1st Quarter 2014
International equity markets were broadly flat during the first quarter of 2014, with mixed performances at the regional level as gains in Continental Europe and Pacific ex-Japan offset declines in the UK and Japan. European markets continued to benefit from increased hopes of economic recovery, while Australia led the improvement in the Pacific region as its currency partly reversed the weakness of the prior quarter. Japan was the worst performing regional market, declining 5.6%. Following a strong year in 2013, Japan began this year on a weaker trend as fears of an economic slowdown grew and hopes of early policy support were frustrated. Emerging Markets again underperformed developed markets with economic and geopolitical factors both at play.
There was a notable dispersion in sector performance as well, with weakness in Telecommunications and Consumer Discretionary contrasting with the strength in Utilities and Healthcare. Utilities rebounded from being the worst performing sector last quarter to the top of the pile during the first quarter in large part from strong gains in European periphery names as falling bond yields proved supportive. Telecomm made the exact reverse move, going from last quarter's top performing sector to the bottom this period owing to sharp declines in a number of industry heavyweights. Japanese auto stocks and Macao gaming stocks within Consumer Discretionary both saw profit taking after strong gains last year.
The Fund delivered negative absolute returns during the quarter and meaningfully underperformed its MSCI EAFE Index benchmark. Performance was mostly driven by stock selection. The main drag came from Europe, where declines in holdings like Adidas added to a lack of exposure to strong peripheral markets such as Spain and Italy. Stock selection in the UK was also a negative with a decline in Rolls Royce weighing on performance.
The allocation effect on a sector level was neutral overall, with positive attribution from Materials offset by weakness in Financials and Industrials. The drag from Financials resulted partly from holdings in Japanese banks and a lack of exposure to the rallies in peripheral European banks for much of the period. We did see a positive contribution from stock selection in the Materials sector aided by a strong recovery in gold mining stock Randgold.
An underweight to Europe and to Pacific ex Japan and an overweight to Japan all provided small headwinds to performance on a regional level. A small exposure to Emerging Market stocks was a negative as well.
It was a fairly active quarter in terms of stock rotation for the Fund, with six purchases during the quarter, including Airbus, Koninklijke (“Royal”) Ahold, and JGC. We continue to like the theme of expanding commercial aerospace demand and think Airbus is likely to benefit from greater managerial focus after a reduction in public ownership. Ahold offers exposure to a well-managed retailer with attractive positions in the U.S. and Benelux countries. We expect strong cash flows to improve shareholder returns. Japanese contractor JGC is likely to benefit from the growth in global liquid natural gas (LNG) demand and the associated infrastructure build out.
We sold eight stocks from the portfolio during the period, including all three Russian holdings—Mobile TeleSystems, Sberbank and Yandex—due to the turmoil in Ukraine. We also sold the position in China Pacific Insurance following a downgrade of our top-down view on Emerging Markets. Elsewhere, we exited Rakuten after a substantial increase in share price in 2013, given high valuations and caution on profit margin delivery. Three stocks were sold on individual company concerns—Elekta regarding its growth outlook and competitive pressures, Experian over its Brazilian operation as valuations seemed a little high to tolerate any slowdown in growth, and Golden Agri-Resources on a disappointing reaction to recent positive news.
We began this year stating that 2013 had seen good performance from international equities with very little improvement in company earnings expectations and that in 2014 we expected that earnings expectations would need to rise to justify the higher valuations that are now being applied to markets. Effectively, we were saying that earnings growth in 2014 would once again be the main driver of international equity markets. We still feel that this will be the case, but it was not the case during the first quarter.
Japan continued to demonstrate some of the best positive earnings revisions, and yet Japan was the weakest regional market during the period. Almost uniquely among the international markets, Japan delivered good earnings growth and now appears less expensive than it was. Barings’ Strategic Policy Group (SPG) continues to rank Japan as our most favored international equity market, and, for our part, it remains an overweight position in the portfolio. From a macroeconomic perspective, we believe it is the developed market least likely to be affected by the tapering of quantitative easing in the U.S. It is also the economy that we feel is most likely to continue to receive aggressively loose monetary policy (via the Bank of Japan’s ongoing quantitative easing program), which we think bodes well for equities. At this point, we remain circumspect about Japanese economic policy leading to a domestic Japanese economic recovery, and thus the investment case for current Japanese holdings are not primarily about a Japan domestic economic recovery. They are however, about self-help situations and companies that sell into the end markets that are benefitting from the ongoing global economic recovery.
From a macroeconomic perspective, Europe has not been a favored market with us—we currently rank it neutral. We began the year with an underweight position to Europe, but this underweight has eased over the course of this quarter. It is becoming less relevant to talk about a single Europe, however, because the region has been growing increasingly heterogeneous. One distinction has been to refer to “core Europe” and “peripheral Europe” but maybe a more helpful distinction is to refer to a “global facing Europe” and “domestic facing Europe”. Global facing Europe is the many exporters and global multinational companies that comprise the European equity market. These companies have benefited to a greater or lesser extent from the ongoing global economic recovery, weak as it may be. Some parts of the global economy have recovered more strongly, such as the global auto sector, and European companies with exposure to these end markets have correspondingly benefited from this. In this part of the European market we continue to find growth stocks at reasonable prices. Earnings expectations for these companies are growing and valuations remain reasonable. The portfolio is overweight to this part of the European market but, despite its attractions to us, it did not perform well during the first quarter.
Domestic facing Europe is struggling. Unemployment for Europe as a whole, but in particular for the peripheral countries, is persistently high. Bank lending continues to contract. The weakest economies have benefited from governments willing to flaunt the European fiscal rules by running higher than allowed deficits, risking a headwind soon as fiscal targets will eventually have to be met. In this part of the European market, company earnings revisions in aggregate remain negative. Despite this, in the first quarter, it was the best performing of all international markets. We don’t dispute that a value argument could be made for domestic facing Europe. Where we have doubts is whether the subsequent earnings growth, in aggregate, will justify the current valuations. The portfolio is underweight this part of the European market, though we have been working to see if we can identify further companies here with unrecognized growth that is consistent with our process.
We took an increasingly negative top-down view on Emerging Markets during the quarter. The initial factor here was our concern about the tightening of monetary policy in many parts of the market, especially China. The subsequent turmoil in Ukraine and the tensions between the west and Russia only added to our caution. From a valuation perspective Emerging Markets are looking increasingly attractive but the great unknown is to what extent the Chinese authorities will have to reign in credit growth in order to rebalance their economy and what impact this is likely to have on companies and on markets. From a global growth perspective, this leaves the U.S. as the world’s major growth engine. Recent economic data has been poor, but our view, for now, is that weather has likely been a factor, and so we continue to expect a moderate economic growth recovery from the U.S.
It was a difficult quarter for the portfolio, and us, from a performance perspective. We did have individual companies that disappointed, and our emphasis on finding and owning companies that are growing their earnings with attractive valuations did not, for the most part, get rewarded by the market. We began the year by saying that we felt companies would need to show earnings growth this year to justify the higher valuations that they received last year. We still believe this will be the case, even if it wasn’t so during the first quarter. To that end, the most important thing we are doing is maintaining the consistency of our process and working hard to find new unrecognized growth opportunities in international equities.
Baring Asset Management
As of March 31, 2014, Adidas comprised 1.24% of the portfolio's assets, Rolls Royce – 1.54%, Airbus – 1.31%, Randgold – 0.44%, Koninklijke Ahold – 1.22%, and JGC – 0.60%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.