Investment Newsletter | 2Q 2016
The second quarter of 2016 was dominated by the buildup and final tally of the referendum vote heard across the world—Brexit. On June 23rd, the United Kingdom surprised many by voting to leave the European Union, with the ‘Leave’ camp securing 51.9% of the vote versus 48.1% for ‘Remain’. The British pound and world equities fell in reaction, while government bonds rallied along with other safe haven assets such as gold, the US dollar and the Japanese yen. David Cameron resigned as UK Prime Minister and will be replaced by Theresa May. Although it is too early to appreciate what the full impact of Britain leaving the EU will be, economic conditions in the UK and around the globe may be challenged and unsettled, at least in the short term.
The decline in global equity markets following the referendum result was immediate and widespread. The MSCI World Index (C$) shed 4.6% in the two days following the referendum, but was followed by a recovery of 4.2% to quarter end. Once the dust settled, the MSCI World Index (C$) returned 1.4% during the quarter.
In Canada, 2Q echoed 1Q themes: gold and energy prices rallied, which drove equities up significantly in both the Materials and Energy sectors. While global equities did not perform as well, Canadian equities have been in favour so far this year, posting year to date performance of 9.84%. Double-digit year-over-year appreciation in housing prices was the headline story in Toronto and Vancouver as buyers scrambled to keep up with the market. At the same time, there are regional disparities across the Canadian real estate market, with home prices in Alberta and Newfoundland lagging in comparison.
While US economic strength remained positive, the May jobs report reflected a big miss with the creation of only 38,000 new jobs, well below expectations. Hillary Clinton and Donald Trump emerged as the Presidential candidates for their respective parties. Trump’s rise, in particular, is noteworthy for the undercurrent of nativism and xenophobia that the New York billionaire appears to have tapped into.
India’s central bank governor, Raghuram Rajan, surprised markets with the announcement he would step down after a single three-year term. Rajan is held in high esteem by foreign investors, particularly for overhauling operations at the Reserve Bank of India and for his efforts to keep inflation contained. However, it appears that Rajan was under pressure from members of Prime Minister Modi’s BJP party. We view his September 4th departure as yet another example of Indian politics getting in the way of Indian progress.
Central banks in Japan and Europe continued to struggle with lackluster economic growth and weak inflation. In Japan, an ascending yen has challenged the central bank strategy and Japanese Prime Minister, Shinzo Abe, has delayed a scheduled rise in Japan’s sales tax—an indicator that Abenomics might not be working as planned. In Europe, the ECB expanded its bond-buying program to now include corporate issues, driving regional bond yields even lower. The moves were taken against a backdrop of already very low, and often negative, sovereign bond yields. In both geographies there are decent odds that the central banks will be compelled to act further with their monetary efforts, however, these kinds of policies may have reached the end of their effectiveness.
Economic data from China continued to paint a picture of slower growth. In an effort to restructure the economy and reduce industrial overcapacity in sectors such as steel, coal and cement, the Chinese government has pushed more “zombie” companies—businesses that continue to operate even though they are insolvent or near bankruptcy—to declare bankruptcy. The efforts seem productive and necessary, given the extent of China’s industrial overcapacity and bad debts, although the magnitude of the clean-up still required appears significant. China’s financial situation remains a key macroeconomic consideration, even if news out of China has been largely overshadowed by Brexit this quarter.
How Did We Do?
(All performance is expressed in Canadian dollars and net of fees.)
Despite the loud rumblings of Brexit, returns for the quarter were steady. Across the Mawer Funds, 2Q16 returns were positive for all funds with the exception of the Global Small Cap Fund. As well, the Global Bond Fund reached its one year anniversary during the quarter so we have included commentary for this asset class.
Chart A: Q2 2016 Fund Performance relative to Index (C$)
Chart A highlights the quarterly performance (net of fees) of the Mawer Funds relative to their benchmarks.
The Mawer Balanced Fund gained 1.7% compared to a 3.3% gain for the benchmark. The difference is primarily attributable to lower relative returns in Canadian equities given underweights in strongly performing Energy and Gold segments of the market. Relative underperformance was also due to allocations to Global Small Cap equities and Global Bonds where currency weights played a differentiating role. These impacts were offset by strong returns in International equities. Positive currency impacts were most pronounced for Brazilian and Japanese holdings.
