Jan. 6, 2004 — Since sinking to lows last March at the outbreak of war in Iraq, equity markets around the world have surged on the back of the rebounding U.S. economy. Though global terrorism continues to cast a shadow over investor sentiment, low interest rates, mild inflation and improving fundamentals have generated strong, and in some cases, spectacular, returns for securities around the globe.

All international equity funds tracked by Fund Advisor posted solid gains in 2003. The average portfolio returned a handsome 40.7%. The best performers, in fact, were invested in either the emerging markets or small-cap issues. The number one fund for the year, the $23-million Eaton Vance Greater India/A (ETGIX), soared 117.3%, including a 43.4% surge in the fourth quarter alone. The portfolio is heavily invested in the booming industrials sector of the sub-continent.

The average global equity fund — those funds with the latitude to invest in both U.S. and foreign stocks — gained a robust 33.8% for the year. The top portfolio in this class, the $12.5-million McIntyre Global Equity Fund (DGLEX), had 86.5% of its assets in U.S. stocks as of Sept. 30, 2003.

“The rebound in the U.S. helped to spur demand for goods and services globally, with corporations spending more and the average individual consuming more,” said Wendy Trevisani, co-manager of Thornburg International Value/A (TGVAX). “Low interest rates have been stimulative in much of the developed world, including Europe, the U.K. and Japan. They have also come down significantly in many developing regions, such as India and Eastern Europe. Moreover, the weak dollar serves as an added incentive to invest abroad.”

Emerging Markets Provide Biggest Lift

Among foreign equities, the story of the year has been the swelling emerging countries; indeed, markets such as Argentina, Brazil, Turkey and Thailand have soared nearly 100% this year. The strong performance has attracted more interest from investors. According to EmergingPortfolio.com Fund Research, 2003 will set a new record for cash flowing into emerging market equity funds. Investors poured $11.23 billion of new money into these funds through December 10, already surpassing the previous $10.89 billion record set in 1996. Of that total, more than half ($5.97 billion) has moved into Asian (ex-Japan) equity funds.

Trevisani notes that the emerging markets are providing more opportunities for both foreign corporations and investors. “Typically it costs less to operate in these regions, and many of these countries, like India, Korea and Taiwan, possess a high level of skilled labor,” she said. “There is also large internal growth occurring, with improvements in infrastructure. As long as many of these countries continue to grow GDP at a rate nearly double that of the developed world, strong returns should continue.”

However, Bernard R. Horn, president of Polaris Capital Management and manager of the Polaris:Global Value Fund/Investor (PGVFX), is less sanguine about the emerging world. “This asset class is as volatile and risky as ever,” he said. “The gains have already been made in the emerging markets. All that new money going into these funds is simply a matter of chasing yesterday’s performance. We don’t think these great returns are sustainable. Valuations are no longer so compelling, and, as the dollar weakens, their competitive advantages may greatly diminish.”

China, with its booming economy, has become the planet’s biggest manufacturing/outsourcing center — foreign companies, particularly in Japan, cannot resist China’s low labor costs and inexhaustible supply of skilled workers. “If China allowed its currency to be more flexible, that is, revalued upward, that would change the entire landscape of international investing,” Horn noted. “It would take away some of the competitive advantage of foreign companies moving jobs to China, which, in turn, would help sustain the overall growth in the rest of the world.”

Markets in Latin America skyrocketed in 2003, particularly Venezuela, Brazil and Argentina. Trevisani notes that stock prices in Latin America staged a “recovery from exceptionally depressed levels,” and that further recovery in 2004 is possible, and even likely, citing stable currencies and interest rates, high GDP growth, and a lack of geopolitical strife. Since their economies are closely tied to the U.S., our economic rebound is a “major” positive for them, she added.

Europe Delivers Strong Gains

Although equity markets in Western Europe have generally delivered handsome gains this year, overall economic growth has somewhat lagged that of the U.S. economy, and some nations, including Germany, are in a recession. Complicating factors on the continent is the continued weakening of the U.S. dollar, which plunged to historic lows against the euro this year, and the sustained strength of the euro. “The German market rose almost 60% in dollar terms, but in local currency it was up just 35%,” Horn noted.

Ivo Kovachev, a Prague-based portfolio manager at Driehaus Capital Management, notes that the weak U.S. dollar presents a double-edged sword since it boosts the performance of European equity markets and profits of some European firms, but will hurt the big exporters who depend greatly on doing business with the U.S. Horn said he expects to see some “very negative earnings surprises” in Europe next year for companies that sell into U.S. dollar-based markets. “Unless the dollar reverses, their profitability will be dramatically diminished,” he said. Trevisani expects most of Western Europe to exhibit low single-digit economic growth in 2004.

Japan Also Rises in 2003

Japan, the world’s second largest market, may finally have escaped a thirteen-year economic drought. Trevisani contends that fundamentals in Japan are strong enough to sustain its market rebound, citing, among other things, renewed consumer confidence, improving retail sales, and the brighter position of the country’s financial industry as evidenced by a reduction in non-performing loans.

Japan has also witnessed some easing in deflation, stronger exports and surprisingly good GDP growth.

Horn takes a more cautious view on Japan. “The rally the Nikkei saw in 2003 was largely liquidity-driven,” he says. “Many investors were initially underweight in Japan. Once they moved money into Japan, the stocks that rose were typically the high-profile, big exporting companies and some banks. This type of liquidity push may not occur in 2004. Moreover, the weak dollar hurts the big Japanese exporters.”

However, Horn said he is adding to his exposure in Japan based on “attractive valuations and modestly improved economic conditions,” but still isn’t getting too excited about Japan’s long-term picture since China continues to rout Japan’s competitiveness.

–Palash R. Ghosh