The world’s second biggest economy is Japan (behind the good ol’ USA). China, India, and Brazil have economies growing at upwards of 10% annually. That’s a lot faster then the roughly 2.5% expected US growth over the next year or so (absent a recession, of course). Together those three economies almost equal the U.S. in GDP.  Add in Japan, and the combined GDP of these four countries exceeds the U.S. The CIA’s World Factbook is an excellent source of country information like this.

 

A good mutual fund investor would be wise to have at least 25% of his or her assets invested outside the US. Global investing makes sense not only to avail oneself of higher growth rates but also because international investments may respond differently to the same event. Global economies is linked and becoming more so. The stock markets of Western Europe, for example, have an 80% correlation with the U.S. markets.  Makes sense, doesn’t it? A good portion of BMW’s profits come from the U.S., so if the U.S. economy (and the U.S. stock market) turns down, so does BMWs profits and its stock price on the German exchange. You don’t gain a lot of diversification by investing in Western Europe (although it would be a play on the Euro, if you think the dollar will continue to decline). Something of a surprise is that the Brazilian stock market has a 70% correlation to its U.S. counterpart. Latin America is more closely liked to the U.S. then it would like to believe. As you’d expect, the stock markets of emerging counties, i.e., China (50%), India (40%), Russia (35%), are not as closely correlated with the U.S. market as are the Western European markets. (Of course, they’re also more volatile.)

 

A second surprise is the uniqueness of the Japanese market. Movements in Japanese stock prices have only a 30% correlation with movements in the U.S. stock market. That’s surprising because Toyota sells so many cars here and we all own at least one Japanese made TV. But it goes to show that the biggest driver of any economy is what’s going on inside a country, not how much it exports. Just like the Japanese culture, there are many unique aspects to the Japanese economy. What’s also nice about Japan is it’s the second largest economy in the world and offers the legal and accounting safeguards of a mature county. Thus, you can diversify without emerging economy risk.

 

How to decide which regions/countries to invest in? Which counties do you think are attractive investments, i.e., their economies will grow. What are the opportunities in Mexico (domestic demand)? Canada (natural resources)? Germany (banking and automobiles)? Then, like with every other investment decision, consider the riskiness of the investment. Canada and Germany are pretty safe. Russia’s GDP is clipping along at 7% per year and Egypt’s GDP is growing at 6%. Both stock markets reflect this growth but they’re riskier investments.

 

There are many excellent international mutual funds and ETFs, some invest globally, some focus by region and some by country.  International funds invest in all sizes and types of companies and, for the fixed income portion of your portfolio, all classes of debt.

It would be wise to invest 25% of your assets internationally and to diversify beyond Western Europe.

Alan Greenspan writes extensively about the global economy in The Age of Turbulence. 

He believes there are common dominators to economic success. One is a cultural desire for growth, which includes government integrity, the acceptance of a certain amount of income inequality, incentives to take risk and the willingness to let market forces determine supply and demand. Markets are the antithesis of government decision making. The fall of Russian communism showed the fallacy of central planning. The socialism of Western Europe and the populism of Latin America are lesser forms of substituting the wisdom of government for the marketplace. Western Europe (India and elsewhere) suffers from bureaucracies with extensive approval processes which slowdown change and bureaucrats who substitute their judgment for the market. Restrictive work rules imposed on employers drive up costs and reduce the incentive to take risk, resulting in lower growth and, perversely, higher unemployment.

 

A second factor in economic growth is education. It speaks for itself. A third is a young, or growing, population.  Workers who save money (accumulate capital) and contribute to their heath and retirement plans aid economic growth. Non-workers, such as retirees, who consume these services, which have been promised to them by their government but have not been funded, place a strain on economic growth. As the ratio of workers to retirees shifts, due to the aging of the baby boomers and increases in longevity, the burden of these transfer payments on an economy/society increases.

 

The last determinate of economic prosperity is a strong rule of law, defined as a protection of property rights (and, by extension, individual rights). This is a major theme of Mr. Greenspan’s. Property rights include real estate, intellectual property, goods and, broadly, commercial transactions.  A strong rule of law is not a dictatorship, in fact, it’s just the opposite.  Individuals/companies will take risk, and invest for the future, if they can see a clear and consistent set of rules. As a corollary, risk premiums will be lower in this environment, meaning the cost of capital will be lower, promoting growth.

