October 11, 2005

Foreign Equity Funds and ETFs -- Third-Quarter 2005 Review

World Stock Markets Soar Despite Uncertainties

After a modest first half of the year, equity markets around the globe soared in the third quarter, pulling far ahead of those in the U.S. This was despite record high crude oil prices, terrorist bombings in Britain, and the continuing war in Iraq.

With few exceptions, overseas stocks delivered extraordinary gains, particularly the emerging markets of Latin America and Eastern Europe, putting year-to-date performance solidly in the black. For the quarter, the average international stock fund/ETF gained 12.3%, while the S&P 500 rose 3.5%. Virtually all foreign equity funds posted gains during the quarter.

Jeff Knight, portfolio leader of Putnam's Global Asset Allocation Funds, says the strength in foreign markets provides further evidence of the progress of global economic rebalancing. "There has been a pronounced decoupling of foreign equity markets from the U.S. market, which showed particular vigor during the third quarter," he notes. "The shift in the balance of global economic activity, from a world whose growth was dominated by the U.S. economy to one whose growth is more balanced, is becoming more visible, and better understood by investors."

To illustrate the increased attraction to foreign stocks, the Investment Company Institute (ICI) reported that in the month of August, U.S. funds that invest primarily overseas had inflows of about $8.2 billion in August -- almost double that of July -- versus an outflow of $1.9 billion for funds that invest in U.S. stocks.

Latin America: Commodities Are King

Mutual funds and ETFs investing in Latin America, driven primarily by robust global demand for energy and commodities, topped the charts. The MSCI EM Latin America index has risen 41.1% year-to-date, including a 29.5% burst in the third quarter alone. The region's two largest equity markets, Brazil and Mexico, climbed 36.2% and 21.8%, respectively, in the third quarter. Both markets recently reached all time highs, as did exchanges in Argentina, up 49.4% during the quarter, and Chile, up 17.0%. Smaller markets like Peru (+29.2%) and Colombia (+26.0%) also delivered handsome gains.

Brazil dazzled in the quarter, despite high interest rates and a bribery scandal that embarrassed the government of President Luiz Inacio Lula da Silva. The Bovespa index has been buoyed by high oil prices, modest inflation, a strengthening economy, strong iron and steel exports, and surging commodity sales to China. Brazil's currency, the real, also recently touched a four-year high as foreign cash pours into the nation's equity exchanges. Mexico, also enriched by high oil prices, is enjoying a climate of improving corporate earnings, economic stability, decreasing long-term interest rates and low inflation. Aside from its powerful energy sector, Mexico's telecommunications, agriculture, services, and banking companies have also delivered strong gains.

One dramatic exception to an otherwise robust scenario in South America is oil-rich Venezuela -- down 11.6% in the third quarter -- as controversial president Hugo Chavez appears to be gradually moving the country towards more socialist economic policies.

Though Latin markets are extremely strong now, investors should consider that as emerging markets they are not very diversified, and remain vulnerable to high volatility and political instability.

Asia: Japan Awakens from Long Hibernation

The vast Asian markets -- comprised of both developed and emerging economies -- also pushed upward in the third quarter on the back of greater-than-expected GDP growth, healthier consumer spending, and the return to prominence of its mightiest member, Japan, which appears to have thrown off a decade-plus long economic malaise.

The Japanese equity markets -- awash in a record quantity of foreign investors' cash and emboldened by the resounding election victory of reform-minded Prime Minister Junichiro Koizumi -- just reached a four-year high. Banking reforms, corporate streamlining, burgeoning business confidence, growing private consumption, high domestic demand, and a possible end to deflation are contributing to bubbling optimism over the prospects for the world's second largest economy. The MSCI Japan index is up 11.0% year-to-date, including an 18.7% bounce in the third quarter alone.

With evidence that deflation is diminishing, Japan's finance ministers have started to openly discuss the end of their zero interest rate policy, Knight notes. "The end of deflation would be a positive for Japanese stocks, and a negative development for bonds; and market reactions underscore this point," he said.

Many believe Koizumi's victory means reforms in Japan are taking hold at both the corporate and political level, and expect to see a positive impact at the macro-level. However, with nearly a 100%-dependence on imported oil, Japan is especially susceptible to rising energy prices. While Japanese corporations are highly energy-efficient, expensive crude presents danger for Japan's export business to the U.S.

Also during the quarter, South Korea's Kospi index soared to an all-time high as economic growth accelerated, and domestic demand recovered. MSCI's South Korea index rose 33.8% year-to-date, including a 21.9% climb in the third quarter.

