Virtus International Series
2Q 2016 COMMENTARY
Equity investors worldwide suffered losses in the second quarter of 2016 as the U.K.’s “Brexit” vote compounded global growth worries that were already heightened. Prior to the June 23 vote, a lack of conviction over market strength had been expressed with a see-saw pattern of stock market returns as the prospects for additional profit growth faded, and attempts to jump-start economic growth through unprecedented monetary policies struggled. In the United States, the S&P 500® Index has failed to make a new high since last summer and has suffered two declines of approximately 10% while the MCSI EAFE® Index, expressed in local currency terms, has not reached a new high since last spring and has endured larger drawdowns.
This tug of war between growth rate and valuation was evident throughout the quarter as equities initially rallied in response to the release of better-than-expected Chinese GDP numbers. Optimism soon faded, however, as apprehension over global growth prospects returned and markets sold off in June. Perhaps ironically, China, which had given the markets a lift in April, contributed to angst among market participants when it began issuing verbal warnings to commentators in the country who expressed negative views on economic growth. Couple this with the uncertainty over European economic and political direction, a downbeat assessment by the OECD, and a poor May U.S. jobs report, and it is no wonder that equity markets swiftly and dramatically reversed course.
The MSCI EAFE Index ended the quarter with a loss of 1.46% while the Series outperformed the benchmark with a positive return of 0.33% (Class A NAV). The majority of the Series’ outperformance was the result of stock selection in materials, telecommunications, and consumer staples. Worth noting is that within materials, the portfolio benefited from strong performance from our two gold mining positions. Stock selection in healthcare, energy, and financials detracted from relative and absolute performance. On a sector basis overall, asset allocation was a minor contributing factor.
We remained cautious even as the quarter opened strongly. As noted in previous commentaries, we have taken a more defensive stance in response to global political developments, the failure of quantitative easing to provide economic growth, and equity market valuations. We did, however, selectively find opportunities in Checkpoint Software, Unibail-Rodamco, and Technip, while also taking advantage of market dislocations to reduce our underweight in financials with the purchase of AIG and Aviva. We also added to our existing holdings in British American Tobacco, Heineken, Randgold, Sony, and Statoil. We eliminated Intesa SanPaulo, Nitto Denko, Cameco, and Valeant, and reduced our positions in Bridgestone, Fuji Heavy, and Marine Harvest. From a sector perspective, this activity resulted in narrowing our large underweight to financials and increasing our overweight to information technology. The portfolio remains overweight in telecommunications while maintaining an underweight to industrials. The cash position of 8.9% remains at the high end of our historical average.
Regionally, we continued to reduce our Japan exposure and are now market weight after having a large overweight for the past two years. The overweight was a significant driver of both absolute as well as relative returns over this period and we have elected to harvest those gains and redeploy the assets elsewhere. The portfolio is now slightly overweight to the UK with the purchase of Aviva and the increased exposure to British American Tobacco. While it may seem counterintuitive to have added to the UK in front of the Brexit vote, our holdings are primarily global companies with strong market positions not tied to the domestic UK market.
Reflective of our top-down views, coupled with a lack of compelling investment opportunities, we remain significantly underweight to Europe and do not have any direct exposure to the European banks. This proved to be beneficial as the group experienced a severe sell-off following the UK vote to leave the EU. The portfolio’s continued underweight to the Asia ex-Japan region is the result of a zero weighting to Australia, although that country is showing some recent strength on the back of higher material prices. Price appreciation in two of our gold mining companies has served to increase our overweight to Canada, and we continue to be constructive on Internet companies Ctrip and Tencent as a consumer focus takes hold in China.
THE MARKET AHEAD
Over the past year, we have witnessed a rise in global populism punctuated by the UK Brexit vote. In the U.S., the rise of Donald Trump and Bernie Sanders can both be explained through the same lens of dissatisfaction with the establishment. In Italy, the mayors of Rome and Turin lost power to populist candidates, and Hungarians will determine whether to break with the EU’s migrant policy this fall after erecting walls to stem the flow of people coming over its borders. Why the angst? After decades of globalization, there is little doubt that uncertain economic times and mass migration from multiple wars have left large portions of the world's population feeling disenfranchised. In a climate that has seen global trade drop below global GDP for the first time in 20 years, the prospect of more nationalistic policies is increasingly becoming a reality, and a logical reaction for many who feel their interests are not being represented by their governments.
In the financial markets, anxiety over global growth prospects is most pronounced in the bond markets. Ten-year government bond yields marched lower during the quarter and touched negative territory in Germany for the first time in history and moved further below zero after the Brexit vote. As of this writing, the entire Swiss yield curve is negative and the U.S. yield curve has flattened to levels not seen in years. It is hard to say if the European experiment with negative interest rates has failed or if these low rates are a result of failed policies; regardless, inflation expectations continue to decline and growth is slow. Compressed net interest margins have been cutting into bank profitability and capital formation while a recent survey of over 9,400 companies by Swedish firm Intrum Justitia AB found that 84% of respondents’ willingness to invest hasn’t increased despite low interest rates.
With regard to the Brexit vote, despite the best prognostications from both pollsters and bookies, the “Leaves” of the UK were victorious in extricating themselves from the EU. In our opinion, the EU experiment may be on its way to dissolving. The UK is an hors d’oeuvre to the relentless stream of global elections over the next 12 to 24 months. Each will be an opportunity for the proletariat to signal its displeasure with the global elite over globalization, technology disruption, and migrant flows. The result will be unending political uncertainty which could serve to depress equity valuations, bond yields, and inflation expectations, with occasional policy-based eruptions in stock prices. Because of these concerns, we think the one currency in the world not influenced by “beggar-thy-neighbor” central bank policies is gold. No country wants a strong currency in this slow-growth, sub-3% global GDP growth environment. If the U.S. dollar declines, U.S. manufacturers, emerging markets, and commodity producers are happy, but the Japanese and Europeans are not. If the dollar rallies, it represents global monetary tightening on $250 trillion of net global debt, strangling EM sovereigns who can least afford it, handicapping U.S. manufacturers and raising the cost to global commodity consumers. Defensive equity investing is something we have historically provided, and this past quarter was a nice proof point. As global markets sold off, we had strong absolute and relative performance. Our current positioning includes a bit more cash than normal, two gold mining names, and a large underweight to European financials. These more top-down exposures surround a high quality, cash-generative portfolio which is well positioned for the current global backdrop of slowing growth, low rates, and increased policy and political uncertainty.
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.