July 1, 2004 — Despite an economic recovery in the U.S. and reasonable corporate earnings growth in many countries, foreign stock markets have, on the whole, delivered uninspiring returns through the first half of the year. The average international equity fund returned 3.1% through the end of June, just below the 3.3% gain for the S&P 500. The average global equity fund, which invests in both U.S. and foreign stocks, also edged up 3.1% in the first half.

Global equities, to varying degrees, face pressure from lofty energy prices, higher interest rates in the U.S., the seemingly endless violence in Iraq, and fears of a second-half slowdown in the mammoth, commodity-hungry Chinese economy. While certain smaller countries such as Colombia, Austria, Hungary and Czech Republic have posted outsized gains, equity markets around the globe are generally sluggish amidst concern that the global rally will peter out.

To be sure, foreign stock investors may have breathed a sigh of relief when, as expected, the Federal Reserve hiked rates by 25 basis points and offered a “measured” pace of tightening. Indeed, global equity markets had already discounted the first rate increase.

Asia: Japan Surges, But Chinese Slowdown Casts Shadow

This year’s best performing international stock funds invest in Japan, one of the globe’s brightest markets. The Japan MSCI Index is up a healthy 10%. Aside from progress in structural reforms, strong GDP growth, and robust consumer spending, Japan’s recovery has been buoyed by its growing export business to China.

The five highest-returning foreign stock funds all invest in Japanese stocks, with the top three portfolios — DFA Invest Grp Japanese Small Company Port (DFJSX), Fidelity Japan Smaller Companies (FJSCX), and Japan Smaller Companies Fund (JSCFX) — benefitted from the surging small-cap sector in Japan. The Russell/Nomura Small Cap Value Index has soared 29.6% year-to-date.

Despite strong performance, two major risks cloud the economic picture: demand in China is expected to slow down appreciably; and Japan’s 100% dependence on expensive foreign oil could cut into corporate profits and hurt consumer confidence.

Lauretta Reeves, chief investment officer at Hansberger Global Investors, finds Japan a bit too rich these days. “On the basis of price-to-cash-flow and especially P/E, the Japanese market is more expensive than the international markets in aggregate,” she notes. “It is still difficult for us to find attractively valued stocks with which we are comfortable as many have muted growth prospects.”

South Korea, an increasingly important Asian economic power, but which is susceptible to high oil prices and U.S. interest rate movements, tumbled about 15% in the second quarter, finishing about flat for the first half.

After soaring to dizzying heights in 2003, India’s stock markets have plunged nearly 19% this year. Indeed, last year’s top performing foreign stock fund, the Eaton Vance Greater India Fund (ETGIX), now ranks as the sector’s worst performer, illustrating the extreme volatility of emerging markets investing.

Bombay’s SENSEX Index was thrown for a curve with the unexpected victory of the Congress Party in the recent national election. Viewed as less business-friendly than the former ruling BJP party, Congress’ July budget will give jittery investors a better idea of Indian’s future fiscal policies.

A Question of Liquidity for Emerging Markets

Rising interest rates in the U.S. will most likely spell trouble for the emerging markets. The asset class got hammered back in 1994/1995 during the Fed’s last round of aggressive rate hikes as tightening drained liquidity from these volatile markets. Certain emerging economies, which performed superbly last year, may likely either show muted gains in 2004 (Russia) or perhaps incur steep losses (Brazil, India, Turkey).

However, Reeves points out that in the aggregate, stocks in the emerging markets still trade at significant discounts to the developed markets. Moreover, companies like Samsung Electronics Co Ltd. of Korea and Embraer-Empresa Brasil (ERJ) of Brazil have evolved into first-class global players.

Western Europe: Lackluster Returns, But Good Fundamentals

Markets across the continent have generally been flat, trading in narrow ranges all year, somewhat lagging behind the U.S. markets. Europe’s largest economy, Germany, remains weighed down by weak consumer demand and high unemployment.

On the bright side, corporate earnings in Europe have been impressive while valuations remain modest, perhaps setting the stage for a strong second-half performance. Also, since economic growth has been tepid and inflation tame, central banks in Europe are unlikely to raise interest rates much any time soon. In addition, considering the continued relative strength of the euro and cost cutting by big corporations, equity prices in Europe may not have much downside risk for the remainder of the year.

Latin America: Brazil Wanes, Mexico Waxes

Latin America’s two dominant markets are going in opposite directions: The MSCI Brazil Index has declined about 14.5% year-to-date, while MSCI Mexico Index has risen by 12.9% Brazil’s markets, which nearly doubled in value in 2003, are now burdened by a slowing domestic economy, prodigious debt levels, fears that President Luiz Inacio Lula da Silva will fail to enact much needed reforms, and growing concerns that China’s demand for Brazilian commodities will decelerate.

In Mexico, strong equity returns have been supported by high oil prices and a resurgent economy in the U.S., Mexico’s number one trading partner. However, as emerging nations, Brazil, Mexico and much of Latin America will undoubtedly suffer the effects of rising U.S. interest rates.

International Equity Funds
Best Performers Mid-Year 2004 Returns (%) Worst Performers Mid-Year 2004 Returns (%)
DFA Invest Grp Japanese Small Company Port (DFJSX) +27.6 Eaton Vance Greater India/B (EMGIX) -18.2
Fidelity Japan Smaller Companies (FJSCX) +27.3 Wells Fargo Funds:Montgmry Emg Mkt Foc Fund/B (MFFBX) -13.0
Japan Smaller Companies Fund (JSCFX) +24.5 Eaton Vance Asian Small Companies/B (EBASX) -11.6
ProFunds:Ultra Japan/Iv (UJPIX) +20.6 U.S. Global Investors Fds:China Region Opport (USCOX) -10.7
Matthews Japan Fund (MJFOX) +19.3 AllianceBernstein Greater China 97/B (GCHBX) -9.1

Global Equity Funds

Best Performers

Mid-Year 2004 Returns (%)

Worst Performers

Mid-Year 2004 Returns (%)

Tweedy Browne Global Value Fund (TBGVX) +11.9 Prudent Global Income Fund (PSAFX) -5.6
Hartford Global Health Fund/Y (HGHYX) +10.5 GAM Global Fund/D (GAGDX) -5.5
Seligman Global Growth/R (SGGRX) +10.2 Janus Adviser:Worldwide Fund/C (JWWCX) -3.7
Ivy Fund: Cundill Global Value Fund/Adv (ICDVX) +10.0 Janus Aspen Srs:Worldwide Grth/Svc -3.7
Oppenheimer Global Opportunities/A (OPGIX) +10.0 Gabelli Global Growth/C (GGGCX) -3.0

Source: Standard & Poor’s. Total returns are in U.S. dollars and include reinvested dividends. Data as of 6/30/04.

Contact Robert F. Keane with questions or comments at:

bkeane@ia-mag.com.