- The portfolio’s allocation to small and mid cap companies proved beneficial during the fourth quarter.
- An improving economy and a greater focus on corporate governance makes Japan an attractive market for future growth.
- China and India exemplify the potential of emerging markets equities, which we expect to be a significant contributor going forward.
Another strong quarter of performance in international developed and emerging markets was led by small and mid cap stocks. The benchmark MSCI All Country World Ex-U.S. Index was up 5.00% for the fourth quarter and 27.19% for the year while the MSCI All Country World Ex-U.S. Small Cap Index did even better, up 6.61% for the quarter and 32.12% for 2017. Meanwhile developed market growth stocks maintained their consistent outperformance over value stocks for the year with the MSCI EAFE Growth Index gaining 5.24% in the fourth quarter and 28.86% for the year, outperforming its value counterpart by 200 basis points for the quarter and 742 bps for the year.
This is interesting because the MSCI EAFE Index is underweight traditional growth sectors such as information technology (IT) with just a 6% weight. Health care - also traditionally a growth sector - underperformed for the second year in a row. While not having a large weight in the index, small and mid cap stocks have had outsized returns within EAFE. One catalyst has been M&A activity as very large companies looking for growth are often buying it. Flows into international equities and fixed income also continue to be very strong.
Exhibit 1: MSCI All Country World-Ex U.S. Index Performance by Market Cap
Given the outperformance of smaller companies, our portfolio’s overweight in the $3 to $10 billion range and underweight in mega caps above $50 billion has served us well. Our proprietary model is invaluable in helping us find these undiscovered, under-researched ideas that meet both our valuation and growth focus.
When we look back at the year, we are certainly pleased with the degree of outperformance, primarily because it was not confined to a handful of ideas but came from many sectors and nearly all regions. Good participation from our top holdings as well as smaller, riskier names in our emerging growth bucket that were acquired by bigger competitors (Mobileye by Intel and Advanced Accelerator Applications by Novartis) validates why this area of growth is so important, even though valuations may seem high.
Participation from stocks in the secular growth and structural growth buckets were also important. Secular growth encompasses firms like Temenos Group, a developer of software for banks, with established, superior business models, underappreciated growth prospects, margin expansion, and long-term compounding of capital returns. Structural growth stocks such as London Stock Exchange generally have misunderstood earnings, may be trading at discounts to historical performance, or may be engaging in self-help stories that can accelerate earnings.
We emphasize stock selection as the key metric to focus on when it comes to understanding the sources of our performance. Unintended factor risk bets are well monitored and controlled to ensure that stock selection is the principal driver of alpha generation.
Regionally, the portfolio is well balanced, with an overweight in Europe Ex UK while Asia (including our emerging markets exposure there), and the UK are roughly neutral with our benchmark. Although slightly underweight Japan, this is not a true reflection of our exposure as Aflac, a 2017 purchase, generates more than 70% of its revenue from its Japanese third-party cancer insurance business. Japan, in fact, is experiencing something of a resurgence. Illustrative of these trends, merchandise trade exports have grown for 12 consecutive months, unemployment is at a 24-year-low of 2.7% and the Nikkei 225 is at a 25 year-high. It’s also worth noting that Japanese government debt is also at multi-decade highs.
"Flows into international equities and fixed income continue to be very strong."
Will these trends persist or might this be another false dawn for the Japanese market? At the center of these trends and a driving force for change are two individuals with bold plans and policies which have spurred dramatic change: Shinzo Abe, the Prime Minister of Japan and head of the Liberal Democratic Party, and Haruhiko Kuroda, Governor of the Bank of Japan (BOJ), and architect of the massive quantitative and qualitative easing (QQE) policy to end deflation. In October Abe, in a bold and politically shrewd move, called for and won a snap general election. Abe’s coalition won a supermajority (greater than two thirds) of seats, securing a strong mandate for his policies, and likely keeping him in control until 2021, which would make him the longest serving prime minister in Japanese history. Abe’s victory also indicates that Kuroda will sign on for another five-year term at the helm of the BOJ. Kuroda’s second term will provide continuity to his signature stimulus and massive monetary easing policies which have been positively received in the market.
Although achieving the BOJ’s stated QQE goal of 2% inflation has remained elusive, we have seen movement in the right direction. Japan is no longer in deflation, the economy is virtually at full employment, and wage growth is poised to accelerate. Wages are a key metric to watch as it relates to Abe’s economic reflation strategy as he is calling for a 3% increase in pay. While this call has been largely ignored by Japanese corporates previously, given the current severity of labor shortages, upward pressure on pay could materialize in 2018.
While we are bottom-up stock pickers, improvement in the economic environment is healthy and good for growth. Japan’s domestically-oriented companies have typically lagged their export-driven brethren, but there are signs that consolidation is at long last taking effect. Within Japan, we are overweight consumer staples which will benefit both from company-level efficiency improvements as well as an improving domestic market, with potential for better volumes and pricing as consumer wages slowly adjust upwards.
