International Equity Strategy Commentary

International equity markets had a strong end to 2023 helped by bond yields falling significantly in response to better inflation data and a perceived ‘pivot’ in interest rate policy by the Federal Reserve. The EAFE Index returned 5% in local currency terms and 10.47% in US dollars. The ‘long duration’ IT sector was the best performer with a 21.34% gain, while the energy sector, rose only 0.42%, which was the worst. Growth stocks outperformed but cyclicals also did well as hopes for a soft landing in the US were strengthened.

As we forecast, inflation has fallen rapidly in line with broad money growth with the usual two-year lag. What has surprised us is the resilience of the US economy despite monetary tightening, which appears partly to reflect consumption driven by savings built up during Covid. Improvements in the global supply chain have also supported industrial production. Better inflation news has allowed the Fed to stay on hold since July despite strong Q3 GDP growth and a still-tight labour market. With inflation likely to continue to fall, investors are more hopeful of a soft landing coupled with rate cuts in 2024 and have rerated risk assets accordingly. However, with global manufacturing PMI new orders likely to decline further and money trends yet to suggest a significant subsequent recovery, this optimism on a soft landing may prove premature.

Prospects in the UK and Eurozone are still worse than the US as money trends continue to lag, suggesting further economic underperformance and more urgent need for policy relief. A general election must be called in the UK by late January 2025, but Prime Minister Rishi Sunak has hinted that he favours the second half of 2024, no doubt hoping that tax give-aways in the Spring Budget will turn the stubbornly negative polls. The UK / Eurozone economies are on the brink of technical recessions, with GDP falling by 0.1% in Q3 in both cases and early Q4 data remaining downbeat.

Japanese stocks have been hitting 33-year highs in 2023 in local currency terms although Canadian returns have been pared by Yen weakness. The market has found favour again within Asia as investors rotate away from China just as corporate Japan is making efforts to improve shareholder returns and capital efficiency. In China, the policy missteps continue with an ill-timed announcement of proposals to reduce spending on video games hitting related internet and gaming stocks. Government measures to prop up the property market have failed to reverse the decline in home sales and the sector’s woes remain a significant drag on the economy. The PBoC accelerated liquidity injections at year-end, suggesting a policy shift that could revive historically undervalued equities, but a large fiscal package is probably also needed to boost investor sentiment to a level that might offset the structural outflows of international capital wary of the geo-political tensions and a more autocratic regime.

Relative performance improved over the period as growth stocks outperformed although the strong gains made by cyclical shares were unhelpful. Stock selection was the main positive notably in Japan while country and sector selection were small negatives. Several stocks that had lagged in Japan recovered as there was a significant rotation back to quality companies normally favoured by investors. Recruit (+34%) and healthcare stocks Terumo (+20%) and Hoya (+19%) all benefited. Sony also found favour again as margins are improving across a range of products and growth in console sales accelerates. Semiconductor photomask inspection system maker Lasertec (+65%) rose strongly on a broker upgrade and comments from the company signalling higher second half demand.

In Australia performance was mixed. Blood plasma specialist CSL (+18%) improved on lower US rates, an easing of cost headwinds and increased optimism about several potential positive catalysts in 2024. On the downside accounting software group Xero (+3%) lagged the strong IT sector as the company missed on headline subscriber growth in its H1 numbers. Lithium miner Pilbara (-5%) fell on a weaker spot price but the EV tipping point buy thesis remains intact and the company looks like a take-over target to us. Alibaba (-12%) cancelled its cloud spin-off and remains under pressure from negative sentiment towards China. We have exited the position. In Europe Swiss healthcare related company Lonza (-12%) was weak again after a capital markets day that led to cuts in consensus earnings revenue estimates, while Bank of Ireland (-10%) fell on rising cost pressures and a lacklustre Q3 trading statement.

Transactions over the period have raised exposure to Japan through the introduction of Shin-Etsu Chemical, retailer Kobe Bussan and silicon wafer manufacturer SUMCO. Shin-Etsu is a global leader in PVC, demand for which could recover as US rates relief revives housebuilding. In addition, its semiconductor wafers business is well-positioned to benefit from a turn in the tech cycle, partly reflecting new value-added areas. Kobe Bussan has traded sideways since Covid as the market has looked for more cyclicality and higher interest rate beneficiaries. The private label business, which sources overseas products to sell domestically, has been negatively impacted by yen weakness, which could reverse as US / Japanese rate differentials narrow. SUMCO is the number two in silicon wafer production and is benefiting from an ability to raise prices coupled with structural demand growth in electronics.

In Europe we have added to energy with the purchase of BP, industrials with the French defensive aerospace company Thales and consumer staples with German personal care company Beiersdorf. In financials we have re-introduced French insurer AXA, which offers an attractive capital return through dividends and buybacks. In real estate we have introduced UK development company Segro, which should benefit from falling UK interest rates.

On the sell side we have reduced emerging markets exposure with the sales of Alibaba and Taiwan Semiconductor. In Japan we have taken profits in Lasertech and exited Olympus to fund the purchases previously mentioned. We have also sold outright food manufacturer Kerry Group and life sciences group Qiagen in Europe.

The significant gains in equity markets at the end of 2023 have pushed bullish sentiment measures to high levels consistent with a correction. Our analysis suggests that inflation has further to fall and rate cuts should be forthcoming this year, but the bond market has discounted a lot of good news in a short space of time and at least a consolidation seems probable near term. We continue to believe that hard landings are possible in the US / Europe, with resilience to date not inconsistent with historical lags with monetary weakness and yield curve inversion. Against this backdrop, and with our excess liquidity measures still negative, we expect quality to outperform and defensive sectors to make a comeback versus now-expensive cyclicals.

Accordingly, the portfolio is overweight healthcare and staples versus underweights in materials, industrials, consumer discretionary and financials. Exposure to emerging markets has been reduced and is focused in India, Greece, and Korea, while Japan has been raised closer to benchmark. Europe is close to neutral, and we have moved to a slight underweight in Pacific ex Japan. We continue to focus the portfolio on companies with strong financials where earnings will prove more resilient in an economic slowdown, and which benefit from internal growth drivers or exposure to industries that have structural growth.

The Composite rose 12.65% (12.49% Net) versus a 10.42% rise for the benchmark.