International markets—outlook for the second half

International markets experienced an explosive rally in the second quarter of 2009, as signs began to emerge that government economic stimulus packages may be stabilising the global economy. The MSCI EAFE Index gained 25.43% in the period — the sharpest quarterly gain since the 1980s.

However, we remain cautious about the outlook for the second half of the year, as there is still much uncertainty about the ultimate success of the stimulus efforts. For the long-term, our outlook is more favourable. We believe that US investors are, for the most part, still underexposed to international markets, especially emerging markets. Even though flows have improved somewhat, they started from a base of extreme underexposure, in our opinion.

Looking back at the rally
On a regional basis, emerging markets led the quarter, with the MSCI Emerging Markets Index gaining 34.73%. On a cap-size basis, small caps beat large caps, with the MSCI World ex-U.S. Small Cap Index returning 34.09%.

The second-quarter rally was not surprising, in our opinion, considering that the MSCI EAFE Index had fallen by more than 50% since late 2007 and international equities had become quite undervalued at the apex of the financial crisis.

Looking ahead to the second half
The rally took much of the undervaluation out of the equity markets, meaning that second half returns will be driven more by earnings than valuation. With economic growth still in question, we believe the scope for earnings-driven equity returns is uncertain. In the short term, we believe share prices may consolidate after such a hard and fast run-up. In the long-term, however, we are more optimistic.

Emerging markets
We believe the long-term emerging markets story is compelling. This was the last area to enter the recession, and it’s not unreasonable to expect that it will be the first to exit it.

For the most part, emerging markets have not experienced banking or balance sheet crises in the way that developed markets have, and the region still has dry powder to stimulate growth. The MSCI Emerging Markets Index is running between a 5% to 10% discount to its 10-year-average price-to-book and price-to-earnings ratios, which we believe is appropriate in today’s global environment.

Within this asset class, China has been at the forefront of the government stimulus movement, and the results have been quick and visible (unlike in the US, where stimulus funds have largely served to bail out the financial sector.) The “cash-rich” government has been successful in moving jobs away from export-oriented areas and into domestic infrastructure, and the country’s GDP growth rate has not collapsed, as many feared it would.

One interesting trend is that about one-third of emerging markets investments are in passive, index-based funds.[1] (Overall, index mutual funds represented just 13% of the mutual fund market in 2008.) [2] We believe this trend creates anomalies in which companies within the index may become much more expensive than those outside the index.

This environment, we believe, bodes well for active managers who can look outside of the most popular countries and the most popular names, and seek out the best opportunities. We are focusing on locally biased businesses throughout Asia, as Asia-centric companies have not been as exposed to the worst of the global contraction.

Japan
Unlike China, Japan has been more on the sidelines of the economic stimulus movement, as its government has been constrained by a high debt-to-GDP ratio. Japan’s stimulus measures so far have been more about incentives — such as tax breaks for homebuyers — and less about direct injections into the economy.

We have seen a flattening in the rate of deterioration for several macro conditions – unemployment, business confidence and consumption – but we still haven’t seen the spark that will really get the economy moving. We believe that, for the most part, the Japanese market is near fair value.

Europe
While US investors have been pulling out of Europe as of late, we believe the region’s valuation and risk-reward profile are compelling. European equities are valued at close to a 35% discount to US equities – near 35-year lows. [3] To compare, the average discount over the last 35 years is around 20%.

Like Japan, Europe has also been more of a “stimulus spectator” rather than a player. However, because Europe’s economy is export-sensitive, we believe global stimulus efforts could potentially offer some ballast to the region by closing some of this valuation gap.

In short, we view Europe as undervalued and underowned by US investors, and we believe there are good opportunities to be found.

Small caps
From a cap-size perspective, international large-cap stocks are dependent on exports into the industrialised world, while small caps can be seen as a play on emerging market demand.

We believe small caps are inherently attractive and offer far larger opportunities for the second half. While the valuation gap between international small caps and international large caps has closed, there is still a significant valuation discount for foreign small caps compared to US small caps. The MSCI World ex-US Small Cap Index traded at a 27% discount to the Russell 2000 Index at the end of the second quarter.

Implications for investors
As experienced investment managers, we realise that we can only control our investment process; we can't control the market.

We’re focused on companies with strong cash flows and high return on capital. We believe these companies should be able to continue generating relatively stronger returns, even in a more difficult environment. In emerging markets, we focus on established and dominant local franchises with good cash flow.

Our “EQV” investment philosophy and process emphasizes companies with attractive earnings, quality and valuation characteristics, and we believe the current, more challenging environment really underlines the importance and timeliness of quality.

1. Source: Barron’s, “Passive Portfolios’ Emergence,” July 6, 2009
2. Source: Investment Company Institute, 2009 Investment Company Factbook
3. Source: Morgan Stanley, “Valuation Gap Europe versus U.S. Close to 35-Year Low,” June 22, 2009

Additional sources: Invesco Aim, Lipper Inc., Thomson Financial, MSCI, Frank Russell & Co.

Written by Matt Dennis, Barrett Sides and Borge Endresen.

The opinions expressed herein are based on current market conditions and are subject to change based on factors such as market and economic conditions. These views and opinions are not necessarily those of Invesco Aim and are not guaranteed or warranted by Invesco Aim. These views and opinions are not an offer to buy a particular security and should not be relied upon as investment advice. Past performance cannot guarantee comparable future results.

The MSCI EAFE® Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East. The MSCI AC Asia Pacific Ex-Japan Index is an unmanaged index considered representative of Pacific region stock markets, excluding Japan. The MSCI Europe Index is an unmanaged index considered representative of stocks of developed European countries. The MSCI Japan Index is an unmanaged index considered representative of stocks of Japan. The MSCI Emerging Markets IndexSM is an unmanaged index considered representative of stocks of developing countries. The MSCI World Ex-US Small Cap Index is an unmanaged index considered representative of small-cap stocks of global developed markets, excluding those of the U.S. The S&P 500® Index is an unmanaged index considered representative of the U.S. stock market. The Russell 2000® Index is an unmanaged index considered representative of small-cap stocks. The Russell 2000 Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co.

Not FDIC Insured | May Lose Value | No Bank Guarantee

Consider the investment objectives, risks, and charges and expenses carefully. For this and other information about AIM funds, obtain a prospectus from your financial advisor and read it carefully before investing. Note: Not all products, materials or services available at all firms. Advisors, please contact your home office. Invesco AimSM is a service mark of Invesco Aim Management Group, Inc. Invesco Aim Advisors, Inc., Invesco Aim Capital Management, Inc., Invesco Aim Private Asset Management, Inc. and Invesco PowerShares Capital Management LLC are the investment advisors for the products and services represented by Invesco Aim; they each provide investment advisory services to individual and institutional clients and do not sell securities. Invesco Aim Distributors, Inc. is the distributor for the retail mutual funds, exchange-traded funds and U.S. institutional money market funds represented by Invesco Aim. All entities are indirect, wholly owned subsidiaries of Invesco Ltd. Invesco Aim Distributors, Inc.