2nd Quarter 2013
International equities gave back some of their year-to-date gains during the second quarter, with the Fund’s MSCI EAFE Index benchmark falling by 1%. Though the quarterly drop was relatively mild overall that masked the pronounced drop since late May, with the index declining nearly 8% since May 21st. As ever, markets have been influenced by economic data, corporate earnings prospects, equity valuations and central bank monetary policy, with this latter factor playing a dominant role during the second quarter. The drop in prices coincided with U.S. Federal Reserve Chairman Ben Bernanke’s speech to the Joint Economic Committee of the US Congress on May 22nd. It was then that Bernanke introduced the idea of tapering the $85 billion per month that the Federal Reserve has been purchasing in US Treasuries and mortgage-backed security assets. The result has been a rise in the US 10-year Treasury bond yield from 2.0% to 2.7% and a strengthening of the US dollar versus other currencies.
Strong Stock Selection
The Fund gained ground in besting the benchmark during the quarter, powered by a number of different themes. An underweight position in the Pacific ex-Japan region, which heavily underperformed international equities overall, aided by the absence of struggling Australian banks boosted returns on a relative basis. Stock selection and an overweight position in Japan (one of the best performing regions) also contributed to performance, with the greatest impact coming from stock selection. Industrial company Mitsubishi Electric, Internet retailer Rakuten, Hitachi Metals, Toyota Motor, and insurer Tokio Marine all performed strongly for the portfolio.
Stock selection in the Continental Europe region aided returns as well, where the Fund’s holdings in Deutsche Boerse (the German-listed exchanges group), Swiss investment/private banking group UBS, and French-listed insurer SCOR, all performed well. On a sector level, Financials was the primary driver with the above-mentioned holdings along with Tokio Marine outperforming the benchmark. Similarly, stock selection within Consumer Discretionary outperformed, particularly in Japan led by Rakuten and Toyota Motor.
The main detractor from performance during the quarter came from stock selection in the Materials sector, primarily from holdings in mining and precious metals stocks as the prices for precious metals continued to fall. Gold and silver miner Fresnillo as well as Randgold Resources, both listed in the UK, weighed on relative performance.
Holdings within Emerging Markets also detracted from performance. Emerging Markets are not part of the developed market MSCI EAFE Index. As Emerging Markets lagged international equities during the quarter this produced a drag on relative performance. This drag, however, was minimal relative to the benefits of the portfolio’s underweight position in the Pacific ex-Japan region and the other positive contributors to performance.
The Fund retained an overweight position to the Japanese market at the end of the quarter given reforms to be introduced by the recently-elected Shinzo Abe government. We have selected stocks that we believe stand to benefit from a fall in the value of the Japanese yen relative to other currencies.
The Fund remains underweight the Pacific ex-Japan region. The largest component of this is a substantial underweight to Australia, which we think will face increasing difficulties with economy as the economies of some of its major customers (China in particular) slow. The Fund also remains underweight Continental European, where we believe the ongoing austerity drive will keep economic growth very weak.
The sharp market correction during the quarter gives an idea as to the extent to which the market has been dependent on Federal Reserve asset purchases. But tapering is not the same as rising rates. We believe that the U.S. economic recovery is ongoing, driven by an improving housing market and car sector, even though the overall outlook remains weak and will require ongoing monetary policy support. The most recent US household employment survey saw a gain of 160,000 jobs, but this consisted of a large gain in temporary employment and a decline in full-time employment. Barings’ Strategic Policy Group maintains its view of an ongoing sub-trend economic recovery in the U.S. Still, in a world where economic growth remains scarce, the U.S. is an end market that we continue to try to gain exposure to from international companies.
Chinese Monetary Policy
Similar to the U.S., China is changing monetary policy. The central Chinese authorities continue to crack down on the secondary banking market. That is, they are trying to curtail non-bank lending in the economy. This appears to be an attempt to rebalance the Chinese economy toward domestic consumption. We feel that their concern is that this lending is fueling the wrong kind of investment—speculation on housing or other assets—rather than productive investment in genuine areas of economic growth. This is a difficult policy to implement as it requires using administrative means to control the actions of millions of economic agents.
Chinese policy has implications for the rest of Asia, especially Australia, and underlines why our top-down views for Asia and Australia remain negative. Any curtailment in mainland lending is likely to have a ripple effect on the domestic economies of Hong Kong and Singapore where mainland Chinese investment remains significant. For Australia, if China successfully rebalances its economy away from housing speculation, then demand for iron ore and copper are likely to decrease. These are key export commodities for the Australian economy. This is also why, in the absence of significant corporate restructuring, we remain cautious of cyclical materials producers. Moreover, in addition to weakening exports, Australia has an expensive housing market and rising long-term interest rates. Both factors threaten to weaken its domestic sectors at the same time as exports weaken.
