Invesco Aim | International Markets Review and Outlook

International equity market returns continued their upward run in the third quarter of 2009 as a carry-over from the second quarter's overall brightening economic sentiment. Nearing the end of 2009, government stimulus and monetary policies seem to be stabilizing world markets, and investors continue to favor more cyclical and small-cap equities to defensive stocks, which reflects that same increasingly positive outlook even though market forecasts remain uncertain.

The MSCI EAFE Index gained a healthy 19.47%, which fell shy of last quarter's 25.43% growth because the pricing discounts from earlier this year have, for the most part, dissipated.¹ Because stock valuations are reverting to historical norms and doubts regarding economic recovery exist, prudent securities selection and evaluation should play a substantial role in long-term investment plans.

Recapping recent performance
Repeating a trend from the second quarter, emerging markets outperformed world equities with a 20.91% return in the third quarter.¹ Asian and European stocks posted the strongest regional gains with 22.76% and 22.92%, respectively, while the U.S. and Japan lagged other markets with respective 15.59% and 6.51% returns.¹

Monetary stimulus indicators that support recovery were among the biggest contributors to the markets' overall performance. A weak U.S. dollar and a federal funds rate below the two-year Treasury note, as it is now, have historically helped growth in equities. Corporate cost-cutting that exceeded expectations also pushed markets upward.

Looking ahead to the fourth quarter of 2009 and the start of 2010
Continued positive economic trends over the third quarter are undeniable. Reasons for cautious investing are undeniable as well.

Government stimulus and central bank monetary policies have helped improve market outlook, though any meaningful shift in those policies or higher inflation expectations could dampen their positive effects. Based on the Federal Reserve's recent comments and consumer price indexes (an inflation indicator) from around the globe, we believe significant near-term policy or inflation shifts are less likely.

Growth and earnings are the big unknowns going forward. Earnings forecasts for 2010 are based on near-peak margins. Corporate cost savings may support earnings and share prices in the short run, but companies may have difficulty maintaining the savings levels we've seen in 2009.

While market prices and sentiment reflect meaningful economic recovery, we believe further improvements to key economic indicators, such as gross domestic product, must improve for equity prices to make further gains. Market uncertainty, however, leads us to temper our short-term expectations because a "W" – a scenario where markets decline severely, rally strongly, decline again, then continue to rally – could hamper results. Long term, however, we are more optimistic

Emerging markets
In emerging markets, economic activity has improved at a surprising rate. Strong consumer and corporate balance sheets and a healthy banking sector have allowed emerging economies to respond to fiscal and monetary stimulus positively and rapidly during this downturn and recover faster than developed markets. It's interesting to note that, in general, exports are still contracting, which means emerging market domestic demand has been driving economic activity and helping strengthen these economies.

Earnings are also recovering. After earnings declined sharply from peak levels, we have seen positive earnings revisions, and the earnings growth forecast for both 2009 and 2010 have been revised upwards. We see earnings recovery as broad-based across most sectors and markets.

While improved economic activity and earnings present solid opportunities, valuations are around long-term averages, which aren't compelling. We believe, however, they are at reasonable levels given the emerging market's strong long-term growth prospects and healthy balance sheets.

In light of these trends, we continue to invest heavily in emerging markets where domestic consumption is high and secular growth is less correlated with global demand.

Asia ex-Japan
Continuing its second-quarter 2009 trend, the Asia ex-Japan region outperformed world markets. As in emerging markets, equities in this region produced substantial positive results because of solid balance sheets and increasing economic activity from domestic demand.

Valuation and earnings estimates are also similar to emerging markets. Though Asia ex-Japan has sustained organic economic growth, all eyes are watching exports to the U.S., which have historically been a key part of the region's growth.

Japan
Macroeconomic concerns still plague Japan. Deflation, weak balance sheets and yen strength have hindered economic growth. From a stock perspective, valuations, earnings and growth prospects are not compelling when compared with other world markets.

