4th Quarter 2013 Commentary - ASTON/Barings International Fund
4th Quarter 2013
International equity markets delivered another solid performance during the fourth quarter of 2013. All sectors and all regions posted positive absolute returns, while the Fund performed roughly in line overall with its MSCI EAFE Index benchmark. Asset allocation and stock selection contributed about equally to the overall performance.
Europe ex-UK was again the best performing region as investors continued to bet on a European economic recovery. The UK market was only slightly weaker than the continent as its economy has been surprisingly strong with the housing market responding well to the government's stimulus program. The Pacific ex-Japan region delivered only a slightly positive return, mostly due to an Australian market that was flat in local currency terms as the Australian dollar was weak versus the US dollar.
On a sector level, Telecommunications was the best performing area of the benchmark driven in part by speculation related to consolidation in the sector. Utilities was the weakest sector, dragged down by weakness in many of the Japanese electric utilities, which gave back some of their gains from earlier in the year.
Positives and Negatives
Asset allocation by region was neutral during the quarter. An underweight allocation to the weaker Pacific ex-Japan region was offset by an underweight to Continental Europe and the portfolio’s holdings within Emerging Markets. Stock selection by region was a moderate positive overall, led by stock selection in Pacific ex-Japan. In contrast, holdings in Japan detracted slightly from performance with Komatsu, Japan Tobacco, and East Japan Railway notable detractors.
Asset allocation by sector added slightly to relative performance. The portfolio’s underweight to Utilities was the main positive factor, while cash served as a slight drag given broad based rally during the period. Positive stock selection in Healthcare from Fresenius, Shire, and Bayer was offset by negative results in Materials from Yamana Gold and Fresnillo.
It was a somewhat busy quarter for the portfolio in terms of the number of new positions and holdings eliminated. A positive meeting with the new CEO of Shire gave us confidence in the firm’s growth outlook. We also purchased Telecomm company Vodafone as a potential beneficiary of consolidation in the sector, and what looks to be an improved regulatory environment in Europe. We added a small position in Russian Internet search leader Yandex, as we think the company will benefit from continued growth in Russian internet penetration and the growth of e-commerce.
We sold lower conviction holdings in Heathcare, including Teva Pharmaceutical. The resignation of Teva's CEO left us concerned that Teva's turnaround program might not remain on schedule. We also sold out of a long-standing position in French utility Suez Environment. Suez performed well in 2013, but reached a valuation that looked full relative to its growth prospects. We eliminated the portfolio’s position in Komatsu following a poor update meeting with the company.
Finally, we trimmed Japanese technology company Kyocera to fund a new position in Hitachi. An update meeting with Kyocera highlighted growth prospects that we felt were inadequate given the firm’s valuation. We feel Hitachi profits stand to benefit from its restructuring program and from its exposure to information technology and social infrastructure spending should the Japanese recovery continue.
Developed market international equities had a strong 2013, delivering excellent absolute returns and outperforming Emerging Markets. Note, however, that developed equity markets rose more than their underlying earnings. This leaves them looking more expensive than last year and in need of good earnings growth in 2014 if we are to see a repeat of this strong performance. Conversely, Emerging Markets saw their valuations decrease in 2013. This leaves that area less in need of earnings growth to justify current prices, but economic growth and monetary policy matter, and it looks like a wide range of potential outcomes for economic growth and interest rates are possible.
To us, the U.S. has the best outlook for economic growth. Improving employment is helping to support a recovering property market and a continuing recovery of the auto market. This looks likely to remain the main driver for the global economy with the main risk being the potential impact of higher long-term interest rates.
China is at a different point in its economic cycle than the U.S. China has had an extraordinary period of credit growth since the 2009 financial crisis. That credit growth helped it to avoid a meaningful recession, but now leaves it with an unbalanced economy—too dependent on fixed-asset investment and exports, and not enough domestic consumption. The Chinese are targeting reforms that should lead to a more balanced economy. If implemented, this will be positive for China in the long term, though potentially disruptive in the short term.
This will be a key year for Japan Prime Minister Abe's economic program. He has delivered on monetary policy and implemented fiscal reforms. We now need to see the third arrow of his program—policy reform for a liberalized economy. If we see these reforms, and we get moderate inflation with wage growth, then we expect the Japanese market will continue to recover strongly. Japan remains the favored market of our Strategic Policy Group (SPG), and an overweight in the portfolio.
We have been cautious on the uneven European recovery, and the picture remains mixed. France is disappointingly weak, Germany is strong, while Spain and Ireland have shown improvement. The Purchasing Manufacturers Index (PMI) survey continues to improve, but still remains at a low level consistent with around 1% economic growth. Unemployment, while improving, remains at high levels. We worry about the political unrest to which this could lead, but has yet to be seen to any great extent. Bank lending also continues to contract. From an investment point of view, it has been much easier to not look at the overall European economy and focus on individual companies and their end markets. From this perspective, we have continued to find interesting European investment opportunities.
Economic recovery from the global financial crisis has been very dependent on extremely low interest rates. Low rates have stimulated asset markets, including equities and housing. This has led to good growth in other financially sensitive sectors like the auto sector, but may also have led to distortions in the economy. Bond prices around the world do not look consistent with economies that are recovering (and governments that are more highly indebted than they ever have been in peace time). The great test for 2014 will be to what extent the rise in longer-term yields from the U.S. Federal Reserve’s tapering of its quantitative easing (QE) program will hinder the economic recovery. The early signs are mixed. U.S. car sales have held up relatively well, but year-on-year growth of U.S. pending home sales has been declining.
Elsewhere, ultra-low rates in the U.S. have been a boon to many Emerging Markets. Countries that have been running current account deficits have had no problem funding those deficits in such a yield-starved world. Reducing those deficits in sympathy with the new funding environment is not likely to be helpful to growth—likely causing a headwind. We have seen little inflation since the global financial crisis, and even with the ongoing recovery we continue to see deflationary pressures in segments of the global economy. Perversely, ultra-low interest rates may have helped to mitigate inflation in some areas of the economy. For instance, low borrowing costs improve investment economics and lead to greater investment in capacity than would otherwise occur. This may have been part of what encouraged the Chinese to invest so much in manufacturing capacity. Could higher rates make these investments look less attractive and therefore reduce supply just as the U.S. economy starts to recover? We do not know exactly how markets will respond to the potential end of low long-term interest rates. Our point is that it would be too complacent to think that it might not lead to some unexpected outcomes and some unexpected opportunities.
Baring Asset Management
As of December 31, 2013, Komatsu comprised 0.00% of the portfolio's assets, Japan Tobacco – 1.63%, East Japan Railway – 1.28%, Fresenius – 1.75%, Shire – 1.51%, Bayer AG – 1.87%, Yamana Gold – 0.00%, Fresnillo – 0.52%, Vodafone – 1.69%, Yandex – 0.85%, Kyocera – 0.71%, and Hitachi – 1.29%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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