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International Equity Strategy Commentary - Q2/2020

International equity markets staged a dramatic recovery in the second quarter driven higher by the unprecedented policy actions of global monetary authorities. The EAFE index rose 12.80% in local currency terms and 15.08% in US dollars as the loonie recovered some of its Q1 losses. Materials was the best performing sector gaining 24.06% whilst energy was the worst again rising 0.24%% despite an 81% gain in the Brent oil price.

Our liquidity analysis at the end of last quarter suggested that the loosening in monetary and fiscal policy around the world, to offset the negative impact of the lockdowns on demand, would cause global money growth to surge, creating excess liquidity to support financial asset prices. Also, given the normal nine month lead, our view is that global economic momentum will rise into early 2021, at least. Recent government intervention in economies is unprecedented outside of wartime and we question the political will to roll back policy actions in some countries. Financial repression may occur near term to control the cost of government funding but the rise in broad money growth suggests that inflation may return after 2021. This could be reflected in a recovery in labour’s share of GDP at the expense of corporate profits which have grown their share over recent decades.

Equity markets have duly recovered with the Covid-19 pandemic accentuating existing trends towards technology and ‘new economy’ stocks at the expense of ‘old economy’, although some cyclicals staged a recovery in Q2. The most affected areas related to travel and leisure have typically not recovered to their Q1 highs and banks continue to perform poorly crushed by pressure on interest margins and fears of rising bad debts. Profit estimates for the next twelve months have turned negative in many sectors but investors have been prepared to write off 2020 earnings, preferring to focus on 2021. We are concerned that current assessments by analysts are too optimistic, showing a ~5% improvement for 2021 earnings versus 2019, which seems too hopeful in our opinion.

In Europe historic steps have been taken with the EU negotiating a €750 bn recovery fund paid for by EU-issued debt to be distributed partly as grants. This will move firepower to fiscal policy from the ECB’s overburdened monetary actions and history may view this as a significant step towards fiscal union within the EU. Germany has suffered less economic damage and fewer deaths than others and a re-invigorated Chancellor Merkel has led the show of solidarity with stretched neighbours like Italy. The UK economy shrank by a record 20.4% in April following a 5.8% contraction in March. The reliance on services could mean that the recession is deeper in the UK and Chancellor Rishi Sunak will be hoping that the recovery will be similarly more pronounced. The spectre of Brexit still hangs over the economy and the date for requesting an extension of membership has passed meaning the UK will leave the EU on 31st December 2020 with or without a trade deal.

In Asia the Japanese and Chinese policy responses have been more measured than their Western counterparts although the approaches to battling the virus have been markedly different with Japan preferring a voluntary lockdown appealing to national pride. Beijing has introduced a new national security law for Hong Kong which includes the ability to arrest foreign nationals and send them to mainland China for trial. The authorities hope that the new law will allow them to crack down on the Hong Kong protest movement. The strong diplomatic response from the US and UK suggests that ‘business as normal’ with China remains a distant hope and US sanctions against Huawei remain in place.

Our emerging markets check list is giving the most promising signal since 2016. Helpfully Beijing has urged its citizens to buy the local market. Cyclical equity market sectors and emerging market equities usually outperform during global economic upswings, a trend that could be reinforced on this occasion by simultaneous accelerations in business/housing investment and associated strength in commodity prices.

The portfolio has benefited again from its growth bias particularly the preference for ‘new economy’ over old. Transactions were focused on taking some profits in quality defensive areas and adding to more cyclical stocks that we like but have suffered in the Covid-19 correction. We have added to Asia ex Japan and emerging markets and reduced Europe and Japan. We have moved overweight materials and added to financials, industrials and IT. We have moved underweight consumer staples and healthcare and reduced utilities. Stock selection was strong across regions and notably in financials and IT.

The Composite rose 20.66% (Net 20.45%) versus a 14.88% gain for the benchmark.

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