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.