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International Equity Strategy Commentary - Q3/2018

International equity markets continued to rise in the third quarter despite policy tightening by the Federal Reserve, rising bond yields and the global economy losing momentum. The EAFE index rose 2.42% in local currency terms and 1.42% in US dollars as a Bank of Canada interest rate hike supported the Loonie, as did anticipation of a trade agreement to replace NAFTA. Healthcare was the best performing sector rising 5.59% as concerns on drug pricing dissipated, improving sentiment towards pharmaceutical stocks. Real estate was the worst performing sector falling 3.02%, hurt by rising yields.

"Goldilocks" is over. The economic backdrop for markets has been unusually favourable in recent years, with growth mostly solid but not strong enough to produce capacity strains, allowing monetary conditions to remain loose. Now, growth has gone cold but hot labour markets are pushing up wage costs, squeezing profits and causing central banks to turn more hawkish. Faster growth of wage bills has contributed to a slowdown in profits in Japan, Euroland and the UK, a trend that may extend to the US during the second half. Fed policy tightening is being transmitted globally via the strong US dollar: central banks in 12 out of 32 developed and emerging markets raised official rates during the third quarter, while none cut. The current monetary backdrop, in our view, warrants a cautious stance towards equity markets.

In Europe the focus has been on the Italy/EU fiscal clash - the populist government's budget plans include expensive welfare payments and tax cuts and assume unrealistic economic growth for the next three years in excess of all other forcasts. Italy, as the third largest economy in the Eurozone and a founding member of the Euro, matters. The European Commission is being asked to approve an Italian fiscal deficit which will push out debt reduction on the country's approximately 132% outstanding debt to GDP. Italian bond yields have risen in response and the forthcoming withdrawal of QE support by the ECB for weaker sovereign bond markets will increase political tensions within the Eurozone. In Germany the future of Mrs Merkel as chancellor is being openly questioned as the parties of the centre come under increasing pressure from the right wing populist Alternativ für Deutschland party which has capitalised on local anti-immigration sentiment. Germany's manufacturing sector has been under pressure but services and consumer areas remain robust and business sentiment has remained resilient despite weakening foreign demand for the country's exports. In France President Macron's approval rating has fallen creating concern about the sustainability of his reformist project. Success in pushing through pro-business reforms making the labour market more flexible and reducing taxes should now be followed by cuts in public expenditure – government spending in France is 56% of GDP, much higher than the European average.

The UK economy has slowed but the Bank of England boxed itself into a tightening of policy with interest rates raised in August. Inflation has risen above expectations but our analysis suggests it will subside in 2019-20 barring significant sterling weakness or a commodity shock. A Brexit deal feels closer at the time of writing as the comments from the EU appear more conciliatory but Prime Minister May still faces the challenge of passing the deal through parliament with an opposition party seeking another general election and many members of her own party opposed to her favoured deal which keeps the UK subject to many EU trade rules.

The Bank of Japan meeting at the end of July was expected by some to signal a change in its zero rate policy but the announcement was dovish indicating interest rates lower for longer. The market has pushed out any changes to policy until after a consumption tax increase scheduled for October 2019, a potential date for a rate rise being as late as 2020. It has been pointed out that the statement in the English version about extremely low interest rates being maintained 'for an extended period of time' actually means 'for the time being' in the Japanese text. This may be a case of lost in translation. Foreign investors have reduced exposure to the market despite an improvement in returns and better corporate governance and pressure to unwind inefficient cross holding structures. If the US economy slows and stocks cheapen, Japan may benefit from a return of international investor interest.

The authorities in China have been easing policy in response to a weaker economy. Recently they have cut bank reserve requirements, probably in reaction to weak manufacturing data, but capital outflows picked up in September and could stymie easing efforts. Weakness in emerging stocks and currencies impacted developed market sector performance notably European banks, especially those with Turkish exposure.

Transactions have moved the portfolio further underweight Japan and raised continental European exposure. The emerging market exposure remains low at 2%. In terms of sectors we have moved overweight energy and raised exposure in industrials and healthcare at the expense of IT.

The composite rose 1.82% (1.63% Net) versus a 1.42% rise for the benchmark.


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