What's Propelling Foreign Stocks?

A weaker dollar and strong economic growth prospects abroad add luster to international equities

From Standard & Poor's Equity Research

It was an ugly spring for world stock markets, but a good summer. All major equity asset classes have enjoyed a robust recovery from their June 13 lows. International equities are pacing the gains. The S&P Europe 350 index is leading the way with a total return of 15.4% in U.S. dollar terms this year through September 5. It was followed by the MSCI Pacific ex-Japan index, up 12.6%, and the MSCI Emerging Markets index, up 11.7%. The MSCI Japan index, with a 4.3% gain, is the only major international equity index that has not outperformed the S&P 500, which has generated a 5.2% total return thus far in 2006.

Why the foreign outperformance? In a word, growth. S&P expects U.S. economic growth to slow to 2.3% in 2007, down from the 3.4% increase forecast for 2006. And while we expect Europe, Japan, China, and India to slow as we head into 2007, the magnitude of their expected deceleration is less pronounced. Europe and Japan remain above trend, while emerging markets like China, India, Russia, and Latin America are all experiencing continued robust expansions.

S&P Equity Strategy believes this solid growth explains the underperformance of U.S. equities. With the U.S. economy leading the current slowdown in global growth, anxiety about future earnings predictability is highest stateside, thereby limiting equity market upside. In addition, on average, U.S. equity valuations are 15% higher than those for international stocks, despite similar profit growth prospects.

Although confidence in U.S. Federal Reserve Chairman Ben Bernanke's ability to engineer a soft economic landing has risen recently, the housing market remains a weak spot. Further monetary tightening cannot be ruled out, as inflation is heating up and unit labor costs are rising. Conversely, while rates are rising internationally as well, most major foreign economies are earlier in their economic cycles, allowing for more gradual central bank tightening from lower absolute levels. For example, short-term interest rates are 5.25% in the United States, compared with only 0.25% in Japan and 3% in the Eurozone.

Finally, positive currency translations are giving a boost to international equities. The expectation of continued tightening overseas, coupled with the prospect of an imminent end to Fed tightening, is lifting foreign currencies vs. the U.S. dollar. The U.S. dollar index, which measures the value of the dollar vs. six major world currencies (the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc) has fallen 6.8% this year through August 30.

S&P Equity Strategy expects international stock outperformance to continue through year-end. Investors should maintain a 20% foreign equity allocation, consisting of stocks from both developed and emerging overseas countries. The recommended allocation in our Model ETF Portfolio is 12% in developed international markets (EFA), 4% in emerging markets (EEM), 2% in Japan (EWJ), and 2% in Pacific ex-Japan (EPP).

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