International Equity Markets: A Stronger 2015 Likely

This year international equity markets oscillated between sizable gains and equally sizable losses, with the continuing appreciation of the US Dollar significantly reducing the returns to US-dollar-based investors unless their positions were suitably hedged. Looking at MSCI equity market indices, All Country ex US performance year-to-date through December 19th, in US dollars, reflected a decline of -8.37%, while in local currency terms there was an increase of +2.73%. For the advanced economies outside of North America, the corresponding index, EAFE, recorded a similar result: -6.97% in US dollar terms and +2.87% in local currency terms. Emerging markets were more volatile but with similar year-to-date returns: the EM index is down -5.97% in US dollar terms and up +1.10% in local currency terms.

Factors affecting the advanced markets this year included a slowdown in the recovery in Europe, with some countries tipping back into recession and geopolitical developments regarding Ukraine and Russia impacting business confidence. A significant decline in the euro-US dollar exchange rate meant that a year-to-date +1.83% advance in Eurozone equity markets in the local currency, the euro, was transformed into to a -9.37% drop in US dollar terms. Within the Eurozone there were great differences among national markets. In US dollar terms only Ireland (+1.63%) and Belgium (+2.97%) escaped a year-to-date loss; and elsewhere in Europe, only Denmark has remained in positive territory, at +7.03%. The losses in US dollar returns for Finland (-2.893.19%) and Spain (-3.89%) were relatively small. In contrast, very sizable losses in US dollar terms were the case for Germany (-11.22%); France (-11.33%); and, with oil prices plunging, Norway (-23.03%). US investors in the Eurozone who used an ETF hedged against currency changes were able to limit their losses. For example, the WisdomTree Europe Hedged Equity Fund year-to-date return is -1.64%.

In Asia, the recovery in the Japanese economy under Prime Minister Abe’s “Abenomics” was brought to a halt by an increase in the sales tax in April, while aggressive monetary easing led the currency down. As was the case in Europe, hedging against currency changes has been the difference between an acceptable return and a significant loss. The MSCI Japan Index is down -4.99% year-to-date in US dollar terms. We are using the WisdomTree Japan Hedged Equity Fund, DXJ, in our International and Global ETF accounts. It is up 6.41%.

Emerging-market equity returns were even more volatile and diverse, as significant gains in the spring and summer reversed into a downturn beginning in September. More recently the selloff had become widespread and acute, but there has been a bounce-back following the Federal Reserve meeting on December 17, which increased confidence that US interest rate increases were not coming soon. Economic growth in the emerging-market economies has slowed somewhat from 5.2% last year to a projected still-healthy 4.6% this year. Investors apparently feared a greater slowdown. Early in the year the emerging markets were hit by concerns of a slowdown in China that might become severe, by global economic growth that was also slowing, and by the development of a secular bear market in commodities. More recently, while the slowdown in China appears to be modest and economic prospects in the advanced economies are looking brighter, even in Europe, a plunge in emerging-market currencies (other than the Chinese yuan) relative to the US dollar has raised concerns for countries with sizable foreign currency (largely US dollar) debt, much of which has been issued by emerging-market nonfinancial companies. This is the case for Russia, for example, where the ruble has plunged. The decline in the oil price is having mixed effects, crushing equity markets of economies dependent on oil exports such as the UAE and Russia while providing a welcome tailwind to oil importers such as India, Thailand, and the Philippines.

Political developments also have been a factor this year in emerging markets, ranging from Russia’s annexation of Ukraine’s Crimea, a military coup in Thailand, and protests in Hong Kong, to the more positive events of elections in India and Indonesia that brought in reform-minded governments. Toward year-end an important development affecting prospects for the Hong Kong and Chinese Mainland markets was the start-up of Shanghai-Hong Kong Connect, providing reciprocal market access to investors in both markets. This should be a positive for both markets going forward.

Selectivity was particularly important for investors in emerging markets this year. Considering US dollar returns year-to-date, positive gains were registered by the Philippines (+21.72%), India (+20.30%), Indonesia (+21.41%), Thailand (+14.65%), Turkey (+14.76%), Peru (+8.36%), Qatar (+4.22%), and Taiwan (+4.17%). In China, A-Share stocks have surged, up 40.81% in US dollar terms, but there is very limited access to these shares for US investors. The MSCI China Index of shares available to foreign investors is up just barely, at +1.37%. With the exception of Peru, Latin American markets were all in the red, with Brazil down -17.69%, Chile down -16.32%, and Mexico down -10.87%. The emerging markets of Europe and the Middle East as a group are down -30.59%, led by Russia’s -48.79% plunge. The Asian region was the strongest for emerging markets, up slightly by +0.86%. The major underperformers were Malaysia (-14.93%) and Korea (-11.61%).

As we look forward to 2015, global growth should be somewhat stronger. Among the advanced-market economies, Europe should be advancing at a better, though still moderate, pace as the global manufacturing cycle recovers. Europe’s gains from lower oil prices will be modest, as it is not a heavy consumer of oil. Nor will the expected increase in quantitative easing have a great effect on the pace of economic activity, as it is weak credit demand, not a shortage of liquidity, that is the major headwind to growth. Nevertheless, earnings are improving as cyclical growth picks up, while cost pressures remain depressed. As the euro is likely to fall further against the US dollar, though at a slower pace, hedging against this currency factor will still be desirable. Japan’s economy and equity markets should advance further in 2015, and hedging against additional yen depreciation will also be desirable.

Emerging-market economies will continue to encounter the headwinds that have been evident since September, including the strengthening US dollar. China’s economy will likely slow somewhat further. Brazil’s economy may pick up somewhat from the current recession, but the growth certainly will not be robust. The same appears likely for Russia. India’s economy, on the other hand, is expected to accelerate, benefiting from both lower oil costs and economic reforms. The outlooks for Indonesia, the Philippines, Thailand, and Taiwan are also positive.