Falling foreign exchange rates brought on by the strengthening US dollar are raising the prospect of inflation and leading to rising government bond yields elsewhere in the ASEAN region. The Indonesian government, for instance, is countering this by attempting to improve its fiscal position by raising taxes and curtailing fuel subsidies. This in turn is leading to weaker domestic growth. Thus, we’re less sanguine on some of these Emerging Market areas.
The Bank of Japan continued its asset purchase program during the quarter. This policy is helping to maintain a weak yen, with the yen falling against the dollar during the period. The weak currency is improving the competitiveness of Japanese export companies with the potential for gains in market share. The policy is having an impact—Japanese companies are seeing strong positive earnings revisions—one of the few regions of the world where analysts are upgrading their earnings expectations.
Our Japanese investment focus remains on export related companies, but should growth begin to broaden into a stronger domestic economy we would look to add more domestic-oriented companies to the portfolio. Japan is implementing an unprecedentedly aggressive monetary policy and there is no assurance that it will work. The first phase, of achieving yen weakness, has worked, and we continue to monitor the progress toward the next phases of the recovery. In our view, the main risk to a Japanese recovery remains a sharp rise in government bond yields. The Japanese government is highly indebted, and high interest rates would undermine the recovery by hurting the Japanese fiscal position as well as making borrowing costs for companies too expensive. So far Japanese government bond yields have remained relatively stable but this is something we are keeping a close watch on.
Austerity is showing some signs of working in Europe. The region has a rising current account balance as peripheral countries are seeing improvements in their competitiveness through increasing labor flexibility in Spain, for instance, and evidence of nominal wage declines. It is not all good news though. Much of the improvement in the current account balance has been due to falling imports, and there is a question of whether there is enough patience by the electorate to allow a multi-year restructuring in the face of high ongoing unemployment.
Europe may be beginning to suffer from austerity fatigue. Unemployment rates continue to rise in the periphery to levels that do not bode well for social stability. In both Spain and Greece unemployment stands at 27%, with youth unemployment at 56% and 59% respectively. Political tensions are rising and are most acute in Portugal where the finance minister and the foreign minister have both recently resigned from the government. A common message we hear is that we are unlikely to see any letup in austerity until the German election in September. Once Chancellor Merkel secures a victory she will then have the political power to soften her stance on how Europe deals with peripheral Europe. For export driven Germany, the falling yen remains a threat to some of its export sectors.
The Eurozone remains in recession. The latest European Central Bank (ECB) lending survey showed bank lending declining year on year and the ECB balance sheet shrinking, signaling a tighter monetary policy. ECB President Mario Draghi, however, has revealed new monetary policy guidance of continued low rates for an extended period of time. We remain convinced that loose monetary policy will continue in Europe and remains a reason not to be too pessimistic about European equities. In the UK, the Bank of England’s (BoE) new Governor signaled monetary policy very similar to what the ECB announced. Although its domestic economy has remained remarkably resilient, we remain cautious of UK exposure given high household indebtedness, an expensive housing market, and continued fiscal headwinds. Instead, we prefer the companies in the UK market with global exposure that we think will benefit from a weak British pound.
Precious Metals Conviction
One area that we continue to have conviction though has not been working is precious metals miners. Our view remains that negative real short-term interest rates are supportive for gold prices, and real short-term rates remain negative in just about every economy in the world. Europe and the UK have just committed to an extended period of low rates and monetary policy in Japan is extraordinarily loose. The US Federal Reserve’s talk of a tapering of asset purchases is the only tangible sign of monetary tightening in the west, though based on Eurodollar futures the U.S. market does not expect significant rate rises until early 2015.
With global growth lackluster overall, our investment focus remains on finding companies with strong end markets. The US auto sector remains robust with the most recent data showing a new post-recession high of 15.9 million cars being sold on a seasonally adjusted annual rate (SAAR). We have significant exposure to this recovering market through the Japanese auto sector. We continue to find good individual growth ideas in Healthcare where end markets are driven more by rising Emerging Market wealth and global demographic trends. We continue to like the growth stocks we are finding in the communication technology area and other selected technology areas. We have a meaningful holding in financial stocks that benefit from growing demand for financial services in Emerging Markets and Asia. We also have holdings in agricultural related companies where again, demand is driven more by demographic factors than by the economic cycle.
Baring Asset Management
As of June 30, 2013, Mitsubishi Electric comprised 1.25% of the portfolio's assets, Rakuten – 1.65%, Hitachi Metals – 1.03%, Toyota Motor – 1.79%, Tokio Marine – 1.47%, Deutsche Boerse – 1.70%, UBS – 1.30%, SCOR – 1.41%, Fresnillo – 0.64%, and Rangold Resources – 0.38%..
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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