Japan's recent elections, however, could improve the country's economic outlook. For the first time in more than 50 years, Japan's Liberal Democratic Party won't be in power.² Though the new dominant political power, the Democratic Party of Japan (DPJ), will have an opportunity to enact fundamental structural changes to potentially improve the country's financial system. The DPJ will have to overcome a highly leveraged economy, substantial government debt and an aging, savings-oriented population to produce a quick turnaround in Japan's economy. The need for fundamental structural changes and limited resources for economic stimulus will likely leave the new government with little room to work.

Europe
Market sentiment in Europe is improving as earnings forecasts have begun to trend upward. In fact, a recent Merrill Lynch global fund manager survey showed that Europe is no longer the world's most disliked region among investors, and investments have started flowing in.³ Even with increasingly positive news, Europe is still the most undervalued region in the world.

We continue to find solid investment opportunities in Europe and, on average, own cheaper less-leveraged companies than European market indexes

Small caps
Looking at market capitalization, international small-cap outperformance this year has eliminated most of the pricing discounts to international large caps. Canada, however, is one country where we are finding cheap small-cap opportunities, and we have added to our Canadian small-cap holdings. Long term, we think small caps are an attractive class due to their structural ability to potentially create higher returns than large-cap stocks.

We believe our small-cap holdings are positioned to benefit from quality becoming more of a driving factor in returns.

Implications for investors

We've seen extremely volatile price movements across world markets during the past 12 months, so we view market action as uncontrollable. Regardless of this volatility, we can control our investment process, which concentrates on three factors: earnings, quality and valuation.

Much of the market rally, in our opinion, has been due to the substantial undervaluation in stocks earlier in the year. In September 2009, we were encouraged to see early signs of investors focusing on fundamental factors beyond simple valuation, e.g. relative revenue and earnings growth rates in the coming year. So we may be witnessing the start of a transition from simple valuation trades to more balanced earnings-driven markets as we close 2009 and enter 2010.

This shift underscores the importance of not only finding stocks that are priced appropriately, but investing in companies that generate strong earnings and high return on capital. We believe those companies should be able to produce generally stronger returns even when the economic outlook is uncertain.

1 Source: Lipper Inc.
2 Source: "Japanese Opposition Set for Victory; PM Quits as Party Head," cnn.com, Aug. 30, 2009
3 Source: "Merrill Lynch Fund Manager Survey Finds Nervous Investors Pause for Breath After Summer Rush," reuters.com, Sept. 16, 2009
All data provided by Invesco Aim unless otherwise noted.

The opinions expressed herein are based on current market conditions and are subject to change based on factors such as market and economic conditions. These views and opinions are not necessarily those of Invesco Aim and are not guaranteed or warranted by Invesco Aim. These views and opinions are not an offer to buy a particular security and should not be relied upon as investment advice. Past performance cannot guarantee comparable future results.

Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, relative lack of information, relatively low market liquidity, and the potential lack of strict financial and accounting controls and standards.

Investing in developing countries can add additional risk, such as high rates of inflation or sharply devalued currencies against the U.S. dollar. Transaction costs are often higher, and there may be delays in settlement procedures.

Investing in a single-country mutual fund involves greater risk than investing in a more diversified fund due to lack of exposure to other countries.

Investing in a fund that invests in smaller companies involves risks not associated with investing in more established companies, such as business risk, stock price fluctuations and illiquidity.

Political and economic conditions and changes in regulatory, tax or economic policy in Japan could significantly affect the market in that country and surrounding or related countries.

The MSCI EAFE^® Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East. The MSCI AC Asia Pacific Ex-Japan Index is an unmanaged index considered representative of Pacific region stock markets, excluding Japan. The MSCI Europe Index is an unmanaged index considered representative of stocks of developed European countries. The MSCI Japan Index is an unmanaged index considered representative of stocks of Japan. The MSCI Emerging Markets Index^SM is an unmanaged index considered representative of stocks of developing countries. The MSCI World Ex-US Small Cap Index is an unmanaged index considered representative of small-cap stocks of global developed markets, excluding those of the U.S. The S&P500^® Index is an unmanaged index considered representative of the U.S. stock market. The Russell 2000^® Index is an unmanaged index considered representative of small-cap stocks. The Russell 2000 Index is a trademark/service mark of the Frank Russell Co. Russell^® is a trademark of the Frank Russell Co.