 

 We can extrapolate from Mr. Greenspan’s thinking as to the best international areas for investment.   So let’s go for an around the world tour. Western Europe has a strong rule of law but their bureaucracies, aging population, restrictive immigration which could otherwise offset an aging population, and expensive social services means their economic growth will be limited. Eastern Europe is on its way to a well developed rule of law and does not suffer from the problems of Western Europe (yet). It’s overcoming its Communist legacy and production costs are low.

 

Russia has inconsistently applied laws which vary with the whim of its rulers. It also has the Western European population demographics. A currency inflated by the high price of oil and gas exports is another limiting factor. However, abundant natural resources, an entrepreneurial spirit, and burgeoning consumer market are positives. Russia has great potential but equally great obstacles to overcome. 

 

Japan has greater population problems than Western Europe in terms of age and immigration and a bureaucracy structured to prevent companies from failing, limiting imports, and preventing foreign companies from operating in Japan. Yes, it has a strong rule of law but it is very Japan-centric. Is it any wonder that the Japanese economy has been stagnant for the last 15 years? Mr. Greenspan says that it will no longer be the world’s second largest economy by 2030. 

 

China is the global wildcard. Its growth has been impressive and it has moved towards a comprehensive rule of law.  But a Western-style rule of law and the personal freedom which it, and economic growth, brings are in conflict with a ruling autocratic party. One or the other will have to give way at some point.   Mr. Greenspan believes that China’s growth will continue, and although he doesn’t come out and say it, China will surpass Japan in GDP by 2030.

 

India has a strong rule of law but a bureaucracy which makes Western Europe’s look like a Ferrari. Its growth has been impressive but it hasn’t kept up with China due to severe infrastructure problems and cultural crosscurrents preventing its markets from freely functioning. Latin America is cursed with populism (take a look at Venezuela), Brazil being the possible exception. Severe income inequality, education and rule of law (government instability and corruption) problems abound.

 

Emerging economies, Mr. Greenspan cites Vietnam, are where the biggest money will be made. Of course, they carry great risk.  Nonetheless it will be exciting to see new economic hotspots emerge as the world looks for low cost production areas and certain counties seize the opportunity. Lastly, the United States looks pretty good by comparison to the rest of the world, despite our problems. Mr. Greenspan predicts we’ll still be the biggest and the best in 2030, although a smaller part of a bigger global pie. 

 

How do you invest globally? Stick with Mr. Greenspan and go with a strong rule of law. Invest in Europe, East over West and, if you can take more risk, invest in China and India. Constantly look for changes in law, or a shift in attitude towards a change, and watch for emerging gems.

 

International mutual funds should be a part of every investor’s portfolio. I’ve beaten this drum before (see A Euro, A Yen, a Buck or a Pound and The CIA Guide to International Investing).  But when the cover of BusinessWeek asks: What’s the Most Extreme Emerging Market on Earth?  (remember the Sports Illustrated curse) I begin to get a little nervous. Let’s stick with China for a minute. The Hang Seng (Hong Kong stock market) is up 30% in the past year. This is against a current back drop of Chinese government concerns about their stock markets becoming too speculative, widening the trading range of the Yuan, and possible U.S. trade limitations.  

 

International markets will go down at some point in time and I take the above as warning signs that a correction might occur sooner rather then later. Does this mean you should sell your international mutual funds or not buy, if you don’t yet own any? No. What it does mean is – don’t get carried away.  Markets that have risen the most are most likely to correct the most AND markets of “newer economies,” i.e., riskier economies/counties, will be more volatile then the markets of mature economies.

 

I (being very American) lump the world’s economies into four categories (with representative examples): 

1. Mature - Germany, Japan.

2. Big New - China, India.

3. Emerging - Vietnam, Egypt.

4. All Others.

 

I’ll leave it to you to fill in the rest of the counties in each category (maybe you can tell me if Russia fits into 2 or 3). Volatility in a nation’s markets increases as the size and maturity of those markets decreases. An analogy is U.S. Big Cap, Mid Cap and Small Cap stock funds. Investing internationally is no different then investing in the U.S. – understand the risk and diversify.