India, potentially Asia's most powerful market in the future, saw its equity markets rise to an all-time high as well, flush with unprecedented inflows of foreign investors' cash and solid export growth. India's economy is expected to grow 7% to 8% this year, making it one of the fastest-growing economies in the world.

One of the few Asian indices to fall, Taiwan (down 6.4% in the third quarter), suffered from losses incurred by its technology industry, notably its dominant semiconductor sector.

Europe: East Waxes, West Wanes

In sharp contrast to the frenetic gains of the emerging markets, Western Europe has slogged along with relatively modest, unimpressive gains. While labor reforms and economic restructuring measures move apace, equity returns on the continent have been sluggish. Emblematic of Europe's problems is its largest economy, Germany, where an inconclusive election has led to a stalemate that may result in a coalition government. Unemployment is at record levels (5 million), and business confidence remains tepid, hurting consumer spending and economic growth.

The scenario in the newer, more vibrant economies of Eastern Europe is far brighter. EU convergent plays like Hungary, the Czech Republic and Poland are forecasting GDP growth of more than 4%. MSCI's EM Eastern Europe Index has gained 45.9% year-to-date, including an astounding 37.2% surge in the third quarter alone. In the near term, "the major drivers of Eastern Europe appear to be the liquidity in those markets, and investors' attraction to higher growth and still lower valuations of Eastern European stocks," says the value team at Hansberger Global Investors, an investment manager based in Ft. Lauderdale, Florida.

Russia also continues to roll -- and it's due almost entirely to the energy/commodity industry which dominates that county's economy. With high oil prices, immense natural resources and political stability under the presidency of Vladimir Putin, Russia's markets will likely remain robust.

A Question of Valuation

Another concern for investors may lie in valuations, particularly among the surging emerging markets. However, a closer look shows that valuation in many of these economies remains attractive. For example, according to data* from S&P/Citigroup Global Equity Indices, Brazilian stocks are trading at a 12-month trailing P/E of only 9.3; Mexico is at 9.0; and Russia, 9.4. However, certain other emerging markets may be due for a correction -- e.g., Colombia is trading at 19.4; Egypt, 27.7; and India, 17.8. As a whole, emerging market equities are trading at a trailing P/E of about 13.0.

In general, equities in the developed markets are more richly valued than their emerging markets counterparts. But even in the developed world, there are pockets of attractive pricing. For example, Belgium trades at only 11.7; Hungary, 12.1; Norway, 11.9; and South Korea, 12.4. By comparison, the U.S. stock market trades at 21.2.

"The emerging markets offer the best combination of attractive valuation and leverage to global rebalancing," notes Knight. "This is not simply a result of commodity price strength, though this helps for markets like Mexico, Russia, and Brazil. It's also a result of spreading prosperity across the emerging world driven by a robust global economy and low risk aversion among investors.

*S&P/Citigroup data as of July 29, 2005

International Equity Funds & Exchange-Traded Funds

Best Performers

Third-Quarter 2005 Returns (%)

Worst Performers

Third-Quarter 2005 Returns (%)

ProFunds:Ultra Japan/Inv (UJPIX)

+40.6

iShares MSCI Taiwan Index Fund (EWT)

-4.7

ING Russia Fund/A (LETRX)

+38.2

Eaton Vance Greater China Growth/B (EMCGX)

+2.0

iShares MSCI Brazil Index Fd (EWZ)

+34.6

iShares MSCI Netherlands Index Fund (EWN)

+3.4

Third Millennium Russia Fund (TMRFX)

+34.0

AllianceBernstein Greater China 97/B (GCHBX)

+3.7

US Global Accolade Fds:Eastern European Fund (EUROX)

+33.2

Dreyfus Premier Greater China Fund/C (DPCCX)

+4.0

Best Performers

YTD 2005 Returns (%)

Worst Performers

YTD 2005 Returns (%)

ING Russia Fund/A (LETRX)

+57.5

iShares MSCI Taiwan Index Fund (EWT)

-2.9

T Rowe Price Latin America Fund (PRLAX)

+52.1

Seligman International Growth/B (SHBIX)

-0.1

T Rowe Price Emerging Europe & Mediterranean (TREMX)

+51.5

Hartford International Capital Appreciation/B (HNCBX)

+0.1

iShares MSCI Brazil Index Fd (EWZ)

+50.6

Hartford HLS Intl Capital Apprec/IB (HBICX)

+0.8

Third Millennium Russia Fund (TMRFX)

+50.0

Gartmore China Opportunities/A (GOPAX)

+2.8

SOURCE: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.
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