How international stock funds could profit in 2012

Euro zone crisis is biggest risk for investors; Wall Street may guide

For international-stock investors, the year 2012 is akin to a hurricane a few hundred miles away. Everyone knows a direct hit will be deadly, but hopes the blow can be softened by better leadership, preparedness — and a bit of luck.

As Europe’s leaders grapple with the region’s debt troubles, asset managers and strategists see the possibility of their failure to do so as the greatest risk to global markets. Opinion is divided whether the 17 countries that share the euro will remain in the currency bloc next year, but few doubt the region will slip into a recession for at least a part of 2012.

Its impact will be felt worldwide. The euro zone is not only a major trading partner for both the developed and the developing world, its banks have lent trillions of dollars to emerging markets from Eastern Europe to Latin America and Asia.

Performance of international-stock mutual funds and exchange-traded funds in 2011 reflected these concerns. The average diversified foreign-stock fund lost 15% in 2011 as of Dec. 28, according to preliminary data from investment researcher Morningstar Inc. A fourth-quarter 2.4% average gain for this category only mitigated the damage. A popular international ETF, iShares MSCI EAFE Index EFA -0.04% , reflected the dour climate with a decline of 15%.

Europe-focused stock funds were hard hit, down 16% for the year. The turmoil rippled across emerging markets, with China-region funds losing more than 25%. One of the most popular China ETFs, iShares FTSE China 25 Index Fund FXI -0.01% , lost almost 19%.

Meanwhile, Latin America funds were off 24% on average and diversified emerging-markets offerings lost 21%. For example, the heavily traded Brazil ETF, iShares MSCI Brazil Index EWZ +0.65% , shed 26%, while the biggest diversified emerging-markets ETF, iShares MSCI Emerging Markets Index EEM +0.24% , lost 20.5%.
‘Perfect storm’

As a result, investors’ mood as 2012 unfolds is markedly different from a year ago, when the Federal Reserve’s quantitative easing sparked a rally in risk assets. At the beginning of 2011, policy makers in emerging nations were more worried about inflation than growth, and investors were more optimistic about stock prospects.

The euro zone debt crisis has changed all that.

The severity of the blow from the crisis will likely depend on whether the European Union transforms itself from a monetary union to a monetary-and-fiscal union, integrating government finances and policies within the bloc. It is hoped that such a change will allow the fiscal heft of countries like Germany to mask weakness in other nations such as Greece and Portugal.

“What I see for 2012 is that the European Union will move to deep crisis, and in this deep crisis, they will convene the convent … and you wait for the white smoke to come through the chimney,” said Steen Jakobsen, chief economist at Saxo Bank in Denmark, likening the formation of a fiscal union in Europe to a signal that a new Pope has been elected in Vatican City.

Jakobsen said a “perfect storm” was waiting to play out in the euro zone. The euro EURUSD -0.21% will likely survive both 2012 and 2013, but it looked “inevitable” that some of the 17 nations may have to stop using the common currency, he said.

Jakobsen isn’t alone in his views. Nor is his opinion the consensus. Everyone appears to accept that a smaller or splintered euro zone could take a substantial toll on the region and global markets, at least in the short-term.

Some see the euro zone crisis as so alarming that in the absence of a break-up, or some other messy outcome, several global markets would do fairly well next year.

“The only thing that these global equity markets have going for them is that America, which is still a very powerful economy, will hopefully sustain the recovery,” said Mike Lenhoff, chief strategist at U.K.-based Brewin Dolphin Holdings PLC, which manages investments for private clients.

Lenhoff said signs of U.S. recovery were particularly positive against the backdrop of gloomy headlines, about an expected recession in Europe and loss of growth momentum in emerging markets. That optimism isn’t dulled despite fears of a policy stalemate between the Republicans and Democrats in a year of Presidential elections.

“I suspect this is one economy that could surprise on the upside next year,” he said. “The backdrop for earnings and profitability in the U.S. is comparatively good. So from that perspective, my guess is that Wall Street should sort of at least hold its own, [and do] at least what it did this year.”

U.S. stocks have been a relative bright spot in a painful year for global equity markets. The Dow Jones Industrial Average DJIA +1.12% rose more than 6% for the year as of Dec. 29, in spite of Standard & Poor’s downgrade of U.S. credit rating and the debt-ceiling crisis earlier this year. Read more: Stock-fund, ETF investors look for a better 2012.

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