Time to Pull Out of Foreign Stocks?

To venture beyond their borders, or to stay home: that is the conundrum facing investors today.

The headlines from abroad are certainly daunting, ranging from the deeply worrying (such as the escalating violence in Egypt) to the odd (flash strikes by French tourism workers protesting budget cuts and working conditions), but collectively they spell potential trouble for investors in search of growth.

Adding to that concern is the latest snapshot of the health of the global economy, unveiled by the International Monetary Fund yesterday. This year, the IMF now says, global growth will be 0.2 percentage points lower than originally forecast, or about 3.1 percent. It has cut its outlook for 2014 growth by the same amount, and now calculates it will be only 3.8 percent.

So much for the argument, often heard five or six years ago, that in the event of a slowdown in the developed economies of North America and Europe, investors could count on the emerging markets to pick up the slack and continue to generate healthy investment returns. In fact, the IMF says, the opposite seems to be happening: The prospect of an end to the Federal Reserve’s easy money policies may help to deepen the problems of those economies, exposing underlying problems.

Emerging markets face not only volatility but the risk of real financial instability, notably in such areas as China’s hyper-inflated real estate market, which already has triggered a giant market swoon. And this just the emerging markets: In Europe, Portugal’s political woes have reminded us all that the prospect of economic growth from that region is purely hypothetical at present.

So, what should an investor do? Hang on to their allocations to international markets, suggests Paul Christopher, chief investment strategist at Wells Fargo Advisors. That piece of advice seems counterintuitive, but that is part of Christopher’s broader point. The reason to sell, he says, would be if you believe that financial markets outside the United States are likely to “underperform persistently” in the coming years. That’s a different test than most investors apply to their portfolios: we tend to react to anxiety and uncertainty by selling, even if those concerns already are priced into current market valuations.

Christopher is suggesting that we stop focusing only the turmoil around us today, and examine the longer-term outlook for international markets. Staying invested in foreign stocks not only gives you exposure to any potential future growth, but it can actually reduce portfolio-wide volatility for investors with a long-term time horizon, since domestic and non-U.S. stocks tend to move in opposite directions. In the short run, Christopher admits, sentiment can offset this, overwhelming the market’s ability to focus on longer-term prospects for growth in both overseas economies and corporate profits. If anything, he argues, we’re heading toward a period when the U.S. and other stock markets will be less correlated, and local differences in outlook play a greater role in shaping returns.

That doesn’t mean that outlook will always be positive, however, and the trick for many investors will be finding a way to follow Christopher’s advice – that “long term success comes from time in the markets, not timing the markets” – without propelling themselves to the edge of a nervous breakdown. It’s tough to allocate fresh capital to China right now, however confident you may be that the People’s Bank of China isn’t going to let the banking sector or the real estate industry collapse or that the country’s demographics argue against any bubble being as destructive as some warn. Going long Europe is equally troublesome, demanding a level of confidence in Eurozone policymakers that probably isn’t warranted.

Count economist Ed Yardeni as one of the skeptics. He notes that it isn’t just these known trouble spots that are generating negative buzz. Russia’s GDP growth is slowing, to only 1.6 percent in the first quarter of 2013, down from 2.1 percent in the fourth quarter of last year – and that is in spite of the relatively high price of crude oil, which accounts for a hefty chunk of that country’s economy. Meanwhile, he notes, real GDP in India is growing at less than 5 percent, well below the recent norm of 8 percent or so.

Whether it’s outright corruption or simply the inability of national policymakers to undertake needed reforms to spark economic growth, there appear to be plenty of factors that will constrain growth outside the United States. A lack of global economic growth, in turn, will weigh on the prices of key industrial commodities, such as copper. In turn, that will constrain growth in some developed economies that are disproportionately reliant on exports of those commodities, such as Australia and Canada.

So, how can you set about slicing this Gordian knot and making a decision? It boils down to something vitally important; something too many investors tend to overlook, at their peril: their time horizon.

How old are you? When do you hope to retire? How much have you managed to set aside to ensure that you don’t outlive your savings? All of these questions have a bearing on whether you can afford to take a long-term approach to asset allocation decisions – indeed, they dictate whether you must adopt such a view – or whether you need to pay an increased amount of attention to shorter-term trends.

If your allocation to non-U.S. stocks leaves you with a loss over the next two or three years, how much damage will that do to your overall financial objectives? The shorter your time horizon, the more difficult it will be to recoup those losses, and the more risk you may be tempted to take – unwisely – to fill any gaps that emerge.

Most of us, however, still have decades ahead of us. If we’re still working and earning and setting aside new money to invest, it makes sense for anyone whose portfolio is significantly underweight non-U.S. stocks to take advantage of the chance to add to those positions, slowly and in a prudent manner. That doesn’t mean running out and buying a Portuguese stock ETF, betting that the market will snap back in the next 90 days as sentiment improves, but rather, seeking out global funds with solid long-term track records and reasonable fees.

That advice may provide little solace to anyone who believes that there is no way that Chinese authorities will be able to contain a real estate bubble or manage its fallout; that European policymakers will still be in limbo a decade from now as the Eurozone slips into long-term stagnation; that countries like Brazil are doomed to follow in the footsteps of, say, Egypt or Syria as riots turn into rebellions and lead toward civil war. In that kind of extreme situation, it makes sense for even those investors with a long-term time horizon to be alarmed enough to stick close to home.

Then again, if this kind of doom-and-gloom is your real view of what lies ahead, it may prove hard to find shelter in U.S. stocks. Like it or not, we are part of the global economy and can’t insulate ourselves from what happens outside our borders. But ignoring non-U.S. stocks altogether isn’t a cure and could, as Christopher implies, end up contributing to quite another form of malaise: an underperforming and volatile long-term portfolio.

Read more at http://www.thefiscaltimes.com/Columns/2013/07/10/Time-to-Pull-Out-of-Foreign-Stocks.aspx#qfJrw5skLT9ufrGs.99