Emerging Markets a Bright Spot in the Third Quarter

In the global financial markets, most of the developments that were in place halfway through this year remain intact as we head into the final quarter of 2016. As a result, the performance results in the Morningstar Categories for funds look much like they did at the end of the second quarter.

Most notably, developed European markets--and thus funds that focus solely on that continent--have continued to struggle. In fact, through Sept. 23, the Europe-stock category was the only one of the 15 international-stock groups in negative territory for 2016, with an average return of negative 0.5%.

The poor showing of many European markets had a damping effect on funds in the more popular, broad international categories as well. On average, foreign large-cap funds have about 60% of their stock assets invested in developed Europe. Not surprisingly, the foreign large-value, foreign large-blend, and foreign large-growth categories take up three of the next four slots at the bottom of the rankings. Even so, these categories managed to outpace the dismal performance of the Europe-stock category, posting positive year-to-date gains ranging from 3.3% to 4.0%.

Many of the broadly focused large-cap funds managed to post modest gains partly by treading lightly in the most troubled areas of the European market. Avoiding the big banks generally has paid off. For example,

Holding stocks in Japan also helped many broadly focused large-cap funds overcome the malaise in Europe. While Japanese stocks--which make up a substantial portion of many broad international portfolios--have had a tough year for the most part, currency gains have helped offset that. The yen has risen sharply against the U.S. dollar this year, and the returns of funds that are unhedged or mostly unhedged--the vast majority of international-stock funds--get a boost when the currencies of countries in which they’re invested climb versus the dollar.

Meanwhile, emerging markets have been a bright spot for investors. The huge rally in Brazil’s stock market and currency fueled gains for many funds bold enough to own the right stocks in that country. That might seem puzzling; Brazil’s economic difficulties and corruption concerns haven’t improved much since those issues helped drive that country's market and currency way down in 2015. But a perceived resolution of the country’s political crisis, with the embattled president being impeached and eventually replaced, seems to have calmed global investors to some degree. Rising commodity prices also helped. (They also helped Russia and Canada, whose markets and currencies have rebounded this year as well. Europe-stock funds didn’t benefit from the revival in Russia’s market or in the ruble, though, because those region-specific funds overwhelmingly steer clear of the continent’s emerging markets, such as Russia and Hungary.)

The rebound in Brazil’s market and currency is the main reason why the Latin America stock category stands as the top performer of all 15 international-stock categories for the year to date, with a gain of more than 30%. Brazilian holdings make up more than half of the portfolios of nearly all pan-Latin America funds.

Brazil and Russia weren’t the only emerging markets providing solid gains in 2016. That explains why the diversified-emerging-markets category is second only to the Latin America group in the rankings thus far this year. Many Asian emerging stock markets and currencies have posted nice gains for the year to date. The strong third-quarter showing of China’s market, in fact, has offered one of the few major contrasts between this period and the first half of 2016.

Meanwhile, sector over- and underweightings have also played roles in the performance of many international-stock funds. For example, the sharp rise in energy prices since early this year has boosted the return of

Finally, while the United Kingdom’s stock market and currency plunged after that country’s late-June vote to leave the European Union, its market soon revived. Thus, the size of a fund’s U.K. stake generally hasn’t affected its performance very much one way or another this year, even though the pound’s value has remained subdued. One reason: encouraging reports on the U.K. economy. Another factor is the size and breadth of the U.K. market, which means that different funds’ stakes in that country could perform very differently depending on which individual stocks they hold.