3rd Quarter 2010 Commentary
Strong Gains Amid Weak Economic News
International equities finally delivered a substantial positive return during the third quarter, with the Fund's MSCI EAFE Index gaining 16.5%. The best performing region within the benchmark was Pacific ex-Japan closely followed by the UK and Europe ex-UK. Japan was the worst performing region after two consecutive quarters of leading the index. On a sector level, Energy lead the way followed by Telecommunications and Materials, with Technology and Healthcare bringing up the rear in lagging the benchmark. Interestingly, virtually all of the performance came in September, and, somewhat worryingly, most of the performance came in an environment of generally weak economic and market indicators.
What did we see during the quarter? In the West, unemployment numbers remain persistently high: 9.6% in the US and now nearly 20% in Spain. Second quarter Gross Domestic Product (GDP) growth showed a weakening trend: 1.7% in the US versus 5.0% during the fourth quarter and 3.7% in the first quarter. In addition, sovereign credit spreads for the troubled European countries have moved out to record levels.
And now, the political consensus for a course of action is beginning to fragment. In the US, the rise of the Tea Party movement represents a general dissatisfaction with the current government and with the role the taxpayer has played in supporting various bailouts. In Europe, general strikes in Greece, Belgium, and Spain reflect a similar dissatisfaction, and more of this is likely.
Lagging UK Picks
The Fund lagged the benchmark during the quarter, mostly due to weak stock selection in the UK. One factor here was the portfolio's holding in paper products and cash handling firm De La Rue which was negatively affected by production problems at one of its banknote printing operations. Another factor was despite the rising gold price the Fund's holding in UK listed gold miner Petropavlosk was weak. Finally, after a strong second quarter, software company Autonomy Corp languished somewhat during the period.
Allocation by region was moderately negative, as was the Fund's allocation by sector. The former was due to underweight stakes in Europe ex-UK and Pacific ex-Japan relative to the benchmark, as well as a small holding in cash. In regards to the latter, an overweight to Technology, the weakest sector during the quarter was offset by an overweight in the strong Energy sector and underweight to Utilities.
Stock selection was also weak within Industrials. In addition to De La Rue, mentioned above, Japanese motor manufacturer Nidec Corp also delivered weak returns. This was offset somewhat by strong stock selection in Materials where the portfolio's agricultural holdings performed well and some decent Healthcare picks.
We made a number of changes to the portfolio during the quarter, mostly in Europe. The Strategic Policy Group for Barings upgraded its rating on Europe, and from a very underweight starting position we added a number of European holdings, including communication satellite operator SES.
Other purchases included UK-based companies BP and insurance company Resolution. We felt the growth prospects for the Energy group were better than the market was discounting and this made BP attractive from a growth and valuation perspective. Although the UK insurance market is mature and low growth, Resolution has been consolidating the sector, building scale, and is forecast to grow earnings through cost savings. In addition, following our analyst's upgrade, we purchased a holding in French pharmaceutical company Sanofi-Aventis.
We sold the Fund's position in Nomura Holdings. This had been a disappointing investment. We had been anticipating that with consolidation in the investment banking sector Nomura might benefit from margin improvement and growth, but this has not been evident. Following Barings analyst downgrades we also sold holdings in Kurita Water and UK telecom company BT Group. Finally, the portfolio's holding in gold miner Lihir Gold was acquired by Newcrest Mining during the quarter. The stock had performed very well for the fund and we may well look to add other precious metals miners to the portfolio in the future.
Despite all of the broader economic problems, equity markets have performed extremely well recently. The best reason we can see for this is the hope and expectation of the market for more stimulus via a second quantitative easing (QE2) from central bankers. This troubles us a bit, largely because the better that markets perform the less likely we are to actually see QE2. The prospect of more easing is a good reason not to be too pessimistic when markets are down, not a reason to bid markets to new and greater heights.
There is another reason why equity markets may be performing well around QE2 rumors, however, and that has to do with competitive currency devaluations. This economic crisis was met initially with massive global monetary stimulus followed by global fiscal stimulus. Monetary stimulus remains in place, with low interest-rates in the West likely to continue for some time. Fiscal stimulus, however, is now mostly being withdrawn, in some cases voluntarily and in other cases because the bond market has said "no more." To us, it increasingly looks like governments and central banks would like to effect currency devaluations to replace fiscal stimulus.
By implementing quantitative easing, the US Federal Reserve massively expanded the size of its balance sheet, effectively creating a mountain of new dollars. This has helped the US dollar to decline in value, but not against all currencies. Currencies, like the Chinese renminbi, that are pegged to the dollar are matching the US dollar decline. Other currencies such as the Japanese yen, the euro and the pound that are not pegged to the dollar are therefore bearing the brunt of the currency adjustment with resultant competitive headwinds for their economies.
The essential economic problem we face is that the West is over-indebted and their economies need to rebalance away from consumption and more towards exports. The concomitant requirement is that Asian and Emerging markets, that are relatively un-indebted, need to rebalance towards increased consumption and less exports. Every dollar pegged currency is an impediment to this necessary rebalancing.
Moreover, it is causing an unprecedented level of currency interventions from countries the world over. Japan, tired of the deflationary headwind of a strong currency, has unilaterally intervened to weaken the yen. Brazil has implemented foreign exchange taxes to slow the flood of hot money into its economy and is said to have directly intervened in foreign exchange markets in recent weeks. South Korea is also said to have intervened. The Swiss have been intervening massively, with little effect, to try and stem the appreciation of the Swiss franc against the euro.
This massive beggar-thy-neighbor policy must ultimately be futile. Any country is limited in its ability to weaken its currency only by its appetite for accumulating foreign exchange reserves and by the problems of inflation that that policy would create. The current situation is likely to end either in some form of global currency cooperation like the Plaza Accord of 1985 or in trade wars. We hope it will be the former, and we hope it is soon.
In the meantime, what does this mean for investments? First, ongoing efforts to weaken currencies are unambiguously positive for commodities, particularly gold and agricultural commodities. We continue to look for new ideas in these areas for the portfolio. Second, efforts to maintain weak currencies are inflationary. Very bubbly asset markets are starting to emerge in places like Hong Kong and Singapore. Lastly, real economic growth for the world as a whole looks like it will continue to be weak. Ongoing deleveraging in the West means consumption spending growth, a big engine of global economic growth for the past 50 years, is likely to be weak. This weak real growth environment should favor growth stocks, and getting more growth ideas into the portfolio remains our main objective.
The main risks to this view have not changed. The first risk is that we do suffer a renewed recession. Leading indicators have not been robust but they are not pointing toward a renewed recession at this point. This scenario would probably still see growth stocks outperform the broader market but they would likely underperform bonds.
The second risk is that the sovereign debt crisis becomes more widespread and includes the US. This would lead to higher bond yields that would effectively kill an economic recovery. To us, this is the scarier scenario because equities and bonds would underperform and cash would struggle to keep pace with inflation.
As we said last quarter, neither of these risks forms our base case but we continue to manage the portfolio with a more than normal awareness of the economic environment and the bond market. This quarter we would also add that we are managing portfolios with a more than normal awareness of the political environment—Tea Parties, general strikes, and global currency intervention or protectionist policies all look likely to continue.
Baring Asset Management
As of September 30, 2010, De La Rue comprised 0.77% of the portfolio's assets, Petropavlosk – 1.83%, Autonomy – 1.61%, Nidec – 1.52%, SES – 1.60%, BP – 1.46%, Resolution – 1.45%, Sanofi-Aventis – 1.54%, and Newcrest Mining – 0.74%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
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