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International Equity Strategy Commentary - Q4/2018

Softer global economic fundamentals and a less supportive liquidity backdrop caught up with international equity markets in the fourth quarter. The EAFE index fell 12.16% in local currency terms and 12.50% in US dollars as falling commodity prices put downward pressure on the Loonie. The Bank of Canada raised interest rates three times in 2018 compared with four hikes by the US Federal Reserve. The defensive utilities sector was the best performing sector rising 0.02% while energy was the worst falling 17.43% as oil prices declined 37.5% as measured by the WTI crude future.

We have previously noted that the economic backdrop and liquidity environment are less supportive of equity markets that have enjoyed an extended period of solid performance. Our latest analysis suggests the global economic slowdown could extend at least through H1 2019 with an H2 recovery possible but this requires an early, significant revival in money trends. Core inflation is expected to be stable or lower in 2019 but profits may have to take the strain of higher labour cost growth. US relative economic strength should dissipate. Markets have had a significant correction in Q4 2018 and a technical bounce near term is possible. However soft economic news flow and likely earnings downgrades mean investors will have to look through weak data focusing on the probable dovish policy statements and actions by the global monetary authorities. Also, an end to the trade war between the US and China would be well received - President Trump will find it harder to deliver domestic policy 'wins' now the Democrats control the House and may hope to 'bank' some of his gains in dealing with China.

In Europe President Macron of France was forced into a reversal of policy by the 'gilets jaunes' named after the yellow vests worn by protesters which are compulsory to carry in all vehicles on French roads. The movement started over anger at fuel tax rises but developed into a broader protest against Mr Macron's reform program. Euro10bn extra spending has been promised to those on lower incomes meaning France will breach the EU's deficit limit of 3% of GDP. This will be higher than the Italian deficit which has been trimmed to 2% of GDP from 2.4% mostly by delaying the implementation of its expansionary measures. The agreement between Rome and Brussels on Italy's budget deficit should ease pressure on Italian bond yields which will be welcomed by the issuing authorities given that they need to raise Euro226bn of medium and long-dated debt this year. In Germany the global trade war has slowed activity with the economy contracting in Q3 and forecast to expand below 1.5% in 2019. Domestic demand is expected to hold up with unemployment low but expectations for industrial exports have been downgraded. European parliamentary elections in May could underline the growing influence of populist parties shifting the balance of power away from traditional centre-left and centre-right politics.

Brexit remains centre stage in the UK with the clock ticking down to departure from the EU on 29th March. The passage through the UK parliament of Prime Minister May's agreement, which has been endorsed by the EU member states, is unlikely in its current form but a modified version may win support as the only alternative to no deal which most believe will be highly disruptive on both sides of the English channel. The UK can ask to extend the deadline but this has to be agreed by all 27 other EU countries. The major stumbling block is the 'backstop' agreement which some argue is unacceptable as it treats Northern Ireland differently to the rest of the UK. A no deal will likely mean a further fall in sterling and fall in UK asset prices. We would like to add UK domestically facing stocks which appear attractively priced but the political outcome is binary and unpredictable at the time of writing.

In Japan natural disasters over the summer negatively impacted GDP which fell at annualised pace of 2.5% in Q3 but is expected to rebound in the fourth quarter. The ruling coalition has unveiled a series of tax breaks for housing and cars to mitigate some of the impact of an 8% rise in consumption tax next autumn which is needed to reduce the budget deficit. Narrow money growth numbers are relatively strong versus other developed economies but concerns over the global activity and trade slowdown have deterred us from adding as Japan is normally sensitive to these factors. Elsewhere in Asia Chinese economic news has been weak and the authorities are in 'whatever it takes' policy mode to stem the slowdown. Policy has been eased, tax cuts implemented, and bank reserve requirements reduced, while there seems to be a genuine desire to come to an agreement with the US on trade. We are looking to Chinese money numbers as possibly the first to improve given the policy easing that has taken place which would be a positive signal for local stocks and emerging markets in general.

Transactions over the period have reduced the underweight in Japan and raised continental European exposure. The emerging market exposure remains low at 2.3%. In terms of sectors we have moved underweight energy and cut exposure to materials adding to the overweights in consumer staples and healthcare.

The composite fell 12.71% (12.88% Net) versus a 12.50% decline for the benchmark.


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