A Rocky Time for Foreign Stocks, Too

07/01/2008 12:00 am EST

Focus: GLOBAL

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, Standard & Poor’s global equity strategist, says there’s been damage to equities worldwide, and he suggests how investors should position their portfolios now. 

Developed international equity markets have been volatile in 2008, as slowing global growth, credit market dislocations, and soaring commodity prices have spurred profit-taking after several years of strong gains.

A looming US recession and mid-cycle slowdowns in the United Kingdom, European, and Japanese economies have accelerated negative earnings revisions, limiting P/E expansion.

We believe greater signs of global economic and credit market stabilization will be needed to stimulate better performance. Significant P/E expansion is unlikely until the profit outlook steadies. However, this appears doubtful over the next few months, in our estimation, given ongoing credit turmoil and weakening momentum in key global economies, most notably the US.

On a positive note, recent P/E compression has left valuations attractive relative to historical averages, in our view. As such, we think [equities] will remain range-bound over the next few months.

Currency has been a big factor in 2008 performance, by our analysis. The US dollar’s year-to-date decline against the euro and the yen has bolstered US investor returns in developed international equities as Europe and Japan represent the majority of this asset class.

Nevertheless, it is worth noting that the dollar has stabilized recently as markets have discounted an end to easing [by the Federal Reserve]. We believe the greenback is likely to trade sideways over the next few months, negating any continued short-term currency tailwind for dollar-denominated developed international returns.

As for emerging market (EM) equities, their year-to-date decline is roughly in line with that of developed international benchmarks and the Standard & Poor’s 500. After five years of strong gains, profits are being taken out of this asset class. [Meanwhile,] slowing growth in the developed economies has investors worried that slowing export demand will dampen profit growth for emerging-market multinationals.

Strong domestic demand and soaring commodity prices are fueling a major increase in EM inflation rates. Inflation now tops 8% in both China and India and is above 14% in Russia. We believe pricing pressure is climbing, as a result of soaring raw material costs and strong domestic economies. As a result, all four BRIC (Brazil, Russia, India, and China) central banks are now raising bank reserve requirements and short-term interest rates.

Taken as a whole, we believe these challenges will continue to pressure valuations and preclude another year of strong price appreciation. However, recent selling has improved the risk/reward ratio of EM stocks. The asset class recently traded at a 2008 estimated Price/Earnings-to-Growth (PEG) ratio of 0.9, reflecting consensus expectations for 14.7% growth in 2008 earnings and a 2008 estimated P/E of 13x.

We believe long-term-oriented investors should maintain exposure to this asset class. We think the infrastructure and consumption-driven secular growth of developing economies remains intact. The S&P moderate global asset allocation dedicates a 15% total portfolio weighting to overseas stocks with 12% in developed markets, and 3% in emerging markets.

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