Sector Watch: Seeking growth in a tense environment

The feared consequences of trade wars have taken the steam out of international equities markets in 2018 after strong returns in the past few years. Some global investors are moving out of volatile stocks, particularly in emerging markets, and back into the safety of U.S. government debt, which is beginning to look attractive as the 10-year treasury yield hovers near 3%.

At the end of June, several key global stock market indices were showing year-to-date declines, including Japan’s Nikkei 225, down by about 4%; China’s Shanghai composite, down by about 15%; Germany’s DAX, down by about 4%; and the U.K.’s FTSE, down by about 1%.

The S&P 500 composite index in the U.S. was up by about 3%, but mutual funds in Morningstar Canada’s international equity category focus their investments outside North America.

In addition, a world awash in debt is facing rising interest rates, led by the U.S. Federal Reserve Board. Higher interest rates could destabilize some already shaky banks or vulnerable government borrowers, with the potential for a default. A major default could trigger a domino effect, bringing down related financial services institutions and ultimately destabilizing the international banking system with a spreading liquidity crisis.

The U.S. Fed raised short-term benchmark rates twice so far in 2018 and signalled there could be another two hikes this year. Europe and Japan are holding rates steady for now, but rising U.S. rates have put upward pressure on the U.S. dollar (US$) relative to other global currencies, which makes paying down US$-denominated debt more expensive for international borrowers.

Since the global financial crisis of 2008-09, much of the economic growth in key regions such as the U.S., Japan and Europe has been fuelled by low interest rates and quantitative easing, and this monetary stimulus may be drying up.

Jeff Feng, head of emerging markets equities with Invesco Hong Kong Ltd., is lead portfolio manager of Trimark International Companies Fund, which has achieved above-average returns in Morningstar Canada’s international equity category by focusing on high-quality companies with good long-term growth prospects.

Feng is dialing down the Trimark fund’s exposure to trade-sensitive stocks, and the fund’s highest sectoral exposure is in more defensive consumer staples. Holdings in that category include Japan Tobacco Inc. of Tokyo, Anheuser-Busch InBev SA/NV of Belgium, Unilever NV of the Netherlands and Amorepacific Corp., a beauty and cosmetics conglomerate based in South Korea.

“The threat of global trade wars is real,” Feng says. “They can last for some time, and have severe consequences.”

Feng believes Trump is threatened by China’s rising economic power and is trying to hamper its advancement.

“It won’t be easy for China to accept the challenges Trump is putting in front of it,” he says. “And the result is that the trade war could accelerate and put a drag on [economic] growth.”

If the tariffs threatened by Trump are imposed, Feng says, China’s economic growth rate could sink into the 5%-5.5% range, an abrupt drop from the 6% or more the country enjoyed for many years.

In addition, China is facing internal challenges, such as the high level of corporate and regional government debt built up during the past 10 years.

Feng is maintaining exposure to China within the Trimark fund, but, he says, careful stock selection is critical: “Each company’s situation is different, and now is not the time to follow the crowd. We are avoiding companies that carry U.S. dollar-denominated debt and those that would be hurt by tariffs.”

For example, in China, the Trimark fund holds Alibaba Group Holdings Ltd., which dominates e-commerce and is growing at an annual rate of almost 20%. Feng says Alibaba will benefit from synchronistic diversification, such as expanding into offline retailing through ownership of the Hema high-end supermarket chain, a move similar to that of U.S. retail giant Amazon.com Inc., which bought Whole Foods Markets Inc. in the U.S.

Alibaba also owns a large stake in Ant Financial Services Group, which offers customers financial products and services such as payment, microlending and money market funds (including the world’s largest money market fund).

Other China-based holdings in the Trimark fund include Kweichow Moutal Co., the dominant producer of hard liquor in China. Feng says Kweichow is the most profitable liquor company in the world, with an operating profit margin of more than 70%.

With an international equity mandate, the Trimark fund has no exposure to the U.S. The fund’s largest geographical exposures are in the U.K., at 23% of fund assets; Japan, at 16%; and China, at 10%.

A top holding for the Trimark fund in the U.K. is Reckitt Benckiser Group PLC, a retailer of health, hygiene and home products, including non-prescription, over-the-counter medications and such famous items as Dettol antiseptic, Clearasil acne cream and Strepsils throat lozenges. This holding also falls into the consumer staples theme.

Peter Lampert, portfolio manager, emerging markets, international equities, with Calgary-based Mawer Investment Management Ltd., says the high valuations of many global stock markets means finding companies trading at a discount to intrinsic value is more difficult.

“We must work harder and turn over more stones as we look for places to allocate capital,” says Lampert, portfolio co-manager of Mawer International Equity Fund along with David Ragan, director, international equities, at Mawer.

“High valuations are a challenge globally,” Lampert says. “But you can’t accurately time when market corrections might occur, and there is a big cost to being out of the market. We look for quality companies with excellent management teams and attractive valuations that can prosper over the long term.”

Lampert continues to find promising companies in which to invest, but says 6%-7% average annual returns are a more “realistic” expectation for the Mawer fund than the 8%-10% achieved during the past few years.

“Investors must have reasonable expectations, and also be prepared to ride out volatility and not get scared away if there’s a drop in stock prices,” Lampert says.

The Mawer fund’s portfolio managers are finding some opportunities in companies that can take advantage of the growing e-commerce trend while avoiding companies that may be hurt by disruptors. The Mawer fund’s investments include Tencent Holdings Ltd., which often is regarded as the Facebook Inc. of China and has interests in various Internet value-added businesses, including mobile payment, social media, entertainment and artificial intelligence.

Another holding is JD.com Inc., the second-largest online retailer in China. Lampert calls JD.com an “enabler” that is helping new brands reach consumers via the Internet. This company also possesses the largest drone delivery system in the world.

“New brands can get credibility and market acceptance without having to gain actual shelf space in traditional retail outlets,” Lampert says. “In the past, you had a handful of consumer goods companies with big name brands and big advertising budgets. Today, there are a lot of low-budget marketing campaigns online, and some are going viral. People are being influenced by what’s being said online.”

Based on these trends, the Mawer fund has sold positions in famous brand-oriented companies such as Unilever and Nestlé SA within the past year. Instead, Lampert and Ragan are focusing on holdings such as Auto Trader Group PLC, the top website for automobile classified ads in the U.K., and Rightmove PLC, which has the top website for real estate listings in the U.K.

“These businesses have attracted the majority of both buyers and sellers to their platforms,” Lampert says. “And that has created a virtuous cycle that reinforces itself and makes it difficult for new competitors to break in.”

The Mawer fund’s largest sectoral weighting is financials, but, Lampert says, these holdings aren’t typical insurers or banks. Instead, the fund has a large position in Aon PLC, a global professional services firm that earns fees for matching corporations around the world with providers of retirement, health and insurance benefits for their employees.

Also in the financial arena, the Mawer fund holds positions in stock exchanges, including Japan’s Tokyo Stock Exchange Inc. and Germany’s Deutsche Börse AG. Like some of the fund’s other holdings, these exchanges tie into the theme of bringing together buyers and sellers in a centralized, electronic marketplace.