4th Quarter 2010 Commentary
Decent Quarter and Year for International Stocks
Whereas the third quarter saw strong markets in the face of weak economic indicators, the fourth quarter delivered more modest returns internationally despite generally improving economic indicators, especially in the U.S. The Fund's broad-based MSCI EAFE Index benchmark rose 6.6% during the fourth quarter and 7.8% for 2010, capping off a good year for international investors.
Japan was the best performing region during the quarter, followed by the rest of Asia (Pacific ex-Japan). The worst performing region was Europe ex-UK, though it still managed to deliver modest gains. Stocks within Emerging Markets gained ground as a group as well, slightly outperforming the benchmark. On a sector level, Materials was the best performing area followed by Technology and Industrials, while Financials and Telecommunications delivered the weakest gains.
The Fund lagged the benchmark during the quarter, mostly owing to weak stock selection within Japan, the UK, and Emerging Markets. A disappointing outlook statement by UK-based software company Autonomy led to share price weakness. In Brazil, earnings downgrades to payment processor Redecard and a negative market reaction to an acquisition by food and drug retailer Hypermarcas were the main factors in the underperformance among Emerging Market stocks.
Allocation by region was moderately negative due to an underweight stake in Japan and residual cash held in the portfolio, while sector positioning was moderately positive, aided by an overweight in Materials. The latter was offset somewhat by the portfolio's gold mining stocks, which were weak relative to the rest of the Materials sector.
Other notable factors included solid stock selection in Europe and strong stock-picking among Financials, where the Fund benefitted from its underweight position in European banks. Unfortunately, both of those areas were among the weakest performers on an absolute basis during the quarter.
Few Portfolio Changes
There were only minor changes to the views of our Strategic Policy Group and few changes to the portfolio during the fourth quarter. Europe and the UK were both downgraded to neutral from overweight and Japan was upgraded to neutral from underweight. Following our analyst recommendation we sold the Fund's holding in oil producer Petrobras. The firm disappointed in 2010. Despite having discovered the largest oilfield in 30 years it is looking to us like much of the potential value from this discovery will not accrue to Petrobras shareholders as much as to the Brazilian state.
Elsewhere, we trimmed the portfolio's position in consumer products company Unilever to help fund the purchase of a new holding in Macau gaming company SJM Holdings and to add to the existing position to the previously mentioned Hypermarcas. In addition, we added to the position in gold mining stock Newcrest Mining, which acquired a previous holding in the portfolio during the third quarter.
We recently reviewed our outlook from a year ago, and what is apparent today is how little has changed. We commented then that we expected the Western economic recovery to be weak and that this would require a continued easy monetary policy with low bond yields. We also felt that this would be a good environment for equities.
This situation, in our view, still remains. Western consumption remains the biggest driver of global economic growth, and with Western consumers still being highly indebted it is difficult to see consumer spending returning to the levels of several years ago. High levels of Western debt continue to require low interest-rates however, which remains a big positive for equities.
A year ago, we were also concerned with a number of risks that were hanging over the global economy. Somewhat surprisingly, none of these risks came to pass to any significant degree in 2010, though neither were they mitigated.
For instance, we highlighted growing sovereign credit risk and the possibility that this could unexpectedly trigger higher interest rates. Rising sovereign credit risk has been priced into a few peripheral European economies but a number of large economies like the U.S., Japan, and the UK have poor and deteriorating fiscal positions that have not been priced into bond yields to any great extent.
We also highlighted the risk of a double-dip recession as fiscal stimulus measures were withdrawn from economies. But the withdrawal of fiscal stimulus has, to date, been only tentative. The prime example is the recent decision by the U.S. to extend the Bush tax cuts and to introduce further measures like payroll tax cuts and extending unemployment benefits. Some now forecast the U.S. fiscal deficit at $1.3 trillion for 2011, whereas a year ago expectations were that this would be back to below $1 trillion.
Finally, we highlighted the possibility of the Chinese introducing measures to cool their economy and the impact this might have on global economies and markets. The Chinese did introduce measures during the course of 2010, including bank lending limits, higher bank reserve requirement ratios, limits on third mortgages, and higher base interest-rates. But these have been minor policy moves and have not impacted significantly on markets. The Chinese do now have a growing inflation problem, as do other Emerging Markets, and the risk in 2011 is that they will increase the pace and severity of their tightening efforts.
In terms of our portfolio positions, we continue to avoid those areas of the market that are overly exposed to the main risks we have outlined and to focus on the growth areas of the market that are less likely to be impacted by these risks. This means that the Fund begins the year continuing to avoid the European banking sector. European banks in general remain highly exposed to sovereign credit risk, have opaque capital positions, and are unlikely to grow in the environment of deleveraging we are seeing in Western Europe.
Asian and Emerging Market financial companies continue to have all of the growth characteristics that Western financial companies lack, and we continue to hold investments in this area. Asian and Emerging Market households are not overly indebted and so we also expect consumer spending in these regions to be more robust than in the West. We look to add beneficiaries of consumption that are in these regions to the portfolio's holdings.
We continue to believe that a weak real growth environment with low real interest-rates is favorable for growth stocks. Moreover, growth stocks look attractively valued relative to the broader international market. We favor companies with pricing power operating in segments that are seeing secular growth despite the weak overall economic growth environment. These growth companies operate in areas such as enterprise technology, material technology, the Internet, healthcare, and energy efficiency. We remain particularly positive about the Fund's investments in the gold miners, agricultural commodity companies, and energy as low real interest-rates should continue to support commodity prices.
The risks that we outlined above, and all of the associated global economic imbalances, remain for 2011 and many of them have even grown over the past year. The result is that we are managing the portfolio with a more-than-normal awareness of the economic environment, and the political environment. The political consensus for the current course of policies in many regions of the world is starting to fragment. A decisive change in economic policy would necessarily cause us to rethink our investment outlook. Until that point, however, and particularly until real interest-rates decisively rise, we continue to believe that the current outlook for international equities is good.
Baring Asset Management
As of December 31, 2010, Autonomy comprised 1.54% of the portfolio's assets, Redecard – 0.00%, Hypermarcus – 1.09%, Petrobras – 0.00%, Unilever – 1.47%, SJM Holdings – 1.40%, and Newcrest Mining – 1.55%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.