the larger emerging markets of China and Brazil, both enduring economic slowdowns.

 But in July, when European Central Bank President Mario Draghi sent a strong signal that the bank would do “whatever it takes” to prevent a eurozone collapse, the positive impact on European equities, and on international equities overall, was dramatic.

Indeed, from late 2011, international markets saw three rallies of almost 20%, each the result of such unconventional central bank actions.

So as uncertainties in Europe subsided over the year, that region emerged as one of the leaders internationally, with the MSCI Europe Index returning 19.9%—outperforming the Japanese and emerging markets overall.

Bob Smith, manager of the International Stock Fund, notes that the European rallies over the last two years have been relatively “riskless,” meaning that defensive stocks outperformed economically sensitive cyclical stocks.

International markets for most of 2012 were led by defensive sectors, though, as in the United States, financials led all sectors.

For 2013, however, Mr. Smith foresees a reversal in the performance pattern of international markets.

He forecasts a much more difficult time for Europe, because of falling growth expectations. Moreover, he says, European defensive stocks that provide downside earnings protection with some growth potential have gotten pricey.

By contrast, he says, emerging markets may lead in 2013, noting the economic downturns in China and Brazil appear to be “bottoming out,” and “sentiment about these bigger markets should improve.”

Also, emerging market stock valuations are relatively favorable.”The market hasn’t begun moving money from relatively safe equities to riskier equities, but I think that will slowly begin to happen over the next 12 to 24 months,” Mr. Smith says. “That’s where the opportunity will be, but it will slowly develop.”

Emerging Growth

 Emerging markets are in transition, too.

 Gonzalo Pángaro, manager of the Emerging Markets Stock Fund, believes that these markets are shifting after a decade of phenomenal performance driven by the rapid industrialization of China and the resulting commodities boom.

 Now, however, growth in China— even short of a hard economic landing—appears to be ratcheting down from more than 10% a year to about 7%, and emerging markets’ growth overall is being driven more and more by rising middle class consumption.

 However, Mr. Pángaro adds, “While the consumer story is alive and well, it also is well known and, in many cases, already reflected in stocks’ prices.”

So some consumer staples stocks have become expensive, he says, but many are still offering the prospect of fairly high growth rates for many years.

He notes that certain emerging markets stocks that had high valuations five or 10 years ago, as measured by their price-to-earnings (P/E) ratios, still delivered good returns. “When there’s robust earnings growth,” he says, “high-quality stocks can grow into their high valuations.”

In 2013, the other likely rotation in emerging markets, Mr. Pángaro says, is better performance by companies in the BRICs, the larger emerging nations of Brazil, Russia, India, and China. (In 2012, such smaller peripheral emerging markets as Thailand, the Philippines, and Peru—less connected to the global economy, China, and commodities— generally outperformed.)

Like Mr. Smith, Mr. Pángaro sees the Chinese and Brazilian economies bottoming as a result of more accommodative fiscal policies, at a time when emerging markets valuations appear favorable.

“This loosening of financial conditions should help spur growth,” he says, “which bodes well for the cyclical outlook in emerging markets.”

But in 2013 and beyond, he concludes, “you’re going to need to be much more selective within emerging markets on the company level, the sector level, and the country level.”

European Morass

 Meanwhile, there has been more progress in Europe, but the crisis is far from solved.

Ken Orchard, an analyst/manager following the crisis for T. Rowe Price, says, “It’s a triple crisis,” made up of competitive imbalances between the eurozone’s north and south, unsustainable fiscal deficits, and excessive public and private sector debt burdens.

So solving Europe’s problems will be a lengthy exercise. The liquidity infusions of the last few years in Europe have bought time and reduced financial stress but are not the solution, Mr. Orchard says.

The eurozone’s peripheral countries need to undertake competitiveness and fiscal adjustments while reducing their debt, he says. “There’s going to have to be greater integration of nations.”

Mr. Orchard says that, rather than a eurozone breakup, the two most likely outcomes for Europe are turning into something akin to Italy or the United States.

Under the first scenario, which he dubs “Greater Italy,” the eurozone ends up with a relatively prosperous, competitive north and a poor, less competitive south sustained by financial transfers from north to south. The north would not like that, he says, but is likely to accept it.

The second scenario, which he calls “Federal Europe,” involves deficit limits on nations and greater borrowing at the eurozone level with strict fiscal and structural reforms to make the peripheral nations more competitive. The problem, he says, is this would be very difficult for the peripheral nations.

In any case, the needed adjustments are without precedent, Mr. Orchard says. “This is an economic, social, and political experiment.”

In 2013, Rays Mills, manager of the Overseas Stock Fund, which has about two-thirds of its assets invested in Europe, says investment, consumption, and growth will be suppressed in Europe—posing “risks to companies’ toplines.”

As a result, Mr. Mills entered 2013 still in a somewhat defensive posture, having added to an emphasis on health-care stocks over the past year and a half and continuing to look for selective opportunities in consumer staples, though many of those stocks have gotten expensive.

“It’s not as though we think we’re through the worst of it in Europe,” he says. “We’re not running out and buying a bunch of cyclical sectors. “But there’re a lot of good companies in Europe that have gotten stronger during the financial crisis in order to survive. They’ve buttressed their balance sheets and gotten more profitable.”

At the same time, however, he also is looking to emerging markets for growth, like Mr. Smith.

While about 7% of the Overseas Stock Fund is invested directly in emerging markets, a substantial share of the revenues of the portfolio’s companies, a third or more in some cases, derives from the emerging market operations of multinationals based in developed markets. And, he says, the percentage of the portfolio’s earnings growth attributed to emerging markets is even higher.

International investing is subject to market risk and risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. Emerging markets investments are subject to the risk of abrupt and severe price declines.

 Charts are for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.

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