2nd Quarter 2014 Commentary - ASTON/Barings International Fund
2nd Quarter 2014
Since the fourth quarter of 2012, international equity markets have not been driven by earnings growth. Performance has been attributed to a higher valuation of companies rather than higher earnings. In our view, the main factor in the market disconnecting from earnings growth traces back to European Central Bank (ECB) President Mario Draghi’s “Whatever it takes” speech in the third quarter of 2012, in which he threatened to use whatever policy response was required to preserve European monetary union.
Draghi’s speech created stability in European monetary conditions and set in motion a reconvergence of peripheral government bond yields, which, in turn, stabilized the European banking sector. This stabilization encouraged investment flows to come back to Europe. The Fund’s performance struggled over this period due in part to an underweight to Europe during this time frame.
Though the Fund underperformed in the second quarter, June was a strong relative performance month. The euro weakened after the muted response of European equities to the ECB’s aggressive June actions. A weaker euro helped the relative performance of some of the fund’s European companies that are more export-oriented as well as the Japanese holdings in the portfolio.
Notwithstanding a good month in June, stock selection for the quarter detracted from fund performance. The biggest source of negative stock selection came from Europe. Capital market banks, such as Credit Suisse, BNP Paribas and UBS, and export-focused companies, such as Airbus, weighed on results. Given the drag from these holdings, the Financials and Industrials sectors delivered the biggest source of negative stock selection during the quarter.
Positive stock selection in the U.K. and in Healthcare helped offset negative results, particularly bid activity surrounding Shire Pharmaceuticals.
Few changes were made to the portfolio during the quarter. We reduced the overall weighting to financials in the portfolio. We purchased AstraZeneca, the Anglo-Swedish pharmaceuticals company, because we feel the potential earnings growth of the company, driven by its pipeline of new drugs, is underappreciated by the market.
Finally, we disposed of the fund’s position in Rolls Royce, the UK-listed manufacturer of jet engines. We anticipate that the company’s earnings growth will slow over the next few years, as highly profitable sales from its legacy programs come to an end, while its new programs, which initially have lower profitability levels, ramp up.
Central bankers across the developed world continue to face the dilemma of when to raise interest rates. They want to get markets used to the idea that “ultra easy” monetary policy will come to an end, but economic data is still sufficiently weak for them to be fearful of when to act. They also need to be sensitive not to undermine their own credibility. Each central bank has a subtly different communication problem.
In the U.S., first quarter gross domestic product (GDP) is still being revised down and now shows a fall of 2.9%. This low base will inevitably lower the growth rate for the year. Slower growth means inflationary pressures remain relatively modest. Even robust jobs growth has had a limited impact on the number of long-term unemployed and those discouraged from the jobs market by the recent recession. We believe the Federal Reserve’s preference will be for rates to stay on hold until well into 2015. However, sharply falling unemployment or surging inflation could make them act sooner.
In the U.K., early data on the impact of tighter underwriting standards on mortgage applications seem to indicate the market has softened meaningfully. This could slow the growth rate from the 3% recently recorded, and delay the first rise in interest rates until next year. But if data remain strong due to continued jobs growth and rising wages, the Bank of England will have to act.
In Europe, the cyclical recovery is progressing, and may hit 1.5% in GDP terms this year, but deflationary forces are still powerful, especially in the peripheral countries. Draghi has put forward a package of measures to try and counter this trend and address the issue of high credit costs to small and medium-sized companies in the south. The ECB’s program of Targeted Long Term Repo Operations will not be running until the autumn. Up to now, the markets have taken most of Draghi’s initiatives on faith. Now that a tangible program is about to be unleashed, he could face a sterner test.
In Japan, the Bank of Japan’s nerve was tested with the rise in the sales tax. So far, the Bank is continuing with its existing program since the data have justified its stance.
Within emerging markets, the markets in India have shot ahead on the assumption of structural reform, a process that could prove frustrating even with the new government’s majority. In China, the government seems committed to financial reform and the economy does seem to be stabilizing. Large countries like Brazil and Russia are seeing growth slow as a result of recent policy tightening or political stresses. We do not see a catalyst for a change of direction there, but markets have largely priced in the poor near-term outlook.
Despite the challenges each central bank is facing individually, global monetary policy still seems to be very supportive of growth. Even the tentative signals for an eventual change in policy in the U.S. and U.K. are being framed in language that is still hugely supportive and highly sensitive to any market overreaction. This environment supports equities as the major building block of portfolios. However, we’d be remiss if we didn’t acknowledge that market valuations have seen a huge rise over the past 18 months, and while the outlook for corporate profits is for modest growth, it is difficult to justify another leap in valuations. Therefore, progress in equities could be quite slow, even if equities are still ahead of other asset classes.
Within equities, Japan still has the capacity to surprise a skeptical investor base. The market is attractively valued compared to its peers, and earnings growth expectations are well underpinned. We are also warming up to emerging markets, where the exuberance of recent years has turned to pessimism and valuations are now reasonable. We are a little more concerned about European equities, where the fragility of the banking system and the strains of the new Basel III rules threaten to derail Draghi’s initiative.
In government bond markets, the mediocre pace of recovery leaves inflation subdued. This will gradually change as labor markets tighten, providing a headwind for bonds. In the short to medium term, we believe the peaks of long-term bond yields and short rates will be lower than previous cycles. We are getting a little more concerned about the shrinkage of credit spreads in Europe and the US. Value is fast disappearing, and liquidity conditions make trading increasingly fraught. We find more value in emerging market local bonds.
Although our central scenario is still for a continued recovery, we cannot avoid thinking about alternative outcomes. Central banks could get their market communications wrong and destroy their own credibility. This would certainly raise volatility, and possibly destabilize currency markets. The risks associated with a regional conflagration stemming from the Iraq situation, or further Russian destabilization, also need to be considered and kept under surveillance. Even if we manage to avoid these scenarios, we should expect a rise in volatility as monetary policy slowly changes from extremely easy conditions.
Baring Asset Management
As of June 30, 2014, Credit Suisse comprised 1.17% of the portfolio’s assets, BNP Paribas – 1.11%, UBS – 1.13%, Airbus – 1.19%, Shire Pharmaceuticals – 2.43%, and AstraZeneca – 1.41%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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