The Mawer International Equity Fund rose 1.3%, beating the 1.1% decline of the MSCI EAFE Index (net) benchmark. Stock selection, particularly in Financials, was the primary factor leading to relative outperformance. Investments in both Consumer Discretionary and Consumer Staples were major contributors to performance. Diversified global consumer goods maker LG Household & Healthcare was the leading contributor, up 47.2%. Two Japanese names ranked in the top five contributors thanks to solid returns and positive currency impact. Global industrial paint manufacturer Kansai Paint gained 25.0%, while drugstore operator Tsuruha Holdings gained 23.6%.
The Mawer U.S. Equity Fund gained 2.6%, slightly lower than the 2.9% return of the S&P 500 Index. The Fund’s performance was driven by stock selection, particularly in Healthcare and Financials. Healthcare companies in the portfolio rose 11.8% vs. 6.6% for securities in the index; for Financials, Mawer’s selections returned 4.6% vs. 2.5% for index holdings. This positive security selection was offset by sector positioning which detracted from overall returns (most notably due to our underweight position in Energy). The top contributor to quarterly performance was healthcare essentials provider Becton Dickinson, up 12.6%. Next highest contributor was global insurance brokerage and risk management consulting company Marsh & McLennan, up 13.7%.
The Mawer Global Equity Fund gained 1.2% in the second quarter, below the benchmark MSCI World Index (net) return of 1.4%. While the Fund has a material weight in UK-listed stocks, the experience for the quarter was performance neutral. For UK holdings, stock returns in local terms (+4.7%) were sufficient to offset the depreciation of the pound (-4.4% vs CAD). The Fund was positioned to add to UK-listed holdings immediately after the Brexit referendum but many of the companies rebounded rapidly on low volume. As a result, we only added modestly to select names. We attribute this to the quality of these companies and investors’ preference for these business models in the aftermath of the vote. Becton Dickinson was the top contributor to performance, with LG Household & Healthcare the second highest contributor.
The Mawer Global Small Cap Fund fell 0.5% in the quarter, below the 2.1% gain of the Russell Global Small Cap Index. The relative underperformance can be attributed to overall stock selection effects, within which country selection played a significant role. Irish agri-services company Origin Enterprises was one of the main detractors in the quarter as negative price performance combined with Canadian dollar strength versus the euro. Swedish cash handling company Loomis also detracted, down 7.3% in local currency and 11.0% in Canadian dollars. The Fund posted local market returns of approximately 2.9% but most of that was given up by appreciation of the Canadian dollar against the euro, European (Sweden, Switzerland) currencies and the British pound. For UK-listed names, the Fund experienced the same performance as the Mawer Global Equity Fund (flat CAD performance composed of local stock price increases offset by the rise in the CAD vs. GBP). Financial Services and Consumer Discretionary sectors were the Fund’s top contributing sectors respectively. Within individual names, alternative payments provider PayPoint plc gained 18.9% followed by Swiss asset management company VZ Holdings, up 14.4%.
The Mawer Canadian Equity Fund posted a 0.2% return for the quarter, well behind the S&P/TSX Composite Index return of 5.1%. The underperformance can be attributed to overall stock selection and sector allocation effects within Energy and Materials. The Fund’s Energy weight is 10.8%, well below the index weight of 19.6%. Given the strong rally in Energy companies this quarter, our portfolio lagged the index. This was even more apparent in the Materials sector, where a surge in gold prices led this sector to rally 26.9%. The Mawer Canadian Equity Fund presently has no exposure to gold or precious metals companies, and our return for Materials sector stocks was -7.5%. Infrastructure/heavy equipment provider Toromont Industries was the top contributor to performance, up 10.2%. Number two contributor was real estate developer First Capital Reality, up 8.5%.
While Brexit was top-of-mind for most investors this quarter, its impact on stocks within the Canadian Small Cap universe was fairly muted. The BMO Small Cap Index was up 14.7% this quarter as resource stocks, especially energy and gold producers, built on their strength from the first quarter. Gold equities in particular fared well, as fears of political and economic instability after the British referendum caused the price of gold to end the quarter at a high. Our portfolio, underweight in energy and bereft of gold holdings, rose a respectable 5.8% but trailed our index by a sizeable margin. The top holding in the Fund was also the top contributor to performance this quarter, as bus manufacturer New Flyer Industries posted a 21.2% return. Second top contributor was Canadian Energy Services, up 27.9%.
