4th Quarter 2012
International equity markets delivered a strong quarter of performance with the Fund’s MSCI EAFE Index benchmark gaining more than 6%. Europe ex-UK was the best performing region followed by Pacific ex-Japan, while the UK was the worst performing region in rising a little more than 4%. Consumer Discretionary and Financials were the best performing sector, both up double-digits, while Telecommunications was the worst.
The Fund delivered positive performance during the quarter, but well behind that of the benchmark. Asset allocation—notably an overweight to Israel—was a moderate negative to relative performance, but it was stock selection that served as the main cause of the overall underperformance. Holdings in the Materials sector, followed by picks in Financials, were the primary detractors. Materials suffered from the weak performance of gold mining stocks, as they gave back much of their good third quarter performance. In particular, a sharp sell-off of Centamin on the back of rising political tensions in Egypt hurt returns. Stock selection in the Industrials sector detracted from performance as well, with a weak performance from Japanese motor manufacturer Nidec the largest negative contributor in that area.
By region, stock selection in the UK, mainly in Materials and Energy, and Japan were the two biggest negative factors. The position in Japanese online retailer Rakuten was the largest single source of underperformance as investors worried over the rollout of its new e-reader. In general, Japanese stock selection suffered from insufficient exposure to the beneficiaries of the weakening Yen.
We made a number of changes to the portfolio during the quarter, including the sale of gold miner Centamin. Through all of the turmoil in Egypt the past two years, there had been no major disruptions to Centamin’s operations. The recent political tensions over the creation of a new constitution, however, look to us like they might have the potential to be materially disruptive. Following a meeting with company management, we also sold the holding in Nidec. We sold because the company is undertaking a change of strategic direction that changes the investment case for the stock.
We have been looking for some time at Japanese car manufacturers for investment opportunities. As a result, the Fund purchased a position in Toyota Motor. Toyota has an excellent position in the recovering U.S. car market as well as a good Emerging Markets business. If Japan is successful in weakening the Yen and stimulating domestic growth, this should be supportive of the investment case.
Other new holdings purchased during the quarter were China Pacific Insurance Group and Experian. China Pacific is the best capitalized of the mainland Chinese insurance companies. It has leading positions in selling life and non-life insurance to the Chinese consumer. This is a market that we believe has good long-term growth opportunities. UK consumer credit agency Experian is a leader in bringing consumer credit checking services to new markets. We feel the valuation of the stock looks attractive relative to its growth opportunities, particularly in Emerging Markets such as Brazil.
International equities had a good finish to a solid year of performance for the MSCI EAFE Index. This strong return belies what has been a difficult economic and political backdrop for much of the world, though there have been some bright spots. The US economic recovery continues, led by housing and autos. Economist Robert Shiller, who famously predicted the U.S. housing crash, is cautious about the sustainability of the housing recovery, but the recovery in auto sales looks real. The average age of the U.S. fleet looks old relative to its history, and the rise in auto sales looks likely to continue as Americans feed their pent-up demand for newer automobiles.
The U.S. outlook would be unequivocally good were it not for the political, fiscal, and monetary mess that the country finds itself in. The recent acrimonious fiscal cliff standoff and the 13th hour compromise agreement highlight the political discord that exists. And there is more discord to come as the focus now shifts to the March deadline for raising the federal debt ceiling. The absurdity of the situation is best illustrated by the semi-serious talk in recent days of the Treasury issuing a $1 trillion platinum coin as a way for the Obama administration to bypass the debt ceiling restriction.
Paper money is a confidence game. It has no intrinsic value, and therefore its value, and its viability, is dependent on the ongoing confidence of its users. What does talk of minting a $1 trillion coin, by fiat, do to views about the value of money? Central banks and governments the world over need to be careful, because once confidence in the money is lost it can be difficult to regain. Just ask Zimbabweans, who abandoned their currency in 2009, or the Hungarians in 1946, or the Germans in 1923. In all, there were 28 hyperinflations during the 20th century, and all occurred under fiat currency regimes.
