Overseas Funds Mostly Beating Domestic Rivals

Many foreign stock markets got off to a promising start in the first quarter, but the woes that dragged down the U.S. market in the second quarter also infected overseas shares.

Still, thanks to the weak dollar, foreign stock mutual funds in general were a far better place for Americans to be invested than Wall Street in the first half.

That’s a turnabout from recent years, when the U.S. market consistently beat major foreign markets.

Overall, Asian markets were the best performers in the first half, while European stocks suffered some of the biggest declines outside the U.S. In the Americas, the Mexican and Canadian equity markets held up relatively well, while Brazilian shares sank on renewed worries about the nation’s heavy debt load.

The average international stock fund slipped 0.4% in the first half, compared with an 11.7% loss for the average U.S. fund, according to Morningstar Inc.

In the second quarter the average international fund was off 4.1%, while the average U.S. fund lost 12.2%.

“The malaise is broadly based” in recent months, said Alan Brown, chief investment officer at the world’s biggest money manager, State Street Global Advisors, with assets of $806 billion. “I suspect we’re not going to get out of this much before next year.”

Investors worldwide have been worried about the pace of the global economy’s recovery and the speed with which corporate earnings will rebound.

In the United States, those worries have been compounded by a mounting distrust of corporate financial reports in general, in the wake of the many accounting scandals that have dominated the business headlines.

That distrust spread to Europe last week, when debt-laden entertainment giant Vivendi Universal disclosed financial woes that led to the ouster of its chief executive.

“Individuals are feeling dismayed and are very reluctant to commit money to the market,” said Stuart Schweitzer, global investment strategist at J.P. Morgan Fleming Asset Management, which has $600 billion in assets.

The sell-off this year has been as bad in Europe as in the United States, as measured by the changes in major blue-chip share indexes.

The French market’s key index, the CAC-40, was down 16.5% year to date through Friday (that includes Friday’s powerful rebound in most European markets). Germany’s main index was down 13.1% and Spain’s key index was down 15.7%. All of those declines are in euro-currency terms.

By comparison, the U.S. Standard & Poor’s 500 was down 13.9% as of Friday.

But because the euro has risen sharply against the dollar this year, U.S. investors’ losses in European stocks have been muted.

Through Friday, the French market’s loss in dollar terms was 8.7%, the German market’s decline in dollars was 5% and the Spanish market’s loss was 7.8%.

How it works: As the euro rises in value, a portfolio of investments denominated in euros translates into more dollars.

One euro now is worth about 97 cents. At the start of the year the value was about 89 cents.

The dollar also weakened against the Japanese yen and other Asian currencies in the first half, boosting U.S. investors’ returns in the region. Japan’s Nikkei-225 stock index is up 2.7% in yen terms year to date, but for U.S. investors the index is up 12.3%.

The South Korean market’s main index is up 13.6% in local currency terms this year, and up 24.6% in dollar terms.

Global investors in the first half seemed to remain most optimistic about Asian markets’ prospects. In contrast to the declines in Europe and the United States, markets in Thailand, Malaysia and Singapore, among others, still are positive for the year in local currency terms. Hong Kong and Taiwan indexes are off about 5% this year.

“Against the backdrop of only very moderate export growth, it has been domestic demand that has proved to be the key driver of both [economic] growth and stock performance” in much of Asia, Merrill Lynch & Co. noted in a June report on the region.

In Japan, smaller-company stocks were the top performers, mirroring the better relative performance of U.S. small stocks. The biggest gainer among foreign stock funds in the second quarter was the Fidelity Japan Smaller Companies fund, up 19.2%.

Smaller Asian markets, and emerging markets such as Russia, also weathered Argentina’s currency devaluation in the second quarter without severe spillover effects.

Likewise, though the Mexican market has surrendered most of its gains this year, it’s still slightly positive since Jan. 1 in peso terms.

As with the U.S. stock market, how foreign markets will fare in the second half may depend on the pace of the economic recovery and how that translates to the corporate bottom line, analysts say.

European blue-chip corporate operating earnings are expected to grow by an average of 26% this year, according to Thomson Market Strategy Group.

That compares with a 7% growth estimate for the S&P; 500 companies in 2002, based on analysts’ estimates as tracked by Thomson First Call.

Expectations of better economic prospects outside the U.S., and a growing disgust over American accounting scandals, have been major factors in knocking down the dollar this year.

A recent Merrill Lynch survey of 282 fund managers at institutions worldwide found that investors have less money in U.S. stocks than at any time since February 2000.

“The best opportunities are probably to be found overseas, outside the U.S.,” Schweitzer said. “The dollar is in the midst of a downdraft that may go on for a while.”

The only problem with that view is that it’s so widely held--which means the market may delight in going the other way. And if the dollar surprises investors by rebounding, it will work against U.S. owners of foreign stocks by devaluing their holdings--the story of much of the late 1990s.

The euro began to weaken last week after peaking at nearly $1 early in the week.

Still, some analysts say that after a lengthy period of under-performing U.S. stocks, foreign markets are overdue for an extended winning streak, at least relatively speaking.

Jay Pelosky, global investment strategist at brokerage Morgan Stanley, contends that foreign economies and markets are “decoupling” from the United States, which had been the engine of growth in the ‘90s. That will favor foreign markets at Wall Street’s expense, and at the dollar’s expense, he said.

But he warns that foreign markets won’t be well-served if the dollar goes into a free fall. “For decoupling, we need a gradual weakening of the dollar, not a collapse,” Pelosky said.

A stronger euro has helped U.S. investors in European stocks this year, but it also has negative implications for European exporters by raising the cost of their exports.

On the plus side, a strong euro reduces the cost of American imports for European buyers, which puts downward pressure on inflation on the Continent.

That’s one reason the European Central Bank has been able to hold off raising interest rates this year, and may continue to do so until the fall, experts say. Continued low rates could help stocks regain appeal.