The Mawer Canadian Bond Fund rose 2.4%, slightly underperforming the 2.6% gain of the FTSE TMX Canada Universe Bond Index. Bonds continued to provide a cushioning effect that helped offset the volatility within equity markets. Performance was led by long-term federal and provincial issues in the quarter while high-quality corporate issues and patience in seeing some opportunistic trading results continued to be positive contributors. Government issues make up 63.0% of the portfolio with Corporates at 36.2% (balance is cash), the index is at 72.7% and 27.3% respectively. All holdings are investment grade, with 41.5% AAA-rated vs. 40.5% for the index. For the quarter, all sector returns were positive led by Provincial bonds on the government side and Infrastructure bonds on the corporate side.
The Mawer Global Bond Fund now has a one year track record. The Fund’s primary purpose is to add to diversification and act as a shock absorber to equities within a balanced portfolio. It invests in investment grade government bonds with a current allocation to AAA-rated bonds of 68.1%. For the quarter, the Fund moved up 0.5%, short of the benchmark Citi World Government Bond Index return of 3.8%. This is primarily due to a zero weight in Japanese government bonds relative to the index weight of 24.6% as investors favoured Japanese bonds as a safe haven asset class (+13.4%). We have deliberately positioned the Fund to have minimal exposure to Japan given the current negative yield environment and its challenging economic and fiscal conditions. As a result, we are overweight securities in countries such as Canada, United States, Norway and Sweden. We think over a longer timeframe that this positioning will yield positive results and aid in overall portfolio diversification. Over one year, the Fund returned 6.8% vs. 15.7% for the index, again primarily due to the large underweight to Japanese bonds. We emphasize that we do not view an index weight to Japan as a prudent diversification strategy. The construction of the index actually favours a large weight to Japan due to the amount of Japanese sovereign bonds outstanding, regardless of all factors that contribute to the credit rating of Japan.
While it is too soon to know the full consequences of Brexit, the net effect is unlikely to be positive for world markets. An immediate reaction has already been seen in global asset prices and the IMF, OECD, Bank of England and the UK Treasury have all warned that the UK may face challenges in the near-term.
Domestically, the UK economy may experience strain. Although there may be some companies that benefit from the fall in the pound, the impacts on trade and business activity from the uncertainty may easily outstrip these gains. Delayed investment or the outright firing of workers may slow down the British economy. Meanwhile, the fall in the pound may stoke inflation—with the potential net result of stagflation, the combination of low economic growth and inflation. If this occurs, it would put the Bank of England in a difficult position. Lowering interest rates would help stimulate economic growth but likely put downward pressure on the currency and worsen inflation; but not lowering interest rates could exacerbate any economic slowdowns that occur.
However, with the UK only representing around 2% of global GDP, the bigger question is why Brexit matters globally. The answer is twofold. First, Brexit may increase the fragility of the financial system by serving as the catalyst for actions that could impact world markets (e.g. central banks may expand stimulus programs). Second, it could stoke undesirable trends like nativism or anti-immigration rhetoric.
Globally, we expect some fallout outside the UK. We have already seen currency markets react to the event: the Swiss National Bank has intervened in markets to prevent a steep rise in the Swiss franc. More ripples of this nature could unfold in the weeks to come. In particular, Brexit increases the likelihood that the BOJ and the ECB engage in yet another round of stimulus. The event seems to have increased the likelihood of lower interest rates for longer, globally.
In events like this, it can be tempting to temporarily re-position your portfolio in anticipation of a particular outcome. However, we do not believe this is a repeatable way to build wealth over time. As much as markets seemed to anticipate a win for “remain” in the week before the referendum, the odds were very close leading up to the vote. Betting wholesale in one direction or the other would have been a risky move. Markets were likely to experience a significant reaction no matter the outcome. To bet in either direction would have been risking a serious impairment of capital.
We went into the event maintaining a broadly diversified portfolio and knowing full well that, regardless of what unfolded, we would have some investments declining in value and others rising. This is not to say that we ignored the issue; in the months leading up to the vote, we trimmed some of our exposure to our UK investments. But the notion of making widespread dramatic changes to our portfolios was not on our radar.
We believe that it is important to maintain a long-term perspective. While Brexit shifted some of the investment landscape, many things do not change with the referendum result. While the macro environment in Europe is in flux, there remain opportunities on the micro side. Britain leaving the EU does not change the fact that there are good businesses in the UK—and elsewhere—that make for attractive long-term investments. Many of the businesses in the UK are global leaders that earn an attractive return on their capital, and even if there may be some short-term pain in holding them, we believe these companies will continue to reward investors.
No matter what “Brexits” may unfold in the future, our underlying philosophy and approach remain the same: buy wealth-creating companies, run by good people, at attractive valuations, and construct diversified, resilient portfolios that can ride out the inevitable storms that will pass through.
Mawer Investment Management Ltd.
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