Euro’s rise signals it’s time to diversify

A decade of U.S. economic hegemony may be ending. For financial advisers, proper allocation to international markets, particularly in Europe and Asia outside of Japan, is critical. Exposure to domestic large-caps and traded-goods companies may be fruitful because these companies could benefit from high international exposure.

Despite the near-record advances in U.S. equities late last month, the market’s severe year-to-date declines have fueled fears that an era of great prosperity is over. But what we are witnessing likely is a shift in equity dominance from the United States to foreign markets. The key to performance throughout this part of the investment cycle is proper diversification – to international as well as domestic assets.

We believe that improving policies abroad will generate faster rates of economic growth, create a positive environment for foreign equity markets and continue to drive the currency markets in favor of foreign currencies. Although we see an economic recovery in the United States, it is likely to be somewhat below average. As long as foreign economic policies improve relative to U.S. economic policies, we anticipate a return to international investing.

Getting even

The euro’s rise to parity with the dollar is the first sign that a shift toward foreign economic performance is under way. Most commentators refer to this “euro strength” interchangeably with “dollar weakness.” Although few stop to distinguish between the two phenomena, the difference is critical to our outlook for economic growth and financial market returns.

Answering this vital question – is the dollar weak, or is the euro strong? – requires an external benchmark by which to value both currencies. Imagine that your car’s speedometer only gauged your speed relative to other cars. All you would know is how much faster you were going relative to the car in the next lane. The foreign exchange markets provide only this type of relative information.

A real speedometer, however, measures the speed of your car against a large fixed object – the Earth. Measuring the value of a currency versus gold provides this absolute sense of speed or value because gold holds its value in terms of other goods and services over long periods of time.

In our view, the majority of the increase in the euro’s value relative to the dollar is due to euro strength, not dollar weakness. We base this assessment on the nearly 14% appreciation of the euro relative to gold in the past nine weeks. In addition, the dollar recently broke out of its $310-$320 trading range, appreciating to $302 per ounce of gold on July 29. The dollar has not been weak; rather, the euro has been strong.

The euro has been strong for all the right reasons. First, its recent strength offsets earlier weakness that was beginning to produce increased inflation within the euro zone. Higher inflation is a natural consequence of a currency’s falling in value.

Second, the strength of the euro is indicative of an increase in the returns on capital in Europe relative to returns in the United States. Falling tax rates, a stronger currency and freer trade are all inviting capital to move to Europe.

The 11% appreciation of the South Korean won relative to the U.S. dollar since April 12 is indicative of a wider pattern of increased real rates of return throughout Asia. South Korea is seeing the positive effects of personal and capital gains tax-rate reductions. In addition, China continues to reduce the barriers to international trade and commerce. Through its World Trade Organization accession, China is opening its borders so that it can expand its trade – both imports and exports – with all of Asia and the industrialized world. Such a massive transition will bring social and political change, which is often resisted, but will lead to faster rates of economic growth and equity market returns.

On average, the dominant equity market switches from the United States to foreign markets about every four years. The U.S. market outperformed significantly for the five-year period from 1995 through 1999. In 2000 and 2001, the United States continued to outpace foreign markets, but to a lesser degree. More recently, the tide has begun to turn in favor of international markets. During the first half of this year, the Morgan Stanley Capital International Europe, Australasia and Far East index outperformed the MSCI U.S. index on a three-year rolling average basis for the first time in seven years.

Multinational plays

Exposure to international assets may be a rewarding strategy in the quarters ahead. Foreign market performance, however, doesn’t preclude domestic investments from capitalizing on this trend. Large domestic companies derive a great percentage of their revenue from overseas; 23% of sales, versus 7% for the average domestic small-cap.

To capitalize on foreign economic growth domestically, large-caps and traded-goods sectors such as technology show the greatest relative potential.

Proper diversification to assets with international exposure is as important in today’s bear market as it was in the bull market of the late 1990s. We believe the economic recovery will be somewhat less than the average U.S. post-recession rebound. The financial markets suggest that economic growth and equity returns may be higher overseas than in the United States over the coming quarters.

Waking our clients up to the potential of international investing may be the best piece of advice we can give them during these difficult times.

Charles W. Kadlec is a managing director with money manager J. & W. Seligman & Co. in New York and chief investment strategist with Seligman Advisors; Mike Aguilar is economist and assistant vice president with Seligman Advisors.