For international funds to race ahead of domestic funds, you typically need a falling dollar and rising foreign markets.
This year,
most international funds are misfiring on at least one cylinder. The average large-company foreign blend fund has gained just 2.38% this year, versus 5.87% for its domestic counterpart. You can blame either a strong dollar or weak foreign markets for the poor performance.
Normally, currency flows go to where the rates are highest. As low as U.S. short-term interest rates are, they're higher than short-term rates across much of the world. Currently, the federal funds rate is between 0.25% and 050%. In contrast, the European Central Bank is making short-term loans at -0.4%, the Bank of Japan lends at -0.1%, and the Swiss Central Bank's rate is -0.75%.
In 2016, however, both the euro and the yen have made small gains against the dollar. The euro ended 2016 at $1.089, versus $1.107 now. A dollar now buys about 100 yen, down from 125 yen in June. “Since the middle of the Great Recession, the yen has taken on a role as a safe haven currency, and that has helped appreciate the yen since then,” said Ronald Simpson, managing director of global currency analysis for Action Economics.
The main foe of international returns this year has been lousy stock markets. Consider the Eurozone, which has been wracked by worries about its banking system. MSCI's eurozone index, which measures stock performance in the countries that use the euro, has fallen 5.4% this year when measured in euros. When measured in dollars, the eurozone index is down 3.85%.
Similarly, the Japanese dollar has been strengthening against the dollar, despite the Bank of Japan's short-term lending rate of -0.1%. A dollar now buys about 100 yen, down from 125 yen in June. “Since the middle of the Great Recession, the yen has taken on a role as a safe haven currency, and that has helped appreciate the yen since then,” Mr. Simpson said.
But Japan's stock market has swooned 13.4% this year as investors worry that the government's stimulus packages aren't working. Translated into dollars, that's a 0.58% gain — better than Europe, but still less than the U.S.
Finally, there's the
United Kingdom. Thanks to the U.K.'s decision to leave the eurozone, the pound has gotten a pounding, falling from $1.70 in June to $1.23. “It's just a piece of junk right now,” said Mr. Simpson. Peculiarly, England's stock market is up 13.71% this year, if you happen to be buying in pounds. If you're investing in dollars, the U.K. market has stung you for a 4.52% loss.
Not surprisingly, funds with big bets on the U.K. have wound up looking like they've had a visit from soccer hooligans. Morgan Stanley Institutional International (MSIQX), down 0.83% this year, had 74% of its portfolio in greater Europe, and 32.5% in the U.K., according to Morningstar. J.P. Morgan International Equity Income (JEIAX), down 0.77% this year, has 27.4% of its portfolio in the U.K.
One secret to a top-performing fund this year:
emerging markets. The MSCI Emerging Markets index has jumped 15.7% this year. Invesco International Companies A (IZIAX), up 14% this year, has 24.11% of its portfolio in emerging markets. Manning & Napier International (EXITX), up 12.4% this year, has 24.2% of its assets in emerging markets.
Nevertheless, it's been a tough cycle for international funds. But those tough cycles usually create happier times. “I've dealt with international strategies since 1998, and we've had these cycles in the past,” said Kurt Umbarger, global portfolio specialist at T. Rowe Price. “Europe and Japan are still struggling, and the economic backdrop gets much more challenging with Brexit. It gets darker and darker when the news gets grimmer and grimmer, until it creates actual investment opportunities.”
With the exception of emerging markets, that hasn't quite happened yet, Mr. Umbarger warned. “Most of our international strategies have been broadly underweighted Japan, primarily because of demographic issues,” he said.
And European bank stocks have been hit by negative interest rates and undercapitalization. “It really is the world turned upside down,” he said.
And, while emerging markets are a bright spot, they are as diverse from an investment standpoint as the developed world is, Mr. Umbarger said. While Chinese manufacturing may be declining, Chinese consumer companies, such as Alibaba, are strong. And judging by nominal gross domestic product growth, countries like Indonesia, India, Peru, Mexico and Brazil are doing well.
One other bright spot: While U.S. short-term rates are generally higher than those in the rest of the world, the dollar's rally could be limited. “You could see this as the last hurrah," Mr. Umbarger said.
