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International Equity Strategy Commentary - Q4/2017

International equity markets ended 2017 strongly as investor sentiment was buoyed by robust corporate profits, synchronised global economic growth and the passage through Congress of President Trump’s tax reforms. The EAFE index rose 3.71% in local currency terms and 4.27% in US dollars as the loonie gave back some of its Q3 gains. Resource sectors continued their recovery with energy the best performing group for the second consecutive quarter rising 10.09%, whilst utilities was the worst falling 0.92%.

We have often observed that for share prices to rise stock markets require two things: cash and confidence. In 2017 there have been both with quantitative easing (QE) in the EU and Japan offsetting the tightening of policy in the US to maintain excess liquidity. Then also synchronised global economic growth leading to better than expected news on corporate profitability, stimulating the ‘animal spirits’ of investors. Corporate optimism is strong after the passage of President Trump’s tax reform which benefited cyclical and value stocks with US exposure. The excess liquidity created by central banks’ QE experiment is under scrutiny for exacerbating the wealth divide in many countries and may explain the surge in value in cryptocurrencies in 2018. Policy makers must hope that they have taken enough action for the global economy to achieve escape velocity from the global financial crisis and subsequent recession without creating more damaging long term imbalances.

Money trends and the stockbuilding cycle suggest that global economic growth will continue strong at the start of 2018 but fade as the year progresses. Labour markets are probably now tight enough to generate faster wage growth and upward pressure on core inflation / downward pressure on margins. Independent of economic developments, the withdrawal of QE flow support may act as a drag on markets. Central banks are likely to be slow to respond to any asset price weakness because of tight labour markets and upward pressure on core inflation.

In Europe the political uncertainty in Catalonia has continued with a narrow victory for the pro-independence parties in the regional election raising tensions with Madrid. In Germany, negotiations have opened between Angela Merkel’s CDU party and the Social Democrats to test if there is enough common ground to form a coalition after talks broke down with smaller parties. French President Macron continues with his high-profile changes to labour law and enjoys the support of the business sector for now but it remains to be seen if he has the strength to face down union opposition without making too many concessions. In Italy parliament was dissolved ahead of the general election to be held on 4th March with a three-way contest likely to end in a hung parliament. The tortuous Brexit negotiations achieved a breakthrough in December with tentative agreement being reached on a divorce settlement representing ‘sufficient progress’ to complete phase one and enter the critical second stage which includes the terms of a trade deal important to the prospects for the UK economy. This success has strengthened Prime Minister May’s position and fears of an early election and Corbyn led Labour government have receded for now.

The reporting season in Japan was one of the strongest we can recall since the economic collapse in the late eighties. Robust exports helped by a weak yen and better global demand have been a driver of earnings and the domestic environment appears to be improving slowly. 2018 should see a gradual reduction in the vast stimulus actions with tapering of the Bank of Japan’s purchases of government bonds and equities. Any softening of the yield curve control policy would boost banks, whose profits would benefit from a rise in longer-term rates. Elsewhere in Asia, China has tightened policy in an effort to reduce speculation in the property market. The shift away from investment towards domestic consumption continues alongside the one belt, one road policy of expanding connectivity across Eurasian countries with a China-centred trading network. Chinese internet groups have matched their US counterparts in terms of stock market performance and were a significant driver of the outstanding performance of emerging markets in 2018.

Cyclical equity market sectors have outperformed defensive sectors by 30% since mid-2016; a reversal is likely during 2018 based on our economic scenario above. Many commentators have suggested that the recent strength of equities is unsustainable given the high valuation levels relative to history. This is true for the long term in the US given the market’s departure from its historical returns path, trend earnings, normal profit margins and valuations but less so of international developed and emerging markets. Also stocks may continue to perform well in the near term as benign economic conditions extend into early 2018 and the end of bull runs is often the most dramatic and painful to miss relative to benchmarks. We prefer to take profits gradually in some of the high beta stronger areas of the market shifting the emphasis within the portfolio towards more quality defensive names with a high, defendable and stable return on invested capital.

Transactions over the period reduced continental Europe to an underweight and added to the UK, reducing the underweight position there. Our favoured market themes include factory automation, Asian tourism and auto technology. Stock selection in Pacific ex Japan was positive as was emerging market exposure.

The composite rose 4.62% (4.42% Net) versus a 4.27% gain for the benchmark.

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