What’s Making Foreign Stocks, Bonds So Alluring

Other than gold-mining stocks, the best investment ideas so far this year have been foreign bonds and foreign stocks. And many pros now believe that the foreign play has greater staying power than the gold play.

The reason is simply that interest rates are continuing to fall in much of the world, and in many countries the rate decline has a ways to go before it catches up with the slide in U.S. yields last year. Falling yields automatically boost bond prices, and sooner or later they usually do the same for a country’s stock prices.

With economic growth anemic in the United States and in Europe, bond yields here and there tumbled in 1995. But so far this year, the U.S. bond market’s rally has stalled, even including Tuesday’s buying binge. The yield on 10-year U.S. Treasury notes, for example, is 5.63% currently, up slightly from 5.57% at year’s end.

In contrast, the yield on 10-year German government notes has plunged to 5.82% currently from 6.03% at year’s end, as Europe’s economic outlook has worsened and as investors have grown increasingly confident that the German central bank will continue to slash short-term rates.

Hans Tietmeyer, German Bundesbank chief and the Teutonic equivalent of Alan Greenspan, hinted Monday that he is poised to cut short rates again.

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For investors who are betting on foreign bonds in general, the logic goes like this: European yields have much further to fall based on the Continent’s economic weakness and, in countries like Germany and France, based on much lower inflation rates than even in the United States.

“German inflation is just 2%,” notes Les Nanberg, who manages the Massachusetts Financial Services World Government bond fund in Boston. That means “real” interest rates are still higher in Germany than in the United States.

In much of the rest of the world, meanwhile, interest rates should continue to fall as the Federal Reserve Board lowers U.S. short rates further. Additional Fed cuts may not help U.S. bonds rally significantly because the U.S. bond market already is expecting such cuts (and a balanced-budget plan in Washington). But foreign bond markets that track U.S. rates, including many Third World bond markets, still may have room to come down.

The only bond market that doesn’t look so hot: Japan’s, because that economy is showing surprising strength, pushing yields up from their extremely low levels; 10-year bonds yield 3.1%.

Individuals who want to own foreign bonds can easily do so through mutual funds. Yet this may be more of a short-term speculative bet, not an asset class that most long-term American investors really need, if they already own U.S. bonds for income. “The European bond rally could last another six to eight months,” says Michael Perelstein, foreign-investment manager at MacKay-Shields Financial in New York.

And then what? That’s the problem with foreign bonds--investors must be wary of potential interest-rate shifts and currency-market shifts.

Indeed, the dollar has been strengthening, and if that continues it may erode U.S. investors’ gains in foreign assets. Partly because of the currency risk, many Wall Streeters say the best way to play falling world interest rates isn’t with foreign bonds, but with foreign stocks: They should get a nice kick from lower rates, and once they start to rally their price gains can far exceed bonds’--limiting any currency-related damage.

Already this year most foreign stock markets have been rising despite U.S. stocks’ slump. After two years of badly lagging the U.S. market, foreign shares are in many cases undervalued relative to their U.S. peers, foreign-stock bulls say.

In many Third World markets in particular, “economic growth has been good, but the stocks have gone nowhere in the last couple of years,” says Mark Madden, manager of the Pioneer Emerging Markets stock fund in Boston. Contrast that with U.S. stocks’ 1995 surge, and the growing jitters about maintaining those gains.

With interest rates tumbling in Europe, Japan’s economy reviving and many Third World nations poised to grow even if the U.S. economy stays lethargic, foreign stocks now look much more interesting from almost every angle.

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Falling Yields

Interest rates are still falling in many countries, pushing bond and stock prices higher. Yields on 10-year government bonds in Italy, Australia and Germany, monthly figures and latest:

Italy

Tuesday: 10.34%

Australia

Tuesday: 8.23%

Germany

Tuesday: 5.82%

Source: Bloomberg Business News