International Equity Strategy Commentary
June 30, 2022
International equity markets fell again in Q2 2022 following the weakness in Q1 leading to one of the poorest performances on record for world stock markets in the first half of a year. The EAFE index declined 7.6% in local currency terms but by 14.29% in US dollars. Energy was the best performing sector for the second consecutive quarter down 3.9% as the oil price gained another 10%, whilst the ‘long duration’ highly valued IT sector was the worst, falling 23.4%.
Stocks have been de-rated as bond yields have risen. Investors have come to recognise that central banks are serious about reducing inflation even at the expense of tipping economies into recession. Earnings have typically met expectations but the second half is likely to be much more challenging as many lead indicators are signalling a sharp slowdown in global economic activity with consumer sentiment hitting record lows in some surveys.
The war in Ukraine grinds on in the east of the country as Russia makes small gains at a great cost to both sides. The threat of President Putin cutting off gas supplies to Europe completely is temporarily threatening the transition to green energy as mothballed coal-fired power stations are re-started. Plans for rationing to keep the lights on are in place and would severely impact German industry and exports, putting pressure on industrial supply chains.
China’s zero covid policy has not helped markets with lockdowns slowing domestic economic growth significantly. The liquidity outlook was showing early signs of improvement with policy easing and money growth improving. Also the regulatory clampdown on certain sectors including the domestic internet giants seems to be easing although relations with the US listing authorities remain strained. In Japan the yen has been hitting 24-year lows as the Bank of Japan continues with its yield curve control in the face of higher rates in the rest of the world.
Stock selection was the main negative over the period partly offset by country and sector selection. Exposure to emerging markets was positive. The overweights in defensive sectors such as healthcare and consumer staples were also positive as was the underweight in materials. The overweight in IT was negative as the underperformance of quality growth factors versus value and high dividend yield was a headwind for our style across most sectors.
Our liquidity analysis suggests that GDP will contract in the US and Europe through Q1 2023. A recession may already have started in the UK. G7 six-month CPI momentum is likely to have peaked in June with a sharp fall in prospect as commodity price pressures and pandemic distortions ease. Hawkish policy actions by central banks may be seen as an unnecessary misstep. Our two measures of global excess money were negative in H1 consistent with the market weakness year-to-date. Normally quality stocks perform well when there is a double negative reading but the factor has an inverse correlation with bond yields. We expect the normal relationship of yields with falling global PMIs to be re-established in the second half with lower yields driving better performance from quality stocks. Also, one of the liquidity indicators is likely to turn positive in Q3 suggesting less weak equity markets. This mix of signals has favoured quality and growth factors historically.
We remain cautious on markets albeit with the hope that one of our key liquidity indicators turns positive in Q3. When stocks have been this weak in the first half of the year before, a recovery of some degree normally occurs in the second half. Lower inflation is needed so central banks can soften their policy actions and rhetoric. We continue to favour defensive sectors such as healthcare and consumer staples with underweights in cyclical sectors such as industrials and materials. We are also underweight financials but prefer insurance to banks
The portfolio remains overweight Pacific ex. Japan with a small exposure to emerging markets against underweights in Japan and Europe. After a period of relative underperformance the outlook for China has improved as policy is loosened in contrast to other countries and the regulatory pressures ease. The zero Covid policy is unsustainable and vaccines will be rolled out eventually which should supercharge a region that is cheap. We are seeking opportunities directly and via companies elsewhere with significant sales in the country.
We expect quality and growth to perform better as the liquidity backdrop improves and earnings growth becomes harder to find as the global economy slows. We continue to focus on companies with a high or improving return on invested capital with strong financials and competitive advantages. High margins and low debt levels are the best protection in recessions.
The Composite fell 15.41% (15.55% Net) versus a 14.51% fall for the benchmark.