U.S. economy's aches are being felt overseas

The Baltimore Sun

Just a few months have made a world of difference.

Until recently, investors could leave worries about the U.S. economy behind, plop money into an international fund, China fund or emerging-market fund and make money with little effort or any attention to world news.

Chinese, Indian and Latin American funds soared. European funds were good to investors. Going outside the United States paid off nicely. But that has not been the case this year. As it turns out, the world is not immune to what ails the United States.

Although major oil and natural resource producers are thriving, the globe is feeling the pressure of rising oil prices, inflation, a credit crunch and slowing expansion.

"It's an unpalatable combination," said Karen Olney, a global strategist for Merrill Lynch & Co.

In a recent survey of fund managers throughout the world, Olney said professional investors were "describing a world where global growth and profit expectations are deteriorating at the same time expectations of higher interest rates are rising on the back of inflation."

During the past year, China's stocks have dropped almost 50 percent and India's are down about 28 percent. Latin American mutual funds, which are profiting from oil and natural resource wealth, continue to climb but at a diminished rate. Instead of more than 40 percent a year for the past two years, they are up about 8 percent this year, according to Lipper.

Emerging-market mutual funds are down 9 percent this year - a change from the past two years in which such funds averaged 25 percent growth a year by picking companies in developing areas enjoying growth spurts, such as China, India and Brazil.

After pouring $138.7 billion into world mutual funds last year, investors yanked $4.43 billion during the first quarter of this year. Recently, investors have grown particularly skittish. According to EPFR Global, which analyzes global and emerging-market fund data, during the week that ended June 20, investors pulled a larger amount out of global bond funds than any time this decade - $3.75 billion. They are also retreating from European, Asian and Latin American stock funds, while favoring funds that specialize in the U.S., Japan, the Middle East, Africa and Russia.

Concerns have been building. In May, Merrill Lynch found about 5 percent of the world's fund managers had cut back their exposure to stocks and were holding on to more cash than usual to buffer possible drops in prices. By this month, the number cutting back on stocks rose to 27 percent.

Among the professionals surveyed by Merrill Lynch, 81 percent think expectations for corporate profits are too high. If they are right, that bodes poorly for world stock markets. When companies report profits that are lower than investors expect, stocks drop.

The world is in a tricky place for investors. With inflation rising, central banks throughout the world - or the authorities like the Federal Reserve that try to keep economies operating smoothly - are considering raising interest rates. While in the long run that keeps economies from overheating, investors are faced with adverse consequences in the short term. Morgan Stanley European strategist Teun Draaisma noted in a recent report that the European Central Bank is likely to raise interest rates in a few months: "This raises the risks to growth in the euro zone." Consequently, he said, he is cautious about investing in European stocks and is veering toward defensive companies that might be affected least in a slowdown: pharmaceuticals, food, beverages, tobacco and telephone companies. In Latin America, Geoffrey Dennis, of Citigroup, notes that inflation is now a worry, rising sharply to 5.9 percent, from 3.9 percent a year ago. In Brazil, inflation has jumped to more than 6 percent. In Chile, it's close to 9 percent.

Amid concerns about inflation, the MSCI Latin America stock index recently dropped 5.8 percent from its May 19 peak.

"Inflation is insidious," Dennis said. "It reduces the value of nominal assets, erodes nominal debt and hurts those on fixed incomes. ... It is a threat to equity markets, as interest rates typically rise in response, raising the cost of capital."

Still, Dennis remains encouraged that inflation won't spiral out of control. It has remained largely in oil and food, rather than drifting throughout the economy. And wages - one of the major drivers of inflation - have been increasing modestly. In addition, Dennis is convinced that central banks will raise rates so an inflation cycle doesn't build.

While investors have found it easy in recent years to bet on a single country or region of the globe, unique conditions driving growth and inflation in the near future make simple investing strategies more difficult.

Fund managers are currently wrestling with country picks and sector picks. For example, James Moffett, who manages the UMB Scout International Fund, says he is underweighting exposure to companies that depend on consumers to make purchases. And he remains heavily exposed to energy companies and those providing raw materials to a fast-growing world economy.

Yet, he said, "I'm starting to think we probably are in a commodity bubble." That won't change his strategy in the short run, he said, "because bubbles can run for a while without popping." But knowing when to enter and exit isn't easy.

"The easy money has been made," he said.


Gail MarksJarvis writes for Your Money.

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