1st Quarter 2012
It was a good quarter for international equities, with the Fund’s MSCI EAFE Index benchmark rising 11% during the first three months of 2012. All regions within the index posted gains during the period, with Europe ex-UK the best performing region. The United Kingdom was the worst performing region, though it still managed to deliver positive returns of more than 7%. The big winner overseas, however, was Emerging Markets which rose by slightly more than 14% during the quarter.
On a sector level, Consumer Discretionary and Financials were the best performing sectors rising more than 19% and 16%, respectively. Telecommunications was the worst performing area, and the only sector that lost ground during the quarter.
Tech and Energy Boost
The Fund slightly outperformed its benchmark during the quarter aided mainly by favorable stock selection in Europe ex-UK and in the Technology and Energy sectors. Strong performances by oil giant Royal Dutch Shell and uranium miner Paladin Energy overcame weak performances from holdings in precious metals mining companies in the Materials sector. The overall stock selection effect for the quarter was neutral.
Asset allocation was a drag on relative performance during the quarter. An underweight position in Europe ex-UK, the best performing region, detracted from returns. Despite having successful stock picking, an overweight stake in the overall lackluster Energy sector as well as being underweight Consumer Discretionary didn’t help.
Other areas of weakness included Emerging Markets stocks and stock selection in Japan. Holdings in Emerging Markets included a Canadian listed stock that hindered returns in the group, while a holding in Nippon Telegraph & Telephone was the main factor behind results in Japan.
There were few changes to the portfolio during the quarter. We exited a position in Korean internet company NHN for better growth opportunities for the portfolio. We also sold a longstanding holding in Japanese personal products company Unicharm. The stock had been a good performer for the portfolio but we felt that its growth potential could no longer justify its rich valuation. The proceeds from that sale were used to purchase East Japan Railway. We think the company has good growth prospects from rising commuter traffic on its main rail lines, and also stands to benefit from its large property portfolio and debt refinancing opportunities.
Another Japanese stock added to the portfolio was technology firm Tokyo Electron. The company produces semiconductor equipment and is a beneficiary of the rapid growth in smartphones and tablet computers owing to its strong structural position.
We think there were two main drivers behind the excellent start that international equities had to the year. The first was the vast amount of money provided by the European Central Bank (ECB) to the European banking system via the Long-Term Refinancing Operation (LTRO). The second was the string of good economic data that has been coming out of the US recently.
Without a doubt the LTRO has made a difference for Europe. At the end of 2011 many of Europe’s banks, along with the economy, were heading for a crisis. The banks needed to improve their capital positions while facing €900 billion of wholesale refinancing in 2012. The result was that many banks began to rapidly reduce their leverage by disposing of assets. This threatened a spiral of falling asset prices as all banks clamored to sell, and risked seeing Europe starved of bank lending. This was the position in late 2011.
By providing €1 trillion of LTRO financing the ECB has eliminated the major part, if not all of, the refinancing risk for European banks for this year, thus avoiding a European banking crisis in 2012. Banks, the thinking went, would now no longer have an imperative to rapidly reduce their assets and would be able to continue to extend loans to customers.
The first part is certainly true. The risk of a European banking crisis in 2012 has been re-priced at a much lower probability and this has led to a sharp recovery in risk asset prices around the world. This has benefited European bank share prices, of course, but also peripheral European sovereign debt, Emerging Market asset prices (where much of the bank de-leveraging had been focused), and global asset prices in general.
The hoped for improvement in European bank lending, however, is not happening yet. The ECB recently released data showing that growth in lending to non-financial corporations continues to decline. It appears that some of the LTRO money has been used to buy European sovereign debt, especially in Spain, and a lot has been parked on deposit with the ECB—with little making its way into the real economy.
This continues to trouble us because it means that European economic growth will continue to grind lower, though not as rapidly as it appeared it would several months ago. And we continue to expect that Europe will have a recession this year due to the very weak economies of peripheral Europe.
Bright Spot—the U.S.?
A brighter spot economically has been the U.S. where improvement in a number of indicators, especially employment indicators has given investors hope that the U.S. can lead the global economy to a sustainable recovery. We continue to believe that the U.S. is in the midst of a continued economic recovery, but that it will remain weaker than the recoveries we have typically seen in the post-World War II period.
Part of our caution on the strength of the U.S. recovery is that we recognize that this is the first economic recovery in the post-World War II period that has happened in the midst of a general de-leveraging of the economy. Our overarching thesis since late 2008 has been that the de-leveraging of the economy would create a headwind and result in trend growth at a lower level than expected. We have not yet seen any data to change our view of this.
The other part of our caution is our belief that recent U.S. economic data has been flattered by a very mild winter in much of the country. Mild temperatures probably allowed some labor intensive construction work that normally waits for spring to be brought forward, flattering the employment data. Mild temperatures meant that U.S. home heating bills this winter were likely significantly lower (some commentators believe by almost $30 billion to $40 billion). This has probably provided a boost to household disposable incomes, flattering retail spending data. Data in coming months should help reveal what impact the weather has had, but we remain alert to the risk that our caution is misplaced.
The main source of concern for markets in the short-term has shifted from Europe to China as fears have increased about the magnitude of the correction in real estate prices and the scale of the associated slowdown in Gross Domestic Product (GDP) growth. The hope remains that we are nearing the point of a major policy response by the Chinese authorities, but we would caution against getting too optimistic about this. This is a year of significant political transition in China, and with their stated intention of shifting the economy away from its heavy reliance on construction and infrastructure spending towards consumption and healthcare related areas the government may prove less accommodating than many hope.
Overall, the first quarter was characterized by equity markets rising as improving economic hopes and large monetary stimulus helped overcome the risks posed by the high refinancing requirements of European banks and governments. As yet we have not seen significant overall improvement in the earnings outlook for companies. This means that the strong equity markets have been due to a re-rating of equity valuations and a lowering of the equity risk premium.
This together with the continued fiscal austerity that we will see in Europe for the remainder of this year means that it is prudent to be a bit cautious and not expect further equity gains to be as easy to achieve as they were during the first quarter. Nevertheless, we continue to underline how supportive to markets the current policies of the key central banks are, and we see little likelihood that these policies will change soon. This coupled with ongoing moderate economic growth in the US is likely to continue to frustrate more bearish investors.
We continue to believe that genuine growth stocks will look increasingly attractive in the low economic growth environment that we expect for most developed markets and that these stocks will increasingly attract premium valuations. As a result, we remain focused on investing in companies and themes that can deliver sustainable growth. The structural imbalances currently present in the global economy and the aggressive monetary responses that central banks have used in response, continue to create investment opportunities. We hope to exploit these opportunities using all of the top-down and bottom-up tools of our investment process.
Baring Asset Management
As of March 31, 2012, Royal Dutch Shell comprised 1.40% of the portfolio's assets, Paladin Energy – 1.37%, Nippon Telegraph & Telephone – 0.00%, East Japan Railway – 1.46%, and Tokyo Electron – 1.48%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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