Virtus International Series
3Q 2016 COMMENTARY
The third quarter began with a post-Brexit bounce and concluded with hawkish comments from the Federal Reserve and European Central Bank (ECB), tumult at Deutsche Bank invoking memories of 2008, and uncertainty heading into the U.S. presidential election. While those were the headlines, the broader market backdrop was one of tepid global gross domestic product (GDP) growth, ongoing central bank intervention globally, continued low-to-negative long-term interest rates in G7 countries, and uncertainty about a post-Brexit Europe. Central banks remained accommodative, although with varying tactics which reflected the different stages of recovery in each economy. Markets demonstrated volatility ahead of, and in reaction to, policy announcements from the Fed, Bank of Japan (BOJ), and ECB. Oil rallied sharply into quarter-end after OPEC members agreed to long-delayed production cuts. And U.S. second quarter GDP growth was revised upward from 1.1% to 1.4%, helping to bolster the consensus opinion in favor of a potential December Fed rate hike.
In the end, the MSCI EAFE® Index ended the quarter with a strong gain of 6.43% while the Series (Class A NAV) modestly underperformed the benchmark with a positive return of 5.10%. While we are disappointed to have underperformed, we also recognize that we came into the quarter defensively positioned on the heels of the Brexit vote with higher than normal cash, and a lower beta orientation. The post-Brexit consensus view was certainly not for “risk on” and a rally in cyclicals. The largest detractors in the portfolio were our position in gold miners, which sold off on the back of the strengthening U.S. dollar and a big first-half rally, and our underweight to the financials sector which regained some traction after a rough first half of 2016. Our overweight to the information technology sector was the strongest contributor, fueled by our position in NXP Semiconductors which received a buyout offer from Qualcomm just before quarter-end.
We have often said that our top-down view is typically used to keep us out of individual countries, rather than dictate where we proactively seek to invest. As such, we remain comfortably underweight continental Europe, as we view the European Union (EU) as a good but flawed attempt at monetary, fiscal, and political unification. Brexit was a populist outcry against the EU, and regardless of the outcomes of upcoming elections, the EU’s problems will not be solved overnight. Other top-down calls have been a continued underweight of financials – particularly banks in an era of compressed net interest margins.
THE MARKET AHEAD
The market has decided, for now, that the uncertainty brought about by Brexit, populist movements globally, and pending elections in the U.S. and continental Europe warrants no handicap. Carry on, there’s nothing to see here. Perhaps slow-and-steady GDP growth, low inflation, and earnings streams being discounted at “lower for longer” interest rates do leave some room for this bull market to run higher, but we entertain this possibility with a cautious stance and higher than normal levels of cash in the portfolio.
While the BOJ has deepened Japan’s monetary stimulus efforts via a continuation of its asset purchase programs as well as its announced “yield curve control” plan, it is difficult to construe these moves as significant additional easing. We view the real keys to a Japanese resurgence to be fiscal and structural reform. We’ve been constructive on the Abe administration, and continue to pick our spots for investing in Japan, with a focus on the domestic names.
As the new U.K. Prime Minister Theresa May sets the country on a course to become a “fully independent, sovereign” country by 2019, we believe Europe and the U.K. will bear a real economic cost that is not yet fully appreciated. Eurozone GDP growth looks set to weaken on the back of softening business activity indicators and the fact that the ECB’s stimulus efforts have not been accompanied by necessary EU structural and fiscal reforms. We also look to upcoming political votes in Italy, France, and elsewhere as further tests of the EU’s ongoing cohesion. We view these risks with less than a casual eye, and thus the portfolio remains underweight Europe.
Overall, we continue a somewhat defensive approach to engagement in developed economies which have been beneficiaries of the artificial asset bubble created by central banks. Underlying symptoms of poor productivity, low growth, political uncertainty, and deflationary tendencies still remain. That said, we do continue to identify compelling bottom up stock ideas for the portfolio, including some from more economically sensitive sectors such as technology and consumer discretionary.
Late in the third quarter we completed an extensive fact-finding trip to Brazil. We were fortunate enough to meet with many senior corporate and governmental leaders, including the chief of staff to Michel Temer, the new president. We found many reasons to be optimistic about Brazil. The economy is clearly bottoming, with GDP growth expected to transition from -3.5% in 2016 to 1.0% in 2017, likely the biggest positive GDP change in the world among major economies. Inflation is expected to fall from high-single to mid-single digits next year, and the Brazilian real has appreciated as well. The future of Brazil is dependent on the politics surrounding ambitious fiscal reforms. If President Temer can pass these reforms through the two houses of Congress, we believe there is significant upside there. We continue to monitor this situation closely and have identified several Brazilian stocks for potential inclusion in our portfolio, after being absent from Latin America for some years.
Beyond Brazil, sentiment toward emerging markets (EM) broadly speaking has improved significantly in 2016, largely driven by a weaker-than-expected U.S. dollar (to which many EM currencies are tied) and a stronger Japanese yen (rendering competing products produced in emerging markets more competitive). Higher bond yields in emerging markets versus developed markets also impact the flow of capital in favor of EMs. Also, the Brexit vote and the implications of the U.S. presidential election have challenged the notion that political risk is confined solely to the EMs. One of the key turning points at the start of the year was China's additional stimulus, which helped assuage concerns about slowing growth in the world's second largest economy. Dovish rhetoric from the Fed also served to cap the appreciation of the dollar and help push EM equities higher.
In closing, we make a broad observation about domestic versus international equities. For the five years ended September 30, 2016, the MSCI EAFE benchmark has returned 43% cumulatively as compared to a return of 113% for the S&P 500 Index. This sort of imbalance is not unprecedented, having also occurred in the mid-1980s and the late 1990s. Much of the current disconnect can certainly be attributed to the earlier use of aggressive easing techniques by the U.S. Federal Reserve, which drove a successful reflation of the U.S. stock market after the 2008-2009 financial crisis. However, if one places any credence in the notion of mean reversion, we believe international equities stand an excellent chance of outperforming going forward.
Benchmark since inception performance is reported from 4/30/1990. Class A operating expenses are 1.18% and gross operating expenses are 1.29%. Operating expenses reflect a contractual expense reimbursement in effect through 4/30/2017.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains.Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. Please visit Virtus.com for performance data current to the most recent month-end.
Index: The MSCI EAFE® Index (net)
is a free float-adjusted market capitalization-weighted index that measures developed foreign market equity performance, excluding the U.S. and Canada. The index is calculated on a total return basis with net dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and it is not available for direct investment.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
The investments for the Series are managed by the same portfolio manager(s) who manage one or more of the other funds that have similar names, investment objectives and investment styles as the Series. You should be aware that the Series is likely to differ from the other mutual funds in size, cash flow pattern and tax matters. Accordingly, the holdings and performance of the Series can be expected to vary from those of the other mutual funds.
Shares of the separate Series of Virtus Variable Insurance Trust are sold only through the currently effective prospectuses and are not available to the general public. Shares of the VIT Series may be purchased only by life insurance companies to be used with their separate accounts which fund variable annuity and variable life insurance policies or qualified retirement plans. The performance information for the Series does not reflect fees and expenses of the insurance companies. If such fees and expenses were deducted, performance would be lower.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Foreign & Emerging Markets: Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk.
Derivatives: Investments in derivatives such as futures, options, forwards, and swaps may increase volatility or cause a loss greater than the principal investment.
Prospectus: For additional information on risks, please see the fund's prospectus.