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International Equity Strategy Commentary - Q4/2019

International equity markets ended 2019 strongly helped by the hope of a ‘phase one’ US/China trade deal and the introduction of liquidity by the Federal Reserve to ease conditions in the repo market. The EAFE index rose 5.23% in local currency terms and 8.21% in US dollars. A stronger British pound helped the UK outperform after the Conservative victory in the general election. IT was the best performing sector gaining 12.65% whilst consumer staples was the worst rising 1.93%.

Our analysis of money trends suggests that global economic momentum will remain weak in Q1 2020 but revive in Q2. We would hope to see a further acceleration in global narrow money growth to confirm this recovery scenario. US narrow money growth has accelerated but the missing link is China where credit conditions are still tight and money growth is losing momentum suggesting a GDP slowdown. Global December business surveys were disappointing and hopes that the US/China trade deal will give a boost to confidence and activity could be misplaced. Our view is that economic weakness has been driven by monetary policies that were too tight a year ago. Markets have been helped by the Fed expanding its balance sheet in response to a spike in repo market rates in mid-September due to unusually high treasury issuance, heavy corporate tax payments and seasonal quarter end demand. Chairman Powell has hinted that the operations are temporary and equity markets will have to navigate the removal of this support. Also stronger US money growth suggests the US economy will re-accelerate in H2 2020 putting upward pressure on US interest rates and the dollar although a rise in official rates is unlikely ahead of November’s presidential election.

In Europe, money trends are still hopeful but an economic pick-up may be delayed by global weakness. Recent PMIs have been disappointing with manufacturing lower and job vacancies falling in Germany. French economic data have been better and more jobs have been created as Macron’s labour reforms take hold. However there have been public sector strikes, with transport severely disrupted, over the President’s pension reforms which propose replacing the existing 42 schemes with a unified points-based system. In Spain parliament confirmed Pedro Sanchez as prime minister heading a coalition of his Socialists and the radical Podemos movement. Politics loomed large in the UK where the Conservative party led by Boris Johnson won a significant majority in the UK parliament. Sterling rallied ahead of election day and mid cap domestically orientated stocks benefited especially those threatened by nationalisation by the left leaning, Corbyn led Labour opposition. The UK’s departure from the EU will now proceed probably by the end of January but a period of tough negotiation lies ahead to agree a trade deal in time to meet Boris Johnson’s timetable. We remain cautious on the UK economy where GDP has flatlined since February held back by falling construction. PMIs have been weak suggesting a Q4 GDP decline and money growth is relatively slow signalling continued anaemic activity.

In Japan manufacturing output has been weak due to disruption by Typhoon Hagibis and a rise in consumption tax. This may cause a drop in fourth quarter GDP as the economy gained some momentum ahead of the rise on October 1st and consumption has been weak post the tax rise. Prime Minister Abe launched the first fiscal stimulus since 2016 with a Yen 13.2tn package to repair typhoon damage, upgrade infrastructure and invest in new technologies. Elsewhere in Asia, China has been squeezed by higher inflation with the CPI rising to 4.5% in November. The main driver is pork prices which jumped 110% in November as African Swine Fever swept through the country’s hog herds. This is weighing on real money growth. Policy makers are reluctant to flood the market with liquidity fearing inflating asset price bubbles and continue to pursue a cautious approach, reflecting concern about excessive credit and possible exchange rate weakness. Moreover, PBoC easing has been partly offset by a tightening of credit conditions resulting from a rise in bank funding costs following the failure of several regional institutions. Chinese money trends remain weak and we suspect that the recent improvement in PMIs represents a false dawn and will be reversed. The unrest in Hong Kong has created volatility but the market only underperformed slightly. Emerging market equities are highly sensitive to shifts in global growth. We are cautious on global economic prospects for H1 2020 though see potential for a pick-up in H2 so we have a low weighting at present but expect to add during the year. We use a seven factor checklist to assess the relative attraction of EM equities. As well as global growth prospects, this includes relative monetary growth rates, earnings revisions and the trend in the US dollar. The checklist suggested a cautious view a year ago but has improved recently, though is not yet giving a positive signal.

Corporate earnings continue to be revised lower as profit growth estimates have fallen for the next twelve months to mid-to-high single digit levels. Transactions over the period have moved industrials to an underweight and added to IT and real estate. The emerging markets exposure has risen to 3.9%. Cyclical stocks have benefited from expectations that 2020 may be a year of global economic recovery but we believe the move may be premature given our cautious view on economic activity in H1 2020. Stock selection was the main positive notably in Europe ex UK and Pacific ex Japan. Quality growth characteristics were in favour again and stock picks within IT, financials and materials performed well.

The composite rose 10.35% (10.15% net) versus a 8.17% gain for the benchmark.

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