Virtus International Series
4Q 2016 COMMENTARY
THE QUARTER IN REVIEW
The landmark event of the fourth quarter was the election of Donald Trump to the U.S. Presidency on November 8. Widely unexpected, the election result sparked a rally that saw U.S. markets rise nearly 8% into year-end. The reaction in international markets was mixed, especially in local terms, as a global risk-on market sentiment was combined with a strong dollar surge. It was certainly a dramatic finish to the year, serving as the mirror image to the year’s historically awful beginning which saw the S&P 500® sell off nearly 8% in the first ten January trading sessions. The quarter also included the Italian referendum vote which saw a defeat of former Prime Minister Renzi’s effort to reform the country’s legislative process. As promised, Renzi announced that he would step down as his reform effort failed. Given that Renzi represented the most decidedly pro-EU political party in Italy, it remains to be seen whether the transition of power will have broader implications.
The winds of change are clearly shifting the focus of economic policy in the U.S. from monetary toward fiscal. While this could provide a blueprint for other major economies to follow, it remains to be seen whether the EU, U.K., and Japan have the ability and desire to pivot in this fashion. The result is a current global decoupling of policy the likes of which has not been seen since pre-2008. This decoupling, combined with global growth, led to a major shift toward cyclical stocks and a selloff in U.S. Treasuries which sent the 10-year yield rising to 2.45% by year-end from 1.83% the day before the U.S. election.
Despite this backdrop, markets proved to be resilient in 2016. They weathered not only the rocky beginning sparked by China growth fears and dramatic oil price declines, but also a steady stream of global electoral surprises, populist movements, geopolitical events, and positive but not particularly robust GDP growth trends. This result stands in contrast to the previous year, where most markets suffered losses of varying degrees.
In the fourth quarter, the MSCI EAFE® Index returned -0.71% while the Series (Class A NAV) underperformed the benchmark with a return of -2.95%. The Series’ underperformance was largely the result of both the allocation to, and stock selection in, the materials sector. Stock selection in consumer discretionary and telecommunication services also detracted from relative performance. The positive effect of being underweight the consumer staples sector partially offset the detrimental effect of being underweight financials, which rose sharply with a steepening yield curve.
Post Brexit in June, we slowly began to change our defensive posture towards global markets. This included rotating toward cyclical sectors and lowering our tactical position in cash. We recognize the positive implications of reform, stimulus, and a weakening currency in Japan, and can now see sluggishness in the EU abating. We see less risk of a hard landing in China. We see attractive opportunities in other emerging markets such as Brazil. And we believe the Trump administration’s efforts to stimulate the economy in the U.S. could have positive implications abroad.
With this view in mind, during the quarter we found opportunities in Fortescue, BMW, LendLease, and Toray. We increased our allocation to Brazil with holdings in PetroBras and CBD. We also took advantage of market dislocations to reduce our underweight in financials with the purchase of SocGen and Mizuho. We sold Randgold, Heineken, Agnico-Eagle, NXP Semiconductor, Tencent, and Ctrip. From a sector perspective, this activity resulted in reducing our underweight to industrials and financials, and increasing our overweight to consumer discretionary. The portfolio remains overweight in technology while maintaining an underweight to consumer staples.
Regionally, we reduced our U.K. exposure more as a result of specific names than a call on that market. We are now underweight all but the most export-centric U.K. companies which benefit from a weak pound. The portfolio is now slightly overweight Japan with the purchases of Toray and Mizuho. Reflective of our top-down views, we remain underweight to Europe, and the strategy is market weight the Asia ex-Japan region. The emerging markets allocation stood at approximately 7% at quarter-end, comprising the two aforementioned Brazilian holdings plus one in Korea.
THE MARKET AHEAD
Headlines suggest that the global economy is on a decidedly expansionary path. Consumer confidence surveys in Japan, the U.S., and elsewhere signal optimism. But for a few exceptions, global purchasing manager surveys are in expansionary territory. Stimulus programs remain in place in the EU, Britain, China, and Japan, while Trump promises fiscal stimulus in the U.S. which would offset the gradual withdrawal of the Fed’s easy money policy.
Inflation expectations, particularly in the U.S., are on the rise. Wages are trending upward, government spending is set to spike, and unemployment is low. Energy prices are being driven up by production cut agreements among both OPEC and non-OPEC member nations. Markets have reacted well to these inflationary pressures thus far, underpinned by the belief that the implications will be benign enough to prevent central banks from becoming overly hawkish toward tightening (U.S.) or tapering existing stimulus (EU). As long as this sentiment prevails and the effect of rising rates and inflationary pressures don’t start to meaningfully cut into GDP growth projections, we expect cyclical sectors such as financials, energy, technology, and consumer discretionary to outperform.
China growth momentum appears to have improved since the second quarter of 2016, abating fears of a Chinese economic “hard landing” that spooked markets early in 2016. That said, emerging markets in general remain on uncertain footing as the potential for domestic growth is offset by a stronger dollar and concerns regarding FDI (foreign direct investment) to support domestic financing needs.
Japan presents an attractive dynamic as higher yields in the U.S. create a flow of funds out of Japan, reducing the value of the yen. And with the prospect of a weaker Chinese yuan to compete with, we believe the yen's strength could diminish even further. The weakened currency provides a tailwind to an already attractive backdrop of Japanese companies having significantly cleaned up their cost structures and moved onto a solid growth trajectory. We have embraced this pro-cyclical opportunity with investments in Mizuho and Toray and will continue to look for new opportunities that meet our valuation criteria. As a side note, Japan also lacks the electoral drama seen in the rest of the developed world.
The Brexit vote in the U.K. and the presidential election in the U.S. were two events that pollsters got wrong, which should serve to dial up global political uncertainty going forward. Populist movements in the EU will also be put to the test in Dutch and French elections in the first half of 2017, followed by German elections in the second half. The future of the EU may hinge on these critical votes.
While in our view the macro backdrop has turned decidedly positive, we will remain mindful that investor sentiment is what moves markets, at least in the short run. We have always kept a watchful eye on the downside and will continue to do so as a balance to the positive macro and pro-cyclical indicators that we are currently observing. To paraphrase a quote from one of our good friends in the industry, we will continue to trade the market we see, not the one we want.
The resilience of markets in the second half of 2016 was largely attributable to expectations of a favorable outcome to the factors discussed above – accelerating GDP growth, a steepening yield curve, a positive move in commodities, and inflation at reasonable levels. These expectations appear to remain in place and bode well for a continued cyclical expansion in 2017. As a final note, it is no secret that the U.S. has been one of the best performing equity markets the last several years, however, history would tell us that a reversion to the mean is inevitable at some point. Just for comparison, the three-year average annual return for the S&P 500 as of December 31, 2016 is 8.9% while for the MSCI EAFE over the same period the average annual return is -1.6%. That is quite a stark difference. While we cannot control markets, we will strive to bring Series shareholders the greatest value for their non-U.S. allocations in 2017.
Benchmark since inception performance is reported from 4/30/1990.
The fund class gross expense ratio is 1.29%. The net expense ratio is 1.18%, which reflects 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 S&P 500® Index is a free-float market capitalization-weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and 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.