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International Equity Strategy Commentary - Q2/2021

International equity markets continued to rise in Q2 but there was a reversal of some of the recent rotation towards cyclical value stocks in favour of quality defensive stocks. The EAFE index rose 5% in local currency terms and 5.38% in US dollars. Healthcare was the strongest sector with a 9.44% gain, having been the worst performer last quarter. Utilities was the weakest, falling just 0.83%. Japan was a notable underperformer, falling 0.25%.

Our liquidity analysis signals a slowing of the global industrial recovery in the second half of this year, with the latest data suggesting that this will extend into 2022. Real narrow money trends have been impacted by a rise in inflation but six-month growth of nominal broad money has moved back to its pre-Covid average, suggesting that medium-term inflation risks are receding. Inflation data may continue to surprise on the upside in H2, partly reflecting Covid-related bottlenecks in the global supply chain, but medium-term inflationary expectations in the US Treasury market moderated later in Q2 and the Q1 rise in nominal yields was partly reversed. Fears remain of a ‘taper tantrum’ as central banks reduce asset purchases sometime in the future but real yields have drifted lower over the last three months.

In Europe the rollout of the vaccines has finally picked up pace although the emergence of the Delta variant in the UK and subsequently on the continent will prevent a normal level of tourist activity for the southern Mediterranean states. Unemployment has fallen with manufacturers taking on new employees at the fastest rate for 20 years and workers recalled from state-subsidised furlough schemes. In Germany the federal election is expected to be held late September with Chancellor Angela Merkel retiring. Fiscal budget plans will be key for the EU as well as Germany as the new government decides how to return to normal spending levels consistent with the debt brake laid out in the constitution - this provision has been temporarily suspended. France’s presidential election is due to be held in April 2022 with the centre-right opposition performing well in recent regional council elections, suggesting problems for President Macron. European stock markets have risen but some indices have struggled to break through their previous all-time highs in 2000. In the UK, the full lifting of Covid restrictions has been postponed until July 19th as the more virulent Delta variant has pushed cases back up although hospital admissions have remained contained thanks to the successful rollout of vaccine. The sharp rise in UK CPI inflation to 2.1% in May supports our long-standing forecast of a move above 3% in late 2021. Six months after Brexit took place the effects of Covid have swamped the impact on trade and employment although it is clear that the new regulations have damaged the economy on both fronts.

In Japan a third state of emergency was declared and Covid has continued to drag down economic activity as the vaccine rollout has been slow, although it is picking up speed now. The market has been relatively weak, with less support from the BoJ, which scaled back its ETF buying and halted purchases of Nikkei 225 funds. However business confidence is showing signs of improving and given the lockdown easing the market may play catch up with others in the second half. Elsewhere in Asia a case can be made that the most pressing monetary policy issue globally is the timing not of Fed tightening but rather of PBoC easing. The mainstream view at the start of the year was that China would continue to lead a global economic recovery, resulting in a further withdrawal of monetary and fiscal policy support. A strong recovery in activity through 2020 prompted the PBoC to withdraw stimulus in H2, resulting in a money / credit slowdown that has fed through to weaker H1 2021 economic data. The central bank, however, has been reluctant to change course, partly to avoid fuelling house and commodity price speculation, and six-month real narrow money growth has fallen to a worryingly low level Our belief has been that the PBoC easing would occur early enough to head off serious economic weakness. Increased pessimism is warranted unless action is forthcoming soon.

Our bias towards quality growth names has acted as a partial hedge against the recent rise in inflation. We favour companies that have a track record of pricing power and above average margins so earnings are less impacted by rising cost pressures. We also prefer companies with low leverage and those offering intangible services, which are less affected by supply constraints. Companies have not typically reported inflation-linked margin pressure and some have seen better than expected revenue growth and progress on cost reduction, both temporary and structural.

Transactions over the quarter raised exposure to defensive areas such as consumer staples and healthcare at the expense of cyclical sectors such as materials, industrials, financials and IT. We have added to Japan, reducing the underweight after a period of relative weakness and cut the overweight in Asia ex-Japan. Stock selection was the main source of added value over the quarter with sector selection also slightly positive. The overweight in IT and staples and underweight in communications more than offset the underweight in energy. Stock picks were strong in Europe and Japan notably in healthcare, consumer staples and materials. 

The Composite rose 6.64% (6.45% Net) versus a 5.17% gain for the benchmark.

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