International Equity Strategy Commentary

International equity markets fully recovered their March losses and made significant gains over the quarter as investors focused on AI driven earnings growth rather than the unstable geopolitical backdrop and volatile oil prices. The MSCI EAFE index returned 11.6% in local currency terms and 10.8% in US dollars. IT rose 55% as the scale of AI investment was reflected in strong demand and pricing across the AI infrastructure complex including semiconductors, hardware and equipment. The worst performing sector was energy, down 17.2%, reversing the gains made in Q1.

New Federal Reserve Chair Kevin Warsh has inherited a solid US economy currently enjoying a growth boost from the enormous capex on AI compute. Our analysis suggests a rate rise is justified in the US but is not necessary in the Eurozone, the UK or Japan, where money growth is much weaker. Inflation pressures globally should remain contained and we expect the economy to slow in the second half of the year. In the UK, Prime Minister Keir Starmer has accepted the inevitable and resigned after his main rival for the leadership of the Labour Party, Andy Burnham, returned to parliament by winning a by-election. Favoured by the membership and less unpopular with the wider public Burnham was highly likely to win any leadership contest with the much-maligned Starmer.

The dominant feature in stock markets remains AI with day to day moves seemingly binary between ‘AI on’ days, when stocks related to AI infrastructure spending perform well while the perceived disrupted names suffer, and alternative ‘off’ days, when the disrupted recover and the infrastructure names decline. Examples of the potentially disrupted can be found in software, business and professional services, data vendors and IT services and outsourcing. Infrastructure winners include semiconductors and their equipment makers, data centre related businesses, power generation and electrical equipment, cooling, networking and optical equipment, and some automation companies. Leadership within the infrastructure group shifts with perceptions of where bottlenecks might develop. More neutral areas include banks, which stand to gain from cost savings but may be disrupted, along with healthcare and staples, although the latter has been negatively impacted by GLP1 weight loss drugs. Headline volatility for the whole market remains subdued but the divergence of returns between subsectors is, in some cases, extreme.

Portfolio relative performance was better in Q2 with added value from stock and sector selection and a positive impact from emerging market exposure. The overweight in IT was a significant contributor with Japanese stocks such as Murata Manufacturing (+233%), and Screen (+98%) making substantial gains while unowned German software giant SAP (-6%) fell, although we re-introduced the stock late in the quarter. Other AI related holdings include Australian real estate play Goodman and Hong Kong listed power tools maker Techtronic (+30%) – both are seen as beneficiaries of high demand for data centres, with the latter also boosted by spending on infrastructure and energy projects.

In communications conglomerate Softbank is the AI play of choice in Japan, reflecting its 86% holding in UK chip designer Arm and roughly 13% stake in OpenAI acquired in return for a commitment to invest $65bn. Not owning Deutsche Telecom was also a positive as telecoms came under pressure from the competitive threat posed by SpaceX’s Starlink offering. In financials the strength of the Spanish economy continues to support Caixabank (+27%), which raised guidance over the quarter, while UK-listed Asian focused bank Standard Chartered (+34%) has been benefiting from stronger earnings growth partly due to improved cost efficiencies.

On the downside some unowned IT stocks posted big positive moves such as German chip maker Infineon (+117%), Japanese IT bellwether Tokyo Electron (+106%) and flash memory card maker Kioxia (+368%). In financials the London Stock Exchange continues to suffer from concerns that generative AI could weaken the value of financial data terminals and analytics platforms, while in healthcare unowned Novo Nordisk (+37%) recovered on an easing of supply constraints and signs that oral obesity treatments are stabilising the company’s market share in the US. More defensive stocks such as East Japan Railway (-7%) and food retailer Kobe Bussan (-24%) tended to lag the market, with the latter also hit by a poorly received acquisition of an airline catering business with few obvious synergies. In an underperforming Hong Kong, casino operator Sands China (-17%) suffered from continued weakness in Chinese consumer trends while insurer AIA (-13%) was impacted – unfairly in our view – by recent Chinese regulatory actions aimed at clamping down on online brokers and offshore securities sales.

Activity over the quarter has raised exposure to IT, consumer discretionary and industrials with reductions in energy, materials and utilities. In Japan, we have introduced Murata Manufacturing, which is no longer simply a smartphone component supplier, now representing a leveraged play on AI infrastructure, data centres and vehicle electrification. We have also added Lasertec, which is effectively the only meaningful supplier of EUV photomask inspection systems. In industrials we have bought Italian cable specialist Prysmian, which will benefit from renewable energy build-out driven by electrification of transport and industry, as well as the installation of new interconnectors between countries and data-centre power requirements. We have also added building equipment company Belimo and valve specialist VAT, both in Switzerland. The former provides critical flow control and HVAC components for liquid cooling systems in hyperscale AI data centres, while the latter manufactures high-precision vacuum valves used in semiconductor fabrication equipment and benefits from rising chip complexity.

In consumer discretionary we have re-introduced Sony, which has lagged the recent strength in the Japanese market, and UK food services company Compass – the US business is exceptionally strong and margins are recovering back to historic levels. On the sell side we have taken some profits in miner Rio and exited engineer Weir Group in industrials. Other disposals include Thales, reflecting a loss of momentum of the defence buy case, and Kone, where weak China new-build remains an overhang. In utilities we have exited SSE in the UK after the stock re-rated and sold Sartorius in healthcare, where a recovery in sales after customer de-stocking is taking much longer than expected.

The portfolio remains focused on broad exposure to the different layers of the ‘AI stack’ with the current emphasis on semiconductors and manufacturing, infrastructure and energy and smaller exposure to models and applications. We are net overweight the theme, acknowledging that in the longer term the applications area may be the best place to be but focusing for now on where the money is being spent. This approach leads us to be overweight IT, real estate, communications and industrials while also liking healthcare for its defensive qualities. Financials are an underweight, with a preference for banks over insurance and services. Our emerging market checklist is still net positive but we are mindful of the strength year to date and the dominance of the tech heavy Taiwanese and Korean markets. The focus is on companies with continued positive earnings revisions as markets have already experienced strong profit upgrades and may be vulnerable to a weaker second half economic and liquidity backdrop.

The Composite rose by 13.7% (13.54% Net) versus a 10.82% rise for the benchmark.