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Fund Spy

The Beat Goes on for Foreign-Stock Funds

Prevailing trends continued across the board in the third quarter.

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Foreign-stock funds posted another quarter of solid gains, with the typical foreign large-blend offering gaining 3.85% in the three months through Sept. 28, 2017. Many of the trends evident in the first half of the year remained in place, such as robust emerging-markets returns and strengthening foreign currencies.

However, this currency strength somewhat obscured the divergence between developed- and emerging-markets equities. While the 6.9% return of the MSCI Emerging Markets Index in dollar terms was largely the same as what the index gained in local currencies, the U.S. dollar's weakness masked what was a largely flat quarter for developed-markets shares.

The MSCI EAFE Index, a proxy for developed markets, rose 3.9% for the third quarter when measured in U.S. dollars. But in local-currency terms, the index gained just 1.7%. This means that share prices were somewhat flat in developed markets. As a result of the better price performance of emerging markets, the gap in price multiples with developed markets has narrowed a bit. In October 2015, the MSCI EAFE Index's 16.4 average P/E was well above the MSCI Emerging Markets Index's 10.6. By the end of August 2017, MSCI Emerging Markets' average P/E rose to 14.9 versus 17.2 for MSCI EAFE. In fact, the MSCI Emerging Markets Index's average price/book and price/sales ratios are now slightly higher than the MSCI EAFE's.

Most of the major foreign currencies continued to strengthen against the U.S. dollar. The euro rose 3.7% versus the dollar, with the British pound increasing slightly more. After losing ground in recent years, the euro has now gained 11.7% year to date versus the dollar.

Thus, foreign-stock funds that leave their currency exposure unhedged are generally faring better than their hedged peers. For instance,  Tweedy, Browne Global Value II (TBCUX), which doesn't hedge its currency exposure, is up 16.1% year to date versus its partially hedged sibling,  Tweedy, Browne Global Value (TBGVX), which has gained 11.6%.

The strength in emerging-markets shares was fairly broad based. Chinese stocks continued their impressive rally, with the typical China fund rising 10.1% during the quarter in U.S.-dollar terms and 32.7% year to date. Chinese companies such as Tencent (up nearly 80% year to date) and  Alibaba (BABA) (up more than 90%) are participating fully in the global tech rally. Elsewhere in Asia, South Korean shares continued to soar despite the geopolitical concerns surrounding its northern neighbor, with bellwether Samsung Electronics up more than 40% year to date.

Latin America, though, supplied the quarter's biggest gains, with Brazil leading the way. Thanks to hopes surrounding the country's current reform-minded president Michel Temer, the MSCI Brazil Index erupted for a 22.3% return in U.S.-dollar terms. After the prior president was impeached, Temer faces corruption charges as well, but the market hasn't deemed these serious enough to dent the rally.

In other market segments, small-cap stocks continued to outperform their large-cap cousins, with the typical foreign small/mid-blend offering gaining 6.2% during the quarter and 24.6% for the year to date. Small/mid-cap outperformance versus large caps now stretches over 15 years, with the average small/mid-blend fund gaining 12.0% annualized, a full 4 percentage points better than the typical large-blend offering.

Overall, the quarter was a reminder--especially in South Korea--that markets are not always driven entirely by day-to-day events. There will always be geopolitical crises and headlines grabbing public attention, but how the market responds is a combination of what is truly new and what is already priced into equity shares. 

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Consumer Cyclical: Tepid Mall Traffic Could Constrain the All-Important Holiday Season

Consumer Defensive: Valuations More Reasonable After Third-Quarter Retreat

Energy: All Roads Point to Oversupply in 2018

Financial Services: Banks Can't Rest Easy

Healthcare: Stock Selection Key as Valuations Rise

Industrials: Worldwide Growth Is Resilient, But Valuations Look Full

Real Estate: Enter With Caution

Technology: Valuations Painting Overly Rosy Scenarios

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M&A Outlook: High Prices Impede Dealmaking in the U.S.

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Venture Capital Outlook: Exits Come Into Focus as Valuations Continue to Climb

U.S. Stock Funds: Steady as She Goes

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Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.