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First Quarter in International-Equity Funds: Reversals Call the Tune

Many fourth-quarter trends did not extend into the new year.

Gregg Wolper, 04/04/2017

To a large degree, the first quarter of 2017 marked a time of reversal for international-equity funds—in a good way. Reversals of some influential trends in global markets that had worked against international-equity funds in the fourth quarter of 2016 turned in a more positive direction in the first three months of this year.

Most noticeable was the broad decline of the U.S. dollar. The dollar had risen in the fourth quarter, especially after the U.S. election results, as investors reasoned that the new administration’s policies would attract investment to the United States and boost the dollar (as would the expected continuing increases in U.S. interest rates). With the vast majority of U.S.-based foreign-equity funds being unhedged—meaning they buy their stocks using foreign currencies and thus their returns suffer when those currencies decline against the dollar—that dollar rise dampened their fourth-quarter returns. (Over time, the impact of the rising dollar can be partially offset by the fact that weaker local currencies help exporters, but that can take awhile to play out.)

The currency effect is a major reason why the first-quarter returns for all the international-equity Morningstar Categories (foreign large-value, foreign large-blend, and so on) topped those of their U.S.-focused counterparts. It also has been helpful that even though Europe’s political environment remains filled with concerns—such as the ramifications of Britain’s exit from the European Union and the continuing financial woes of Italy and Greece—many of the region’s economies have been showing long-awaited signs of recovery.

Another positive reversal occurred in India. That market took a hit in the fourth quarter of 2016 after the government suddenly withdrew popular currency denominations from circulation. But evidence surfaced early this year that the impact of that move had not been as harmful to the economy as many had feared. Then, the governing party won an important state election. As a result, Indian stocks jumped. The India-stock category was the best performer of any international or domestic equity category in the first quarter.

Many other emerging markets were also strong in the first quarter. Most surprising, perhaps, was the impressive showing of Mexico, whose market and currency rebounded from its post-U.S. election decline despite continuing issues with the new U.S. administration. Meanwhile, Brazil didn’t need a reversal—it just continued the strength it showed in 2016.  Overall, the diversified emerging-markets Morningstar Category rose more in the first quarter than any of the Morningstar Style Box groups.

An area that lagged was frontier markets, those countries deemed to be even less developed in investment terms than those classified as emerging markets. The small number of funds devoted to frontier markets fills the bottom of the diversified emerging-markets category rankings for the first quarter. It’s difficult to generalize about such a disparate group of markets, which range from Pakistan to Vietnam to Kuwait to Argentina, and in fact some of them did quite well. But it’s likely that with prospects for the big, "conventional" emerging markets brightening, investors saw less reason to take on the added layer of risk entailed in frontier markets.

On a fund level, one beneficiary of first-quarter trends was Virtus Foreign OpportunitiesJVXIX. That offering suffered through a subpar 2016—partly owing to its long-standing, substantial overweighting in Indian stocks, which sank returns last November. (It also suffered from its huge store of consumer goods companies, whose steadiness and relatively high dividends became less attractive to investors amid rising interest rates and post-election economic optimism.) But the India position helped the fund land in the foreign large-growth category’s top decile for the first quarter.

Another winner was the flagship fund led by Morningstar’s International-Stock Fund Manager of the Year for 2016, David Herro. Oakmark International Investor OAKIX continued the powerful run it made in the third and fourth quarters last year, when it trounced the competition. In 2017’s first quarter it landed well into the top quartile of the foreign large-blend category. Although individual stock showings rather than broad sector or regional movements generally drive performance for this fund, it didn’t hurt that the fund owned no energy stocks in a quarter when oil and gas prices were falling.

Conversely, the first quarter was not kind to one of the better offerings in the foreign large-blend category, FMI International FMIJX. That fund is one of the few that hedges all of its foreign-currency exposure into the U.S. dollar. That stance has generally helped returns over the past few years, but in the first quarter the dollar’s reversal helped send this fund into the group’s bottom decile.

(For all category returns though yesterday, click here.)

 

Gregg Wolper is an editorial director and senior mutual-fund analyst at Morningstar.

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