Market Commentary as of 3/31/08
Our New Road Map
In last quarter's commentary we noted that, "Historically, wherever the traditional fourth quarter rally did not happen, the subsequent 12 months have averaged flat to down. Therefore, this is our new road map." In fact, international equity markets turned out to be even more negative than we expected, with the first few weeks of January recording one of the worst starts to any year on record. As the quarter progressed, the credit crisis deepened and the contagion spread to previously immune Asian and commodity-related stocks, hurting the portfolio’s performance.
All regions and sectors fell during the quarter. The best relative performing regions were Europe Ex-UK and Japan, and the worst performing were Pacific Ex-Japan and Emerging Markets. On a sector basis, Materials and Consumer Staples held up well, with Technology and Telecomm suffering the most. The Fund benefited from an overweight position in Materials, with leading Norwegian fertilizer company Yara International, Swiss chemical company Lonza Group, and Mitsubishi of Japan all outperforming the MSCI EAFE Index. Still, we think their expected growth and valuations remain attractive, so in sticking with our process we are letting these winners run.
Overall, performance was also hurt on a relative and absolute basis by the Fund's stake in small-cap stocks. Our research and portfolio is "all-capitalization," but we were too slow in moving the portfolio up the capitalization curve. Several of the smaller companies that the Fund owned fell by more than 20%, the worst being Peace Mark and China Hongxing in the Pacific ex Japan region, and two Mediterranean banks—Bank of Cyprus and Piraeus Bank in Greece. We sold them all as part of our ongoing process of weeding out the losers from the portfolio, and are currently reviewing the rest of our smaller company holdings.
Three Ways to Make Money
Adhering to our disciplined process is a key component of the Fund's strategy. Selling positions that do not pan out as expected forced us to sell most of our Western bank holdings before the credit crisis hit in July 2007. Interestingly, most of the sales thus far in 2008 have been in small- to mid-cap stocks. In their place, the Fund has purchased a number of Western large-growth stocks with an Emerging Markets or agricultural driver such as global food producer Unilever, wireless firm Vodafone, and global agrichemical company Syngenta. All of which is in keeping with our preference for seeking growth businesses where traditional growth managers don't typically look.
We believe there are three major ways to make money in financial markets—the carry trade (investing at a higher rate than you borrow), mean reversion investing (as practiced by most value strategies), and momentum (most growth strategies). Each has proven capable of making money over time, but as seen recently each can get into trouble if investors become too reliant on faith over analysis. That said, we believe the current momentum trend of commodities over financials is also a long-term mean reversion trade that is justified by the fundamentals of superior growth, healthy balance sheets and positive cash flow. That and the other long-term mean reversion trade of the East versus West, which is equally justified by the fundamentals, has us looking to add to the Fund's current positions once the current negative momentum and sentiment subsides.
A Bull and a Bear Market? Inflation and Deflation?
The twin shocks of the credit crisis and the commodity crisis dominate the global outlook. We believe the credit crisis will lead to more asset price DEFLATION, but the commodity crisis will lead to more INFLATION in terms of the cost of living. The irony is that the more the policy makers cut interest rates and increase government assistance to ease the credit crisis deflation, the more fuel they throw onto the inflationary fire of the commodity crisis.
To paraphrase Richard Russell of Dow Theory fame, "bull market corrections are savage and meant to scare you, bear markets are drawn out and meant to give you hope." By this measure, commodity-related stocks, which comprise about 20% of the world's market capitalization, remain in a bull market while most other stocks are now in a bear market. We are clearly in a bull market for simplicity and volatility, but in a bear market for complexity and the use of leverage.
Fractional reserve banking is always a house of cards built on faith. Markets lost faith during the 1970s when the switch from gold to US Treasuries debased collateral, and they are losing faith now that sub-prime has further debased the collateral. Thus, we are more confident in our ability to deliver positive relative returns than absolute returns. Your portfolio remains well positioned if these powerful and fundamentally justified global trends continue. As before, the main absolute risk to your portfolio is a global recession, while the main relative risk is a turnaround in "value traps" with broken business models like the major Western Banks that the Fund continues to not own.
Baring Asset Management
London, England
Note: Risks of investing in international markets include but are not limited to social and political instability, market illiquidity and currency volatility.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed.
As the fund is actively managed, the securities as presented do not represent the current or future composition of the portfolio.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.