S&P Sells Japan to Lighten Up Overseas

09/17/2007 12:00 am EST

Focus: GLOBAL

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, equity strategist for Standard & Poor's, explains why the firm has cut its exposure to foreign stocks and why it's thrown in the towel on Japan.

[Last week, Standard & Poor's] Investment Policy Committee decided to reduce its exposure to international equities to 20% from 25% and increased its recommended cash allocation to 15% from 10%.

In light of our continued positive outlook on emerging markets and European equities, the 5% reduction in the foreign equities allocation is focused on Japan.

While international equities continue to outperform the US [in 2007], this is largely the result of double-digit gains in emerging markets and solid European returns. Japan has lagged badly, falling 4.5% [so far this year].

As a result, we eliminated our 3% allocation to Japan based on weakening economic growth and high valuations. We're also concerned about earnings, since recent yen appreciation threatens to derail exports.

In addition, we modestly reduced our recommended allocation to developed international equities (as represented by the MSCI EAFE index) to 15% from 17%.

While developed international equities continue to perform well, [they are outperforming US equities by] only 120 basis points through September 12th.
 
We made no change to our 5% diversified emerging markets equity weighting. Superior long-term [economic] and earnings growth, coupled with low relative valuations, gives us confidence that the recent outperformance will continue.

Emerging market equities are up 19.5% [this year through September 4th] vs. modest gains for most developed markets, and S&P believes that less economic reliance on the United States and attractive 2008 [relative price/earnings multiples] are driving the outperformance.

Analysts expect earnings growth of 15.1% for emerging markets in 2008 vs. an estimated 8.6% gain for developed-country stocks and a projected 12.1% increase in the S&P 500 index.

Despite higher projected growth, emerging market valuations, at 12.7x estimated 2008 earnings per share, are lower than those of both US (13.8x) and developed overseas equities (13.0x).

According to International Monetary Fund data, emerging market economies accounted for 69% of 2006 world GDP growth. S&P believes this trend is continuing in 2007, as emerging market economic growth continues to outstrip that of developed countries.

In addition, we expect domestic demand to continue to expand [in emerging companies]. As per-capita incomes rise, more people are expected to move to urban areas. And as the urban middle class grows, consumption should increase significantly.

S&P believes emerging market equities should represent a core, long-term holding in US investor portfolios. The S&P global asset allocation dedicates 5% (of our 65% recommended worldwide equity weighting) to diversified emerging market equities. The exchange traded fund that tracks this group is the iShares Emerging Markets Index fund (AMEX: EEM).

We took the 5% from [developed-market] foreign equities and put it all into cash. We remain underweight fixed income at 25% vs. our benchmark's 30% fixed income allocation. Our exposure to US equities remains at 40%.

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