Governance reform is also underway in Japan, which we see as another catalyst for stocks. A Stewardship Code was launched in 2014 followed by a Corporate Governance Code in 2015. The Stewardship Code primarily targets institutional investors and their responsibilities as asset owners to promote sustainable growth of the companies in which they invest. This has led to a number of changes, including an increase in the percentage of independent directors on boards. By year-end 2017, 78% of Japanese companies have at least two independent directors, a material improvement from only 18% of companies in 2013. Japan has a long road ahead to reach board independence levels seen in other developed markets. Japanese companies have also significantly improved in linking executive compensation to performance, while return on equity, dividend payouts and share buybacks have all broadly increased.
Emerging Markets Hold Promise
We are increasingly positive on emerging markets (EM), but taking a selective approach across markets and companies. We view India and China as the top markets in the EM asset class. Both had a good year, but we believe there is more to come in the years ahead.
India is benefiting from positive demographics, with a young population that will be larger than the same cohort in China by 2025. The country maintains relatively low consumer debt with relatively stable leadership and improving corporate governance. Prime Minister Narendra Modi was reconfirmed in 2017 elections and his reforms are slowly coming through.
"The biggest issue for markets today are low interest rates and the gradual withdrawal of stimulus by central banks."
India has missed out on the upswing experienced by other EM markets as it works its way through deleveraging. Asset quality review, the recognition of bad debt, and demonetization of its currency have been shocks to the Indian economy. Private sector credit growth slowed precipitously in 2017 from double-digit growth levels of the previous decade due to the lagged effect of bad loans. However, bank recapitalization has been successfully addressed and bank balance sheets are mostly cleaned up. Loan growth has bottomed and will likely increase the closer we get to 2019. Manufacturing PMI and Service PMI are just over 50 and signaling the early signs of real recovery. Supply side reforms are working and even governance has improved, positioning India as an interesting opportunity in 2018 and 2019.
In China, meanwhile, the Party Congress held in October established a clear pathway centered on quality of growth. President Xi Jinping wants to move China forward through research, education, improving the environment and de-risking the financial system. Certain sectors have been declared as critical, including electric vehicles and artificial intelligence, two areas where China has good chances to beat the West in the medium term. The likelihood that China gets higher exposure in global equity and bond indexes should also be salutary. The bond market could be partly opened via the bond connect scheme similar to what has successfully occurred with stocks for some years. Index inclusion means international investors can no longer avoid China in their portfolios. From limited exposure to Internet stocks like Tencent and Alibaba, China’s state-owned enterprises will now get more attention.
From a value rally in 2016 to the growth rally in 2017, what’s next? The biggest issue the markets are facing today are low interest rates and the gradual withdrawal of stimulus by central banks around the world. The U.S. is ahead of the rest of the world in its tightening regime with more rate hikes forecast for 2018 and a new head of the Federal Reserve. The good news for investors in international equities is that we do not expect to see much movement on rates from Europe or Japan in 2018. Inflation is starting to appear, but there is still considerable slack in the system, particularly in Europe. Japan’s inflation is still barely breaking 1% but labor markets are tight. In addition to low government rates, yield spreads are equally tight so there is a certain fear that higher rates will lead to a dislocation in credit markets.
For growth investors, we have been grappling with low discount rates and high valuations. Rising interest rates mean higher discount rates, all things being equal. Equity risk premiums have also been high, but a normalization of rates will likely lead to a lowering of premiums. Combined with better growth from a better macro environment, these factors should allow non-U.S. growth stocks to continue to perform.
The ClearBridge International Growth Strategy had a positive absolute return for the fourth quarter but underperformed the benchmark MSCI All Country World Ex-U.S. Index. The main contributors to performance were the IT and consumer staples sectors. The primary detractor was the utilities sector.
On a relative basis, overall stock selection detracted from performance. In particular, stock selection in the consumer discretionary, utilities, financials and health care sectors hurt relative results. On the positive side, stock selection in the consumer staples and IT sectors were the primary contributors to results.
On a regional basis, stock selection effects across emerging markets, and Japan contributed the most to relative returns for the fourth quarter but they were offset by the negative impacts of an underweight to emerging markets and an overweighting to Europe ex UK.
On an individual stock basis, the largest contributors to absolute returns in the fourth quarter included Shiseido, Temenos Group, Ping An Insurance, Fanuc Corp. and Tencent Holdings. The greatest detractors from absolute returns included positions in Direct Energie, Munters Group, Hoya Corp., Allergan and Aumann.
During the quarter, we added a number of new positions including Nidec Corp. in the industrials sector, Rogers Communications in the telecom sector, HDFC Bank in the financial sector, Ambev in the consumer staples sector and Keyence Corp. in the IT sector. The Strategy also closed several positions, including Adidas in the consumer discretionary sector, CK Hutchison in the industrials sector, UniCredit and Credit Suisse Group in the financials sector and Coca-Cola Amatil in the consumer staples sector.