China has also been a bright spot. The Chinese economy has improved on the back of very strong investment growth. We note, however, that this investment growth has been funded to a large extent by Wealth Management Products (WMP). These products are bank loans that have been bundled into a trust structure and sold to investors—forming part of what is known as the shadow banking system. With bank savings rates so low, savers have been coaxed into buying these WMPs. Recent defaults on a few WMPs have attracted the attention of the Chinese authorities. Meanwhile, medium- and long-term bank lending to companies in China actually declined 18% year-on-year according to a Bernstein analysis. We continue to see the Chinese economy growing well in 2013, however, that view would change if we did not see adequate sources of funding for that growth.
Japan’s economy in the latter part of 2012 has slipped back into recession. It has now been more than 20 years since the Japan bubble burst and we have yet to see a sustained economic recovery. Meanwhile, an aging population, a worsening fiscal position, and a decline in competitiveness in many industries finally seems to be bringing things to a head. The election in December saw the LDP party return to power under Prime Minister Shinzo Abe. Abe seems determined to shake Japan out of its deflationary funk and he has talked about policies to generate inflation and weaken the Yen. Those policies include increased monetization by the Bank of Japan, increased fiscal spending on infrastructure projects, and using foreign exchange reserves to purchase the bonds of other countries. Japan is walking a high wire. With a government debt-to-GDP (Gross Domestic Product) ratio exceeding 200%, the inflation that Abe hopes to generate could trigger a debt crisis if it leads to higher interest rates before an economic recovery takes hold. On the other hand, it is a mark of the desperation of Japan’s political class that such extreme measures are being pursued.
Economically, Europe has not been a bright spot either. The economies of many countries within Europe are in, or near, recession. The most recent unemployment data from Eurostat for November continued to show a deteriorating trend with the euro area unemployment rate reaching a new high of 11.8%. Scarier still is that youth unemployment in the region now exceeds 24%, and in Spain it sits at more than 56%. Automobile sales continued to plummet, particularly in the peripheral economies. Bank lending is falling, but loose monetary policy by the European Central Bank (ECB) has helped to avoid a crisis. The Long Term Refinancing Operation (LTRO) reduced the refinancing risk for European banks, and ECB President Mario Draghi’s announcement of Outright Monetary Transactions (OMT) in September of 2012 reduced the refinancing risk for governments. As a result of these enormous policy measures, financial indicators in Europe do not indicate a crisis. European bank paper and peripheral Italian and Spanish government bonds are trading at spreads well below their crisis levels. In our view, however, now that these financial indicators have been locked down by governments and the central bank they are less relevant as a crisis indicator. Instead, the best indicator of crisis in Europe is now political, and that will be driven by the electorate. If European economies do not start to show signs of improvement then the citizens of Italy, Spain, Greece, Portugal and Ireland are likely to agitate for change, and that is where the next European crisis is likely to come from.
The point of setting the scene as 2013 begins is to highlight how politically, fiscally and monetarily abnormal the world remains. We did see solid returns for equities in 2012, but some of those returns look to be based on investor’s expectations of a return to normalcy. Instead, our view remains that we are in an environment where real growth will be lower than we have historically seen in a recovery even though nominal growth is likely to be higher. We continue to look for companies that have pricing power and good earnings growth in this environment. We will look to companies that benefit from the Communication Revolution and Financials and Healthcare companies with Asian and Emerging Market exposure. Holdings in precious metals miners did not perform well in 2012, but we retain high conviction that these companies, along with agricultural commodity firms, should benefit from non-economically sensitive demand growth. In the current environment of ultra-loose monetary policy, we believe these stocks will perform well.
Finally, we have made some changes to the Fund’s Japanese holdings. We increased exposure to the auto sector with the previously mentioned purchase of Toyota, partly on the back of what looks to be a sustainable recovery in the large U.S. auto market and partly because of its good exposure to growing Emerging Market demand. The second change to our view in Japan is that the new government appears, to us, to be serious about weakening the Yen and helping the Japanese export sector to compete. Thus, the portfolio has been updated to reflect this change in view.
Baring Asset Management
As of December 31, 2012, Centamin comprised 0.01% of the portfolio's assets, Nidec – 0.00%, Rakuten – 1.05%, Toyota Motor – 1.39%, China Pacific Insurance Group – 0.56%, and Experian – 1.19%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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