Policy uncertainty in China, currency reversals, and continued domestic weakness in Japan and elsewhere weighed on global markets, but there were some bright spots, says Morningstar analyst Patty Oey.
Jeremy Glaser: For Morningstar, I am Jeremy Glaser. It was a wild first quarter in the U.S. and abroad. I am here with Patty Oey, she is a senior analyst here at Morningstar. We're going to look at the quarter for international funds.
Patty, thanks for joining me.
Patricia Oey: Thank you.
Glaser: So if we are talking about the first quarter and international, China has to be the first question. Really in January there was a lot of concern about China, it seems to have ameliorated a little bit. What happened in China and particularly what happened with China-focused funds?
Oey: Right. So in the first quarter the market was very volatile, it was down as much as 25% in February and then it kind of rallied a little bit, but it is still down about 10%, 15% for the first quarter. And certainly all the usual suspects are cited as the problems. I mean, we have large corporate debt, we have rising bad loans on the banks' books, and we just have slower economic growth. Those are all important issues.
But one of the key issues is we know the government goes into the stock market and buy stocks, we know they are trying to remove the bad debt from those banks, and we know they are trying to stimulate the economy. So the key issue actually is policy missteps. So when the government does something, it could help, or it could really hurt in the long run. And so that kind of uncertainty is kind of what's driving the volatility.
As a side note, I think, today or yesterday The Wall street Journal had an article and it was titled ["China Bulls Become an Extinct Species."] So sometimes people say that when the media finally turns, that's probably where the bottom is.
Glaser: So when we talk about the Chinese stock market we are just talking about the A-shares, the onshore shares, but a lot of U.S. investors don't necessarily have exposure to that, so they have kind of a different experience with China; did funds that invest in China also have a challenging quarter?
Oey: The stock markets in Shanghai and Shenzhen did underperform the stocks that trade in Hong Kong, but not by much, it was probably about 500 basis points or so. So they were both all down.
Glaser: So if we are talking about these policy missteps when you are looking forward do you think we could see more volatility in China, that the worst is not behind us yet?
Oey: I think the policy misstep issue is always a driver of volatility.
Glaser: OK, well, let's take a look at currencies. This has been another big story for international fund investors either because of the swings of returns or if they are thinking about hedging or not. What did we see in terms of currency this quarter?
Oey: Right. So actually after the dollar rallied for couple of years in the first quarter the dollar against a basket of currencies was down about 5% to 7%. And I guess in terms of how it impacted market returns. maybe it didn't impact the U.S. as much, but certainly in Japan, the yen rallied against the dollar, and then the euro rallied against the dollar. And it had a negative impact on those corporates and on those markets because a lot of those companies are big exporters. And also it was like a reversal; it was a big trend over the last two years that you wanted to buy those stocks because they are benefiting from a strengthening dollar and their weakening home currency. And then there was a bit of reversal in the first quarter of this year.
Glaser: I know currencies are tricky, but what do we think kind of drove some of that reversal in the quarter?
Oey: Well, you know the U.S. economy has been doing better. And then there was this view that Janet Yellen was going to--we had the first rate hike and it was probably going to be about four this year and then it was going to be slow but steady and now it's possible that we won't have another hike until the end of the year. You know the election is a big wildcard, and I think Yellen has cited that even something like China--slowing growth in China is a concern for the global economy, so they want to be prudent and not be too risky.
Glaser: Let's look at the returns in some other parts of international funds. You mentioned Japan, how did they perform?
Oey: So the Japanese markets were actually very weak. Yeah, I mean part of it is just a reversal--the yen started to strengthen, so it's a reversal from what's happened over the last few years. But, generally, the same issues that Japan has faced over the last few years continues to be a problem. So they are not seeing a lot of growth domestically and the corporates, you know, in Japan, they--Japanese companies are kind of known to be very--to be not very shareholder-focused, and not very focused on returns, and so they have lots and lots of cash on their balance sheets. They are not spending on capex. Earnings are not growing. So it's kind of the usual suspects.
Glaser: How about other emerging markets, other than China?
Oey: Well, maybe emerging markets can be said to be a little bit of a surprise. Some of the markets performed really, really well and the main issues were that commodity prices kind of recovered a little bit in the first quarter and maybe also with the weakening dollar, that was also a benefit for emerging-markets economies.
Glaser: So where were some of the bright spots?
Oey: Definitely Brazil and some of the commodity exporters like South Africa. Otherwise there aren't really huge, strong fundamental positives for those economies, but there was a little boost from those things I mentioned.
Glaser: How about European stock markets?
Oey: They were a little bit weak, too. I mean the economies there are recovering a little bit. People will cite maybe a strengthening euro is going to be a challenge for the European corporates. I guess the big issue for Europe right now is this Britain exit, which people are calling the Brexit. So that would--there are voting on it in June. So definitely leading up to that, there will be volatility as to what's going to happen. That will certainly impact euro and euro markets.
Glaser: I'm sure we'll be hearing a lot more about that in the months ahead. But looking at fund flows, where are investors placing their bets aboard? Are we still seeing lots of inflows into some of these funds?
Oey: Right. So last year, we saw lots and lots of flows into international equities and in ETFs, definitely a big--lots of demand--there was a lot of demand for currency-hedged ETFs. This year, we are still seeing very strong flows into international equity. One thing we need to note is that actually, there has been a lot--target-date funds are actually a big driver of international equity flows.
If you look at foreign large blends, the category, there were very, very large flows, but actually a good portion of that is target-date, which means that investors aren't choosing to go into international markets or buying a target-date fund. The target-date fund has set allocations. Part of it is international. They are just putting money into the international funds.
But if you look at foreign large value and foreign large growth, they are also seeing inflows. So investors seem to be still positive on those broad funds. Perhaps, I mean maybe it's not surprising that some of these smaller categories like China or Europe or Latin America, they seem to be more trading vehicles, so they kind of move along with the markets. So Japan, Europe, China, those saw outflows. What's surprising is that Latin America also saw outflows, but Brazil had a very strong quarter. So that was a little bit of a surprise.
Glaser: Well, Patty, I really appreciate the update on the foreign fund landscape today.
Oey: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
