Trim Your Sails Overseas

01/30/2008 12:00 am EST


Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, S&P's international equity strategist, says a firming dollar could dampen foreign stocks' performance, and he suggests lightening up on international stocks.

Developed foreign markets have handily outperformed the Standard & Poor's 500 for the past several years, [but they] face mounting pressure from tighter domestic lending standards, large collateralized debt obligation-driven bank write offs, record commodity prices, and fears of slowing exports to the United States. Those factors are negatively impacting economic and earnings momentum and weighing on stock price appreciation.

At this point, positive currency translation is the sole driver of developed overseas stock outperformance relative to their US peers. Specifically, when the impact of currency translation is excluded, the MSCI-EAFE index, a developed international equity benchmark, has actually underperformed the S&P 500 over the past 12 months.

This is especially true in Europe and Japan, which are not as leveraged to the current commodity bull market as Canada and Australia are. (Europe and Japan represent roughly two-thirds of the developed international asset class, with Canada and Australia accounting for only about 15%.)

Given that we expect the macroeconomic conditions to persist, US investors should remain focused on the greenback's trajectory, as it is likely to continue to be a benchmark for equity performance.

US dollar weakness has been driven primarily by deteriorating US economic data, which increases the odds of aggressive Fed interest rate easing. We think the dollar is likely to remain under pressure early in 2008, as US economic momentum continues to decelerate and the market continues to discount additional rate cuts.

However, as 2009 nears, we expect an improving economy in the United States, [and] an end to the Fed's easing campaign will likely be bullish for the dollar. In addition, slowing growth in key foreign economies like Canada, the United Kingdom, and Europe will likely lead to lower rates there, giving the greenback an added boost.

Although we continue to recommend US investors maintain long-term exposure to international equities, we believe portfolio rebalancing is now appropriate in both our developed and emerging-market equity weightings.

We cut the international equity allocation in the conservative, moderate, and growth asset allocations to 10%, 15%, and 25%, from 15%, 20%, and 30%. The developed international allocation in the conservative, moderate, and growth asset allocations declined to 10%, 12%, and 19%, from 13%, 16%, and 22%.

In addition, we cut the emerging market equity allocation to 0%, 3%, and 6% in the conservative, moderate, and growth global asset allocations from 2%, 4% and 8%, respectively.

Lastly, we recommend increasing cash by 5% to 20% in the conservative and moderate portfolios, while raising it to 15% in the growth portfolio. As the current global equity correction abates over the next few months, we stand prepared to opportunistically redeploy these reserves into equities.

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