May 23, 2014
|Ray Mills, portfolio manager of the T. Rowe Price Overseas Stock Fund.|
The international investment landscape paints a mixed picture, but there are reasons for optimism. A modest economic recovery continues in Europe as concerns about the sovereign debt crisis have abated. However, European markets have performed well, so valuations are not as compelling but remain reasonable. Japan also performed well last year but has suffered a setback this year as it continues pursuing economic reforms that should be beneficial longer term.
Many emerging markets offer appealing valuations and improving political conditions but are coping with slower growth and tighter global liquidity. While China's growth has slowed, it is implementing structural reforms and moving toward a more balanced, sustainable economy, but this is not without risk.
Ray Mills, portfolio manager of the Overseas Stock Fund, recently offered these observations on the international investment environment.
Europe: Moving in the Right Direction
- Europe is generally moving in the right direction, but economic growth remains anemic and is not accelerating. The concerns about the sovereign debt crisis have largely receded, which has spurred performance in the periphery countries this year. There have been efforts toward fiscal austerity in these countries and other policies that have started to bear fruit.
- Valuations in Europe remain reasonable, if not as cheap as they were, so Europe has performed much better even as the recovery remains fragile.
- Europe illustrates the lesson we see over and over again—that things don't have to be euphoric for the markets to do really well. They just have to start moving in the right direction, or even stop getting worse.
- Europe has the potential for a virtuous cycle. Improving economic growth will encourage companies to invest more, and that helps employment, which leads to more economic growth. Profit margins are still good, so if topline revenue growth improves, companies should get some operating leverage, which could provide a positive backdrop for European markets.
Japan: Waiting for Reform
- After a strong performance last year, Japan's market has stalled so far this year. Investors are still waiting for Prime Minister Shinzo Abe's economic policies aimed at boosting growth and inflation to be implemented. There have been a few baby steps, but that third arrow of structural reforms to labor markets and tax and regulatory regimens is still in the quiver. The point of the third arrow was to combine looser monetary policy to end the deflationary cycle with stimulative fiscal policy and structural reforms.
- We expect reforms in Japan to progress in fits and starts as Prime Minister Abe works with political factions to bring about structural changes, which are the most challenging component of the government's reform efforts.
- One of Japan's other challenges is its aging population, which does not bode well for economic growth. Increased immigration is probably not likely, either. This makes the country's structural issues that much more difficult to overcome. Also, Japan's currency stopped appreciating, and a new consumption tax took effect in April.
Emerging Markets: Struggling to Get Back on Track
- There are some signs that emerging markets could be pulling out of their slump. Valuations are very attractive generally, and some of the political issues have started to stabilize or even improve. We don't see a real case for a crisis in emerging markets. The biggest risk is if China's financial liberalization has a major hiccup.
- I would caution investors not to focus solely on economic growth. It's not unimportant, but there are other factors that are very important, such as structural reforms in the economy, corporate governance, and capital allocation by management teams. These are the things that really matter for equity returns over time.
- Investors can get exposure to emerging market economic growth by investing in developed market companies that sell products in emerging markets. These companies often have strong brands, advanced technology, and better corporate governance than many emerging markets companies.
China: Slower Growth but Lots of Financial Fire Power
- China has experienced a bit lower growth than investors had hoped for, making it harder for the government to reach its 7.5% annual expansion target. There are also concerns about a deteriorating credit cycle in China and the risks from financial liberalization.
- The financial system is highly leveraged, but China's leaders are trying to address it by imposing new rules and restrictions on banks and other lenders.
- I think China will successfully navigate this period near term, as they have considerable financial fire power to put to work. The problem is they keep spending more on fixed asset investments. It's the easiest way to juice the economy, but the effect that they get for each unit that they spend goes down over time.
No Shortage of Risks
- One risk to global growth that may be underappreciated is the increase in sovereign debt, which leads to lower capacity for fiscal stimulus in the next slowdown. We've gotten through the financial crisis largely due to central bank actions. Some fiscally prudent steps have been taken, especially in the periphery countries in Europe, but less so in big countries like the U.S. where government spending is not on a sustainable path.
- Regulatory complexity is another underappreciated risk. It is inhibiting economic growth and employment. Companies do not want to invest when they don't know what the rules will be in the future or they become too complex. There's a lot of that now in the U.S. and Europe, especially in the financial sector.
- Geopolitics is always a source of uncertainty. Our focus remains on finding companies that can prosper even in an uncertain global environment. And we're finding really good fundamental stories where valuations have not yet been reflected in the price. That's what we have done in the past, it's what we are doing now, and that should continue to result in investment success over time.
Investment Outlook Remains Positive
- The current investment climate is challenging, particularly following the gains of last year. Valuations clearly are not as cheap as they were a year ago. However, we believe there are good prospects for better fundamentals in the near term.
- The transition to better economic growth in developed markets presents potential for a virtuous cycle and significant operating leverage for well-positioned companies. Corporate free cash flow and profitability are generally strong, but the durability of profit margins is a key question for markets longer term.
These views are current as of May 15, 2014, and may have changed since that time.
Investing overseas holds special risks—political uncertainty, unfavorable currency exchange rates, and to a lesser degree, market illiquidity—which will cause the value of the Overseas Stock Fund to fluctuate more than that of a similar domestic fund.