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International Equity Strategy Commentary - Q4/2020

International equity markets ended the year strongly as successful trials of Covid-19 vaccines boosted confidence in a synchronised global recovery in 2021. The EAFE index rose 11.4% in local currency terms and 16.09% in US dollars. Energy was the best performing sector, rising 31.32% as the oil price recovered 27%, whilst the defensive healthcare sector was worst, rising 4.02% as US election uncertainty exerted a drag.

Joe Biden’s victory in the US presidential election and the narrow Democrat majority in both houses of Congress are expected to result in further fiscal stimulus and higher corporate taxes, in turn suggesting upward pressure on inflation and bond yields. The feared Covid-19 second wave arrived resulting in further lockdowns across Europe and the Americas requiring government support for individuals, businesses and the economy. However, the approval of a number of vaccines has boosted investors’ confidence in a global economic recovery in 2021 and commodity prices have been rising, signalling inflationary pressures despite near term economic weakness. Corporate pricing power will be key to relative performance in 2021. Which companies can pass on cost increases?

In Europe, the EU and UK finally agreed an 11th hour trade agreement and the transitional phase of the UK’s departure has come to an end. The UK market has responded well to the end of the uncertainty after a long period of underperformance helped by its value orientation. The ECB extended its QE programme but has baulked at cutting interest rates deeper into negative territory and is setting a higher hurdle for banks to access cheap financing. They have also lifted the ban on bank dividends although payout restrictions remain. Another EU development just before year end was a ‘political agreement’ on an investment treaty with China. Politicians hope that more direct investment will be allowed into China coupled with market opening that will steer Beijing away from its increasingly nationalistic model. The timing ahead of president-elect Joe Biden’s inauguration suggests the US may be more isolated especially after the sealing of the pan-Asia trade agreement earlier in the quarter.

In Japan a state of emergency has been declared in and around Tokyo to reduce the pressure on the capital’s medical system but like most Asian countries the number of cases has risen more slowly than in Europe. The trend towards cyclicals in Q4 has not impacted Japan as much but the Japanese market normally does well when global activity picks up, suggesting solid but unexciting prospects. There will be no shift to a US model any time soon, especially post-Covid, but there is an appreciation of the need to shift to digital. Shareholder activism, revisions to M&A guidelines and even some unsolicited bids are helping to improve corporate governance. Elsewhere in Asia we are concerned that Chinese money measures continued to grow moderately in November, suggesting downside risk to consensus economic optimism, although the central bank will probably provide support soon.

Our liquidity analysis can be summarised as ‘real money leads the economy while excess money drives markets’. The approach had signalled positively on the global economy and risk markets in early Q2 2020 but is now sending a more cautionary message. The current monetary backdrop and possible weaker near-term economic data suggest reducing cyclical exposure relative to H2 2020 but a stabilisation or revival in real money growth would support the positive message from our cycle analysis, arguing for using any setback in cyclical markets to rebuild positions in anticipation of a strong H2.

2020 has been the strangest of years with the global pandemic leading to extraordinary policy actions by the global monetary authorities and governments. Many stock markets have hit new highs despite a collapse in earnings leaving valuations above historic averages. The gap between winners and losers has been stark and a re-balancing of performance between sectors may have begun in Q4. Our focus remains on buying companies that meet our purchase criteria, which include a high or improving return on invested capital, opportunities to grow organically and resilience to change and technological innovation.

Transactions over the quarter have reduced the underweight in Japan while cutting exposure to Europe, Asia ex Japan and emerging markets. We have added to materials and some defensive areas such as utilities and staples and reduced IT and consumer discretionary. Stock and sector selection were both negative as investors rotated away from quality growth towards value areas of markets. The zero weight in energy was negative whilst stock picks underperformed in financials and industrials. Emerging market exposure was positive, as was stock selection in Japan.

The Composite rose 15% (14.79% Net) versus a 16.05% gain for the benchmark.

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