Look to Australia

 | May 02, 2012 | 12:30 PM EDT  | Comments
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Stock quotes in this article:

EWA

,

KROO

I recently wrote about alternatives to the abysmal European economy for investors who feel the need to maintain some allocation in their portfolios to developed-market stocks beyond the U.S. Though the eurozone, U.K., and Japan account for the bulk of this asset class globally, there are other compelling opportunities available from North America to Asia. One of the options I highlighted recently was Australia, which has been in the spotlight lately thanks to developments that have positioned it for continued success in coming months.

Australian stocks have shown signs of breaking out of a rut recently: the iShares MSCI Australia Index Fund (EWA) is up about 10% this year, but still down by about 10% over the previous 52 weeks. The strong performance in 2012 has come in part thanks to a surging Australian dollar; the currency has popped by close to 5% against most major rivals in 2012, which translates into additional returns for stocks denominated in the local currency.

A number of factors have weighed on Australian markets over the past year or so, including the aftermath of a string of natural disasters that put pressure on the country's fiscal resources. Moreover, slowing growth from China, which has emerged as a key driver of the Australian economy, has eaten into stock prices. But there are now reasons to be a bit more optimistic about the short-term prospects for Australia. The primary reason to be bullish towards Australia relates to recent action from its central bank, the Reserve Bank of Australia, which cut a half a percentage point off some of the highest interest rates in the developed world recently in an attempt to kick-start the economy.

While an interest rate cut is obviously important, it's also significant to note what the rate cut represents: a diminishing concern about inflation, which had previously stood out as a major concern for the Australian economy. Price increases are now under control and expected to remain well within the 2% to 3% comfort zone of the central bank for the foreseeable future.

Australia remains vulnerable to external shocks, as European markets are major buyers of Australian commodities, which means that a collapse there would put downward pressure on the currency and prices. But the likelihood that Australia will continue to outperform both Europe and the U.S. in terms of risk-adjusted returns remains very high for several months.

There's one more aspect of the rate cut that is worth examining in the context of a potential investment. The cut took quite a bit of wind out of the sails of the Aussie dollar. The currency slid against the greenback on the news, which was the intent of the central bank. Despite the recent weakness, the longer-term outlook for the Aussie dollar remains strong. Interest rates are lower, but still well above most other developed markets. That creates upward pressure on the currency, as Australia remains an attractive destination for the carry trade and other yield-hungry investors. Moreover, Australia has natural resources in abundance. In other words, don't be confused by the recent pullback in the currency, which ate into stock returns. The currency impact of the AUD/USD exchange rate should remain favorable for U.S.-based investors going forward, which figures to boost returns realized in Australian securities.

I like Australia as a candidate for an overweight position. The economy is getting a much-needed shot in the arm, and the central bank will have the flexibility to provide further assistance now that inflationary fears have largely been calmed.

My preferred instrument for playing Australia, however, is not the ultra-popular EWA but the IQ Australia Small Cap ETF (KROO). It focuses more on Australia's natural resource industry, while EWA is focused more heavily on large financial institutions. Though a bit more expensive than the large cap-focused EWA, this ETF offers more attractive return potential over the next few months as well as the long run.

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