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International Equity Strategy Commentary - Q3/2019

International equity markets were supported again by falling bond yields in Q3 against a backdrop of slowing global economic activity and downgrades to earnings estimates. The EAFE index rose 1.83% in local currency terms but fell 1.00% in Canadian dollars as the loonie appreciated further against a weaker euro and sterling. A stronger yen helped Japan outperform after a weak Q2. Utilities was the best performing sector gaining 2.50%, while energy was the worst, falling 6.32%.

The third quarter was characterised by a strong period of performance for quality growth stocks in July and August followed by a dramatic rotation towards cyclicals and value stocks in September coincident with a reversal in bond markets. We have noted before how crowded certain areas of the stock market appear, creating the environment for short, dramatic shifts in momentum and relative sector performance. The question for investors is whether any of these rotations sustain. With global growth likely to remain below trend for the next few quarters, monetary policy will continue to be stimulative, which may sustain the momentum of quality growth areas such as staples, healthcare and to a lesser extent IT while putting pressure on value areas such as the banks whose interest rate margins suffer. Global coordinated fiscal expansion has been suggested as a solution to the diminishing impact of monetary easing and would reverse the current market trends but this is unlikely to be achievable politically and some nations have no budgetary room for manoeuvre post the global financial crisis.

Consensus profit growth estimates were revised lower in Q3 across regions as the global economy slowed and analysts returned from their holidays and slashed numbers. The monthly MSCI World revisions ratio – upgrades minus downgrades expressed as a proportion of the total number of estimates – fell to a 3½ year low. Earnings revisions are a coincident economic indicator, correlating, for example, with global manufacturing PMI new orders. The revisions ratio had held up in mid-2019 despite a further fall in PMI new orders so recent weakness may reflect a catch-up. The depressed level of the revisions ratio is consistent with our view that global industrial weakness is reaching a maximum in Q3 as the stockbuilding cycle moves into a low. Global narrow money growth is likely to have picked up sharply in September based on data for the US and several other major economies. We expect the global economy to remain weak through Q1 2020 but prospects are improving for later in the year. The case for a portfolio rotation would be strengthened by confirmation of a rise in global real narrow money growth, which would support a 2020 economic recovery scenario. A possible strategy is to start by adjusting exposures that have outperformed or underperformed by more than the historical average for stock building cycle downswings. This would argue for adding to Euroland and emerging market equities and cutting back overweight quality exposure in favour of value.

In Europe attention has been focused on slowing German economic indicators reflecting the weakness in export markets and trade tensions but Euroland money trends have been improving suggesting better economic prospects. Brexit has yet to be resolved with the arrangements for the border on the island of Ireland the key area of disagreement. UK Prime Minister Boris Johnson has lost his majority in parliament but the Labour opposition is reluctant to agree to a general election as their standing in the polls is weak. Recent legislation in theory obliges Mr Johnson to seek a further temporary extension to EU membership preventing a no deal exit on 31st October but he has expended so much political capital promising an on-time departure that he may prefer to stand down and save face. The UK parliament can only agree on what it doesn’t want so a general election before year-end seems the only way forward. Meanwhile UK activity has slowed with many indicators suggesting the economy is already in recession.

In Japan the Bank of Japan has indicated that it is concerned about downside economic and inflation risks but the government went ahead with a consumption tax rise from 8% to 10% in October. Corporate news flow has been better received than expected with share prices responding surprisingly well to often mediocre results. The much vaunted improvements to corporate governance are showing up in higher returns to shareholders in a market that appears cheap on a number of valuation criteria. In Asia ex Japan the escalation of civil unrest in Hong Kong has been shocking and fortunately the Chinese government has been showing restraint so far. The prolonged disorder has negative implications for certain sectors notably global luxury where Hong Kong ranks in the top three cities for sales.

Transactions over the period have reduced the underweight in Japan further at the expense of the UK and Pacific ex Japan. The emerging market exposure remains low at 2.3%. In terms of sectors the underweight in financials and materials has been reduced as have the overweights in healthcare and staples after favourable market moves. Sector selection was the main positive helped by the underweight in energy and materials and the overweight in staples and healthcare. Stock selection in Japan was notably strong.

The composite fell 0.62% (0.81% Net) versus a 1.07% fall for the benchmark.

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