4th Quarter 2011
International equities, as defined by the Fund’s MSCI EAFE Index benchmark, rose more than 3% during the fourth quarter, helping to recover some of the losses that occurred during a poor third quarter. The global economic recovery is continuing, but at a weak pace and with the main risks that we have highlighted before—a European banking/sovereign default, a China slowdown, or a relapse into recession—still present.
The United Kingdom (UK) was the best performing region of the globe, gaining 9.1%, followed by Pacific ex-Japan region. Japan was the worst performing region in posting a loss of 3.8% during the period. Emerging Markets slightly outperformed the benchmark. On a sector basis, Energy was the best performing area in the benchmark in rising nearly 15%, followed by more modest gains in Consumer Staples and Healthcare. Utilities was the worst performing sector, dropping 4.5%.
The Fund slightly outperformed its benchmark during the quarter as asset allocation by region and sector were both positive while stock selection was somewhat negative. An underweight position in Japan, an overweight stake in the UK, and an allocation to Emerging Markets marginally aided returns regionally. The positive effects of an overweight to Energy and underweight to Utilities were offset somewhat by an overweight position in the lackluster Technology sector.
Stock selection was negative owing mainly to holdings in the Materials sector and weak stock selection in the UK. Precious metals miners and agricultural commodity stocks suffered during the quarter on the back of weaker commodity prices. Within the UK, auto insurer Admiral Group dropped noticeably following a weak earnings report.
Those disappointments were offset by solid picks in Europe ex-UK and within Industrials and Healthcare. German pharmaceutical company Bayer AG and asset manager Julius Baer were the portfolio’s two best European stocks. Rolls Royce and Keppel performed well within Industrials, while Sanofi, Shire, and Teva Pharmaceutical were the standouts in Healthcare alongside Bayer.
Few changes were made to the portfolio during the quarter. The Fund received cash for its holding in software company Autonomy Corp following its acquisition by Hewlett Packard. The proceeds were then invested into German software company SAP. We believe SAP should continue to see good sales to corporate clients in 2012.
The Fund sold its holding in Norwegian fertilizer producer Yara International. We still favor agricultural commodity exposure and continue to hold potash producers as well as seed and agricultural chemical companies, however, we felt that urea fertilizer prices looked extended and decided to exit the holding in Yara.
Europe in Trouble
Of the three market risks noted at the beginning—a European banking/sovereign default, a China slowdown, or a relapse into recession—Europe continues to dominate the headlines, and its problems continue to escalate and broaden. We began 2011 worried mostly about Greece and Ireland. Those countries have now been joined by Italy, Spain, Portugal, and Belgium. France is not immune to the crisis given that its banking sector has much exposure to Europe’s problem areas and the country’s AAA credit-rating is in jeopardy as a result.
The potential impact of the European sovereign debt crisis on the global economy is not trivial. History’s largest sovereign default was Argentina’s default on $82 billion of bonds in 2001. By comparison, outstanding Greek sovereign bonds are six times that amount and for Italy it is a staggering 33 times.
Looking at the economic issues for peripheral Europe, Greek unemployment is now at 17%, Spain is at 21%, Ireland is at 14% and Portugal is at 12%. Youth unemployment is approaching 40% for some in the region, and all of these economies are seeing weak growth that will likely lead to a recession in 2012. So the prospect of employment improving in the near term is unlikely.
In general, European policies over the past year have been designed not to bring a resolution to the issues, but to buy time in the hopes that a less painful solution to the crisis might appear—popularly referred to as the “kicking the can” approach. In our view, this cannot continue because peripheral European governments are now struggling to borrow on acceptable terms, because European banks are now struggling to fund themselves, and because unemployment is now leading to rising social unrest. To us, it looks like Europe will have to make some hard choices in 2012.
It is important not to be too negative about European equities, however, because we believe one of the choices that will be made in 2012 will be the European Central Bank (ECB) deciding to increase the amount of debt monetization it undertakes—effectively a victory of French interests over German interests at the ECB. This move would be quite supportive for European equities and has actually already begun.
In December, the ECB launched a massive liquidity facility in its Long-Term Refinancing Operation (LTRO). The facility provides unlimited repurchase based lending for up to three years on qualifying collateral. It is mainly aimed at supporting the European banking sector, though we expect the resulting expansion of the ECB balance sheet to be broadly positive for equities.
China and the Global Economy
China’s economy continues to slow but its economic problems are not yet as critical as Europe’s. China also has more policy options, such as the Chinese government’s recently announced measures to stimulate domestic spending in 2012. We do not believe that this will include the housing sector where authorities have indicated they want to see prices come down to improve affordability. The resulting stimulus is unlikely to have the multiplier effect that the massive lending boom of 2008-2010 had, but it should still be a positive for the Chinese economy. Against this we expect the Chinese housing sector and related industries to continue to struggle.
For the global economy, the US has been the relative bright spot. A below trend gradual economic recovery continues. Given what is happening in Europe and China this has to be seen as a fragile recovery. Still, housing looks to be near its bottom, exports are recovering, and unemployment looks to be falling.
With this as our top-down view, the focus of the portfolio has been on the few areas of growth in an otherwise weak global growth environment and on areas where demand is less sensitive to the economic cycle—much the same as we have been saying for the past two years.
One of these areas is Internet-related companies. Online commerce continues to take market share away from conventional commerce. In international markets this trend has a long way to go. Despite the cycles that we see in overall spending, the market share gains by online commerce has given these companies a better growth rate of sales. We continue to look for new growth ideas in this area.
In Europe we continue to avoid owning banks, many of which are potentially insolvent. The liquidity provided to the banks by the ECB is merely life support, whereas the liquidity that reaches strongly capitalized companies with dominant positions in solid industries can lead to growth. We remain focused on finding more these strong companies that the crisis has left trading at attractive valuations relative to their level of growth, particularly those with exposure to US markets.
One example of this type of European company is German pharmaceutical company Bayer. It manufactures and sells its products globally and has one of the strongest new product pipelines in the pharmaceutical industry. After a strong fourth quarter it still only trades on a forward price/earnings ratio of not much more than 10 times earnings.
We have also favored companies that are less dependent on bank funding. Companies with strong balance sheets that are self-funded out of their internally generated cash-flow have a funding advantage in the current climate of financial stress. This is particularly true of European firms, which tend to be much more dependent on bank lending for their growth. Many Energy and Healthcare companies fall into this category.
Neither gold miners nor agricultural commodity stocks performed well during the quarter, particularly in December. Still, we continue to like this part of the market. Both areas are driven by demand from factors other than the economic cycle, and both benefit from liquidity and loose monetary policy. Though liquidity had been tightening by the end of last year due to European bank deleveraging, the response by the ECB to expand their balance sheet, plus continued loose monetary policy conditions throughout the western world, will remain supportive for non-economically sensitive commodities.
Baring Asset Management
As of December 31, 2011, Admiral Group comprised 1.21% of the portfolio's assets, Bayer AG – 2.17%, Julius Baer Group – 1.90%, Rolls Royce – 1.57%, Keppel – 1.58%, Sanofi – 2.02%, Shire – 1.54%, Teva Pharmaceutical – 1.93%, and SAP AG – 1.59%.
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.