And they’re off to the races again.

Foreign stock markets got off to a strong start in the first quarter of 2006, continuing the robust performance they enjoyed last year despite high energy and commodity prices, and rising rates in the U.S. and Europe. The average international equity fund returned 10.66% for the quarter, versus 4.21% for the S&P 500. The average global stock fund — which has the latitude to invest in both U.S. and foreign stocks — climbed 7.17%.

The emerging markets, especially Latin America, delivered handsome gains on the back of commodity demand from China and sustained high crude oil prices. Japan, last year’s star performer, slowed down. However, the big story among international stock markets has been the somewhat surprising resurgence of Western Europe. Equities across the old continent soared. Scandinavian nations, in particular, rocketed as much as 20%, while old stalwarts France, Germany and Italy showed respectable gains of between 10% and 15%.

M&A Craze in Europe

European markets are in the midst of a merger & acquisitions frenzy that is pushing up stock prices despite overall sluggish economic growth, high unemployment, modest consumer demand and a new phase of credit tightening by the European Central Bank (ECB). Indeed, the ECB raised its key target rate in December 2005 by 25 basis points to 2.25% — it was stable at 2% since August 2003 — and hiked again in March 2006 to 2.5%. Standard & Poor’s expects this rate to finish the year at 3.00%.

Even so, with interest rates still relatively low and corporations in Europe filled to the brim with cash after posting strong profits in recent quarters, M&A activity is likely to accelerate. According to Dealogic PLC, global M&A activity totalled about $923 billion in the first quarter, of which Europe’s portion was a whopping $416 billion. The value of European M&A deals were more than double for the comparable 2005 period. Moreover, merger transactions in Europe have occurred across an array of sectors and industries, notably in utilities, financials, materials, and media and telecom.

Emerging Markets Still A Bargain

Alexander Young, equity market strategist at Standard & Poor’s, attributes several factors to the continuing strength in emerging markets equities: robust earnings growth, relatively low valuations, low global interest rates and strong international money flows. Given that many companies in the MSCI Emerging Markets index are in the energy and materials sector, Young noted, the current commodity bull market will serve to drive growth among the developing markets. “We expect the MSCI Emerging Markets Index to show a return in the mid-teens range this year,” he said. Moreover, the emerging markets are expected, by consensus. to deliver 14% earnings growth this year – a figure higher than for the U.S. and Europe.

The biggest short-term risks facing emerging markets equities, Young said, relate to tighter global liquidity than currently expected by the capital markets. “Despite large year-to-date gains, emerging markets equity volatility has increased since January as concern mounts regarding the pace of global tightening by the U.S. Federal Reserve, the European Central Bank and the Bank of Japan,” he said. “Given emerging markets dependence on exports to the developed world, investors are concerned reduced global liquidity may threaten emerging markets economic and profit growth.”

Young also believes higher interest rates in the U.S. may reduce “the incentive to invest in riskier asset classes such as emerging market equities.”

Still, valuations throughout the emerging markets remain extremely attractive. According to the S&P/Citigroup Global Equity Broad Market Indices, surging emerging economies such as Argentina, Brazil, Malaysia and Mexico sport 12-month trailing P/E ratios of 11.0, 12.2, 14.9 and 13.0, respectively, as of February 28. As a whole, the emerging markets are trading at 14.6, versus 20.5 for U.S. equities. However, several developed countries also feature attractive multiples: Belgium, Denmark, Hong Kong and the U.K. are trading at 10.4, 14.9, 12.2 and 13.4. As a whole, Western Europe trades at 15.1, while Japan is at 27.4.

Interest Rate Speed Bump

Much focus will be on the near-term monetary policies of the central banks of the world’s most powerful economies. For example, after surging 40% last year, the Nikkei turned in a pedestrian 5.8% in the first quarter of 2006. The Bank of Japan’s decision to cease fighting deflation, and possibly end its nearly-zero interest rate stance, may have dampened some investor enthusiasm. Rising rates in the U.S. and Europe, as well as Japan’s monetary policy shift, likely also hurt the markets of Asian tigers South Korea and Taiwan in the quarter.

Jeff Mortimer, manager of the $1.4-billion Laudus International MarketMasters Fund/Inv (SWOIX), said when the U.S. Federal Reserve ends its tightening cycle, it should provide a boost to U.S. investors putting money overseas. “When the Fed stops raising rates, the dollar may lose some of its strength, all else being equal, which would benefit international mutual fund investors, as they benefit from a falling dollar,” he said. “A weakening dollar would make our exports less expensive, and would have the reverse effect on imports. So these two effects work to offset one another.”

Mortimer added that more U.S. individual investors are seeking to play the foreign stock markets, from Europe to Japan to the emerging markets. “I believe that many are, and have been, underweight this asset class for years, and now are playing catch-up because of the strong returns that have happened over the past few years,” he added.

International Equity Funds and Exchange-Traded Funds

Best Performers

First Quarter 2006 Returns (%)

Worst Performers

First Quarter 2006 Returns (%)

Oberweis China Opportunities (OBCHX)

+38.7

Fidelity Japan Smaller Companies (FJSCX)

-3.3

Dreyfus Premier Greater China Fund/R (DPCRX)

+33.6

Japan Smaller Companies Fund (JSCFX)

-1.3

Gartmore China Opportunities/A (GOPAX)

+28.3

Commonwealth New Zealand Fund (CNZLX)

-0.6

Eaton Vance Greater India/A (ETGIX)

+25.2

AMIDEX 35 Israel Mutual Fund/C (AMDCX)

-0.5

FTI European Smaller Companies Fund (FESCX)

+23.8

Fidelity Advisor Korea/C (FAKCX)

+0.8

Global Equity Funds

Best Performers

First Quarter 2006 Returns (%)

Worst Performers

First Quarter 2006 Returns (%)

Alger Fund: The China U.S. Growth (CHUSX)

+21.1

Federated Market Opportunity Fund/C (FMRCX)

-0.7

Oppenheimer Global Opportunities/Y (OGIYX)

+14.5

GMO Tr Alpha Only/III (GGHEX)

+0.8

Lord Abbett Alpha Strategy Fund/A (ALFAX)

+14.3

UBS Dynamic Alpha/B (BNABX)

+2.1

Evergreen Global Opportunities/I (EKGYX)

+13.5

Putnam Income Stratagies Fund/C

+2.3

DWS Global Thematic Fund/S (SCOBX)

+13.3

DFA Global 25/75 Portfolio/R

+2.4

International Exchange-Traded Funds

Best Performers

First Quarter 2006 Returns (%)

Worst Performers

First Quarter 2006 Returns (%)

iShares MSCI Brazil Index Fund (EWZ)

+21.2

iShares MSCI Taiwan Index Fund (EWT)

+2.2

iShares FTSE/Xinhua China 25 Fund (FXI)

+19.9

iShares MSCI South Korea Index Fund (EWY)

+4.4

PowerShares Golden Dragon Halter USX Trust (PGJ)

+19.2

PowerShares International Dividend Achievers (PID)

+5.3

iShares MSCI South Africa Index (EZA)

+17.7

iShares MSCI Australia Index Fund (EWA)

+6.0

iShares S&P Latin America 40 Index Trust (ILF)

+14.3

iShares MSCI Japan Index Fund (EWJ)

+6.4

*SOURCE: Standard & Poor’s. Total returns are in U.S. dollars and include reinvested dividends. Preliminary data as of 03/31/06.