3rd Quarter 2012 Commentary - ASTON/Barings International Fund
3rd Quarter 2012
It was a good quarter for international equity markets as the Fund’s broad market MSCI EAFE Index benchmark rose 6.9%. All regions within the benchmark except Japan delivered gains during the period. Pacific ex-Japan was the best performing region in posting double-digit gains, followed by Europe ex-UK. Financials was the best performing sector overall, while Technology was the worst in posting a minor gain.
The Fund marginally underperformed the benchmark during the third quarter as regional and sector allocation offset solid stock selection. Underweight allocations to Continental Europe and the Pacific ex-Japan detracted slightly from relative returns, overcoming a small boost from Emerging Markets, which included a Canadian listed stock. An underweight to Financials also served as a small drag on performance.
Stock selection in the Materials and Telecomm sectors were the main contributors to relative performance, while picks in Financials lagged. Much of the returns from Materials came from a collection of UK-based precious metal miners. The weak stock selection in Financials came from insurance company Admiral Group and private wealth manager Julius Baer. Julius Baer's share price did not react well to its announcement that they would be buying the international wealth management business of Merrill Lynch.
There was only one noteworthy change to the portfolio during the quarter. We added Swedish medical technology company Elekta, a manufacturer of radiotherapy devices for the treatment of cancer. Elekta, along with U.S. competitor Varian, are the dominant providers of these devices globally. We think the stock was attractively valued at the time of purchase as we expect the company to deliver solid earnings growth over the medium term.
Although ultimately positive, it was a volatile third quarter for international equities. To us, and probably to other investors, it doesn't feel like a year of double-digit gains thus far. The reason for this is that the advance in equity prices has happened at a time when the global economy is in a mess. In Europe, we now have near 25% unemployment in Greece and Spain, and more significantly nearly 50% youth unemployment. Spanish and Greek banks are losing their deposit base as individuals and companies look for safer havens for their money. This naturally puts added pressure on the respective governments as they attempt to shore up their financial systems.
This, by itself, would naturally weigh on equity markets, but the response from central authorities has been repeated policy initiatives with acronyms like ESM, EFSF, ELA and now the OMT. The pattern is in place: markets signal a crisis, a Euro summit pantomime plays out, and a bold monetary initiative is announced though not entirely enacted because markets have by then calmed down. European leaders are acting like they have a plan, but as boxer Mike Tyson once said, “everybody has a plan until they get punched in the face.”
The punch in the face for Europe is likely going to be delivered by protestors on the streets of Athens and Madrid. If you want to know how Europe is faring in coming quarters it might be better to look at the street scenes in Madrid and Athens rather than their sovereign's respective 10-year bond yields or the latest bank stress test. Time is running out for Europe. The unemployed masses in the peripheral countries have had about as much as they can take. Although it isn't certain how events in Europe will unfold, we feel it is much more likely that austerity is abandoned and loose monetary policies that support growth at the risk of inflation are enacted.
The problems in China seem more manageable compared to Europe, for now. There are two main issues for the Asian giant. The first is that a weak global economy will hurt the export sector of the Chinese economy. The other is that there is a need to rebalance the Chinese economy toward consumption and away from fixed asset investment. It is unlikely that this rebalancing can happen without lowering the economic growth rate, which no one expected to grow at 9% forever (5% may be a much more realistic trend rate in the medium term).
The ongoing Chinese leadership transition has delayed significant action on the economy. New leadership has signaled that the outcomes of the economic policy of the past decade have not been ideal. Economic growth has favored a select few over the many and there is a determination to shift the economy away from real estate led growth. This will have a significant impact on the global economy. Australia, for example, will be hurt by China's shift away from commodity intensive growth. In the long run, however, this shift will be good for China and will benefit sectors and companies that are geared toward domestic consumption.
In Japan, the economy has been hurt by slowing global growth in general and slowing growth in China in particular—maybe more so than for China itself. Anti-Japan sentiment related to the disputed islands in the East China Sea is also obviously hurting. That leaves the U.S. as the best economy of a weak bunch. The U.S. has seen a gradual improvement in housing and car sales. Consumption still accounts for around 70% of US GDP (Gross Domestic Product) and the U.S. economy still accounts for around half of global GDP, so progress in the housing and auto sectors is significant for global growth. By itself that would be great news, but there is still the lingering issue of the government’s fiscal cliff in early 2013. Some retrenchment of the U.S. fiscal deficit is likely in 2013 and this will likely dampen the ongoing recovery. So, even the silver lining has a cloud.
As this year has borne out, however, aggressive monetary policy has trumped the economy, which is why equity markets have been strong. Central bankers are increasingly signaling that they will ignore their inflation mandates and investors have become inured to an increasingly extreme global monetary policy. We believe policy will remain extreme until it causes more problems than it solves—and we are not there yet. In our view, loose monetary policy alone is unlikely to lead to real GDP growth but it will lead to nominal growth.
The focus for us remains on identifying sectors and companies that have pricing power, where inflation is likely to be concentrated, and to avoid the areas with no pricing power. Prices are not monolithic. They don't all go up and down uniformly. Prices in economic sectors suffering from overcapacity will lag. It is hard to see how we are going to get inflation in Spanish house prices when there is an overhang of two million excess homes. In areas where supply/demand is in balance, however, we will see price rises that should favor companies operating there. We see some of these areas in gold miners, agricultural commodity companies, Asian consumer credit providers, selected technology companies, and healthcare providers. We continue to look for other beneficiaries. Weak real economic growth but with stronger nominal growth should favor these growth areas of the market.
Baring Asset Management
As of September 30, 2012, Admiral Group comprised 1.42% of the portfolio's assets, Julius Baer – 1.55%, Merrill Lynch – 0.00%, and Elekta – 1.37%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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