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International Equity Strategy Commentary - Q1/2019

International equity markets rebounded strongly from the weakness in Q4 2018 despite weaker global economic data and downgrades to earnings. Risk asset prices recovered, helped by more dovish policy statements by the Federal Reserve and other monetary authorities. The EAFE index rose 10.74% in local currency terms and 10.13% in US dollars as the loonie rose, supported by better oil and metal prices. IT was the best performing sector gaining 15.39% while communications was the worst, up 4.41%.

Our monetary analysis has been sending a cautionary message for a number of quarters for the global economy and liquidity support for markets. The sharp correction in equities in Q4 2018 was consistent with this backdrop but risk assets were oversold and a recovery in Q1 was not unexpected. The latest US narrow money growth data slowed sharply in March while global manufacturing weakness is spreading to consumer goods meaning services strength, which normally tracks consumer goods trends, is unlikely to last. We have been looking for Chinese narrow money growth numbers to strengthen in response to policy easing and this is now needed to sustain recovery hopes and offset the drag on global real money growth from US weakness and an expected rebound in inflation. Earnings estimates have been reduced across regions for the second consecutive quarter with most sectors experiencing downgrades and a rise in inventories suggests no immediate recovery. Further interest rate rises are now on hold but Federal Reserve operations to reverse QE have effectively tightened policy although this will end in September. Any global economic re-acceleration is being pushed back towards the fourth quarter although an outright recession is not being signalled by the current data.

In Europe the German economy has slowed sharply as weak demand from China for autos and factory goods has been exacerbated by a fall in exports to the UK due to rising Brexit concerns leading to a contraction of UK business investment. The gloomy economic data has pushed 10 year bond yields back below zero amid mounting evidence of a Eurozone slowdown. In France President Macron is pushing ahead with his reform program in the face of continued, albeit diminished, protests by the ‘gilets jaunes’ movement. Planned privatisations and reform of the 5.5 million civil service aimed at liberalising the economy should cut the country’s high public spending and recent fiscal results have has been encouraging with the fiscal deficit lower than expected. The Spanish economy has been playing catch up after the deep crisis post the GFC. Employment is growing and disposable income rising meaning growth has been the best of all big Eurozone countries. The country’s general election on April 28th may raise the issues of Spain’s national identity and regional autonomy again but hopefully won’t derail the recovery.

In the UK, the humiliating Brexit saga continues with Prime Minister May requesting a further delay to the UK’s departure from the EU as she tries to negotiate a compromise with the left wing leader of the opposition Jeremy Corbyn. It should come as no surprise that a parliament that had a large majority to remain in the EU would struggle to agree a way to exit and can only pass motions on what it doesn’t want. The real danger for UK asset prices and sterling is another general election that punishes Mrs May’s Conservative Party for its handling of negotiations by electing a Mr Corbyn led government with a Marxist agenda of high taxes and nationalisation. UK money numbers have slowed, investment has stagnated and the housing market is starting to crack notably in London. The Bank of England is postponing more dovish comment on the direction of interest rates while the Brexit process continues and is probably fearful of the impact on the pound.

In China investors were encouraged by stronger NBS PMI new orders but we are cautious given that the series displays a strong tendency to rise in March and is inconsistent with results in Taiwan and Hong Kong. Economic data may be improving but activity is not racing ahead after the monetary ease and fiscal stimulus measures, with more to come if needed. The consumer sector is a bigger stimulus beneficiary due to income and VAT cuts meaning services should rise as a share of the economy. In contrast the industrial sector faces headwinds as the stimulus has been more measured than in past cycles with less infrastructure spending. ‘Old China’ remains a drag on the private sector. The coming US/China trade-war deal may be a ‘lite’ solution satisfying some and disappointing others with some items of disagreement being discarded rather than multiple concessions on both sides. The deal may not clear the air in global supply chains resolving where to produce, invest, hire or source and trade tensions will recur.

The market rally has been driven by an expansion of multiples in the most expensive parts of the market creating a wide valuation dispersion. Factor correlations are high and a negative liquidity shock could result in another correction in the speculations of choice such as IT similar to that witnessed in Q4 2018. Transactions over the period have moved the portfolio underweight Europe ex-UK and raised exposure in Asia ex-Japan. The emerging market position remains low at 2.4%. In terms of sectors we have increased the underweight in financials and reduced the underweight in consumer discretionary with the focus on China plays.

The composite rose 11.17% (10.97% Net) versus a 10.13% gain for the benchmark.

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