Market Commentary as of 9/30/08
A Terrible Quarter for Equities
The third quarter of 2008 was a difficult period for all equity markets. International equities that comprise the MSCI EAFE Index declined 20.5%, Pacific ex-Japan equities dropped 25%, and Emerging Market equities lost the most at 27%. The impact of the global financial crisis is likely to remain severe. The process of de-leveraging has been painful, and it is not yet complete. We expect global growth rates to drop, and analyst expectations are still adjusting lower. We are seeing slower global economic growth, a probable Western recession, and forced de-leveraging across many sectors.
In addition to sharp absolute losses, the Fund's relative performance also suffered. With the notable exception of consumer staples company Uni-Charm, stock selection in Japan was poor during the quarter. Japanese trading companies such as Mitsui and Komatsu were weak on the back of softening commodity prices, while technology company Toshiba disappointed.
Investments in the Energy and Materials sectors also hurt performance during the period after having been standouts during the second quarter. Falling commodity prices hit both areas hard, with soft commodity names and emerging markets energy stocks particularly weak. An allocation to emerging countries in general did not perform well either, as risk aversion caused investors to exit the asset class, making it the worst performing region.
One bright spot was the Fund's focus on secular growth stocks. As mentioned last quarter, in a weak global growth environment, secular growth stocks—or stocks whose growth is less tied to the economy—have historically performed relatively well. We have been finding these growth stocks in a number of sectors, including Healthcare, Consumer Staples, and Telecommunications. An overweight allocation to Consumer Staples aided performance as investors sought the attractive defensive characteristics of the sector.
In addition, stock selection in the UK and a fair amount of cash limited some of the damage of the drastic downturn at quarter-end. A premium buyout bid for platinum producer Lonmin, which was sold for a nice profit, helped as did good results from UK car insurer Admiral Group. Although the Fund did not purposefully raise cash going into the quarter, any cash held during a time of market turbulence contributes positively to performance, and a roughly 5.5% stake as of the end of August 2008 did help.
Current Positioning
The Fund is maintaining a defensive stance, as we have become less positive on economically sensitive areas of the market. In terms of our top-down views, the biggest change was the downgrade our Materials sector view to neutral, which also saw the sale of steel producer Arcelor-Mittal and bulk miner Xstrata. The portfolio now has a zero weight in both base and industrial commodity stocks, though we have retained holdings in gold and soft commodity stocks. Conversely, we have added selectively to the Energy sector, where valuations look attractive, taking advantage of the drop in energy stocks to add producer BG Group.
The Western consumer remains challenged and we continue to underweight the Consumer Discretionary sector, though we are more positive on Asian consumer stocks. We think domestically focused companies in Asia, in particular, will hold up relatively well. Problems in the Financial sector greatly exceeded even our pessimistic expectations, and despite the numerous bailout plans coming forth, we continue to avoid the Western banking sector.
Uncharted Territory
Recent market events have been profound in both the seriousness and the speed at which they occurred. We have witnessed a dramatic but necessary de-leveraging by financial institutions and investors from a starting point of unprecedented indebtedness in the global economy. To mitigate the pain of de-leveraging we have seen interventions in the economy and in the markets by central authorities that are almost unprecedented in scale. It is possible that central interventions in the market will help buy time for financial companies to de-lever in a more orderly way than has happened in recent months. We do not believe, however, that we have seen the peak in non-performing assets for the Western banking sector. Commercial construction loans, consumer credit and corporate credit have not yet featured heavily in banks' earnings reports. Deleveraging, consolidation and restructuring of the Western financial sector will take years. Serious stresses remain in the market and in the economy, and markets will likely remain volatile until they ease. Still, de-leveraging has resulted in attractively priced stocks in a number of other areas (such as Energy) and we have been selectively buying as a result.
In our last commentary, we addressed the debate among market participants as to whether the world is falling into inflation or deflation. Collapsing Western asset markets, centered on the housing market and compounded by de-leveraging, represent a deflationary force, while government interventions will almost assuredly be inflationary. As a result, the portfolio remains overweight Consumer Staples, Health Care and Telecommunications where even in a deflationary environment companies should be able to deliver modest earnings growth with high visibility. On the other side, the beneficiaries of inflationary policies include energy stocks, gold mining stocks and soft commodity stocks. Thus, we continue to focus on the growth areas of the market where pricing power exists to combat inflationary pressures with overweights in Energy, selected Materials, and secular growth stocks. Although these are difficult times for global markets, we feel the structure of the portfolio remains appropriate. While we remain cautious of economically sensitive areas, we believe that many commodities still have a way to run.
Baring Asset Management
London, UK
As of September 30, 2008, Uni-Charm comprised 2.09% of the portfolio's assets, Mitsui - 1.27%, Komatsu – 0.00%, Toshiba – 0.00%, Admiral Group – 2.14%, and BG Group - 1.57%.
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. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
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.