International Equity Strategies

2022 proved to be a challenging year filled with change and disruption. We saw historically low interest rates increase to ten-year highs at unprecedented speed. This was coupled with a pronounced style rotation towards value, following a decade-long growth rally whose winners were highly concentrated in few sectors, namely technology.

Geopolitical risks were arguably the most unanticipated in 2022, with the Russian invasion of Ukraine spiralling Europe nearly into an energy crisis and soaring inflationary pressures. China cannot be forgotten, beginning the year with strong commitments to its zero-COVID policy and ending it with a swift and broad reopening of its economy.

United States

One key variable we are watching for 2023 is inflation. We expect year-over-year inflation in the U.S. to slow to around 3% by mid-2023, with continued volatility, but a deflationary direction of travel in the month-over-month data. As we start the year, all four key components of inflation (i.e. housing, goods, energy and service wages) are decelerating. Goods consumption in the U.S. has now decelerated to below the pre-COVID trend.

We expect the Federal Reserve to pause its monetary policy tightening in the first quarter and for the policy rate to plateau around 5% for the remainder of the year. While we continue to see a narrow path for the U.S. economy to avoid recession, the likelihood of recession is increasing. We forecast growth in the U.S. is likely to trough below 1% in the coming months.

Europe

Within Europe, we believe monetary policy is not far behind the U.S. in reaching its “neutral” monetary policy stance. However, a shallow recession in Europe is likely unavoidable given the declines in consumption on higher housing costs and the energy shock from the loss of Russian gas, which led in 2022 to natural gas spot prices spiking to nearly seven times the levels of the previous year.

European natural gas prices have fallen meaningfully from peak levels, but will remain above pre-conflict levels for the foreseeable future. The mild winter, coupled with rapid investment in alternative energy sources, including liquid natural gas, has thus far mitigated concerns of energy rationing.

China

The primary risk to our forecast is the reopening of China’s economy. China’s population is likely to have the ability to travel for the first time in approximately three years, which could be inflationary in Southeast Asia, Japan, Korea, Europe and North America. This, coupled with reduced yield differentials, will likely reduce the meaningful U.S. dollar strength we saw in 2022.

We expect China’s reopening to buoy demand for goods and services outside of China and, therefore, increase inflation volatility. While the overall trajectory is still one of slowing inflation, this increased volatility may complicate the Central Banks’ objectives and could increase the risk of further monetary tightening and, with it, put further pressure on equity multiplies.

Global Outlook

Our outlook for the coming year is focused on the transformation into what we believe will be a changing investment era that could lead to a broadening of investment opportunities for us, as growth investors. Beyond the near term, the next several years are shaping up to look similar to the last “normal” expansion we experienced in 2003–2007, during which inflation was approximately 3%, and the policy rate capped at 5.25%.

Looking forward to 2023, we expect to continue to be in an era of higher normalized inflation and lower economic growth. We also anticipate corporate earnings growth to continue to slow into the first quarter. Importantly, we believe market returns will be driven by earnings growth rather than multiple expansion.

Overall, we look towards a broadening of growth, as we believe the opportunity set may be changing from what we have experienced in the last ten years. While the core of our investment opportunities continues to be great innovators, and long-term value creators, we look to diversify our attractive growth opportunity set with, for example:

• lower growth value creators, where total shareholder return will be an important factor rather than maximizing exposure to absolute growth;
• sustained growers, with lower duration, consisting of mature rather than emergent companies;
• as well as beneficiaries of a changing environment and higher inflation, such as financials and tangible assets.

With earnings growth expected to bottom in the mid-single digits, and greater stability in monetary policy and interest rates, we believe corporate earnings and company fundamentals will drive market performance rather than multiple expansion or contraction. This will create an environment we believe we are well positioned for as quality growth investors.

International Growth Fund

The Pembroke International Growth Fund underperformed the MSCI ACWI ex-U.S. Small Cap Index during the past year. Underperformance has been primarily due to the continued rotation in the market towards low valuation, low quality, and low growth companies, which has been amplified in the non-U.S. small cap space in the first half of 2022.

Additionally, the underperformance has been highly correlated to the inflationary pressures and increase in interest rates, which has led to significant multiple contraction for growth companies in particular.

Two stocks that made positive contributions to returns of the Fund over the past 12 months

Industrials stock selection was positive bolstered by Rotork (“ROR LN”), a market-leading global provider of mission-critical components. Rotork specializes in producing actuators and related flow control equipment for every part of the oil and gas industry, including production, processing, distribution and storage. A combination of changing end-market exposure, along with broad-reaching improvement initiatives undertaken by the new management team, should drive an acceleration of revenue growth and increase margins to levels exceeding those achieved historically. The share price strengthened following a positive trading update in which management anticipated entering 2023 with a record order book that will likely be significantly higher than at the start of 2022.

Information Technology was also positive driven by SHIFT (“3697 JP”), the rapidly growing Japanese leader in outsourced software testing services. SHIFT is a beneficiary of Japanese enterprise digitalization, which is currently in its early innings, via its outsourced software testing business. The company offers services that are cheaper than legacy system integrators, and is able to quickly capture market share on account of scale and better economics, leading to ultimate high profitability levels. Hiring plans for the company exceeded expectations this year, and management plans to ramp up that pace into 2025. We view this as a positive given that the firm’s pace of hiring is key to sustaining higher topline growth for longer.

Two stocks that made negative contributions to returns of the Fund over the past 12 months

Offsetting performance was weaker stock selection within Financials and Consumer Staples. Within Financials, Aavas Financiers (“AAVAS IN”) detracted from performance. Aavas is an affordable housing finance company based in India with a unique combination of cyclical and structural growth drivers. The company has an exceptional asset quality track record in small ticket segment and balance sheet strength relative to peers and global lenders. Despite a strong earnings growth outlook, the share price weakened amid concerns around growth moderation, net interest margin pressure and rising operating expenses.

Within Consumer Staples, South African holding Clicks Group (“CLS SJ”) underperformed. Clicks is a drugstore retailer with a leading market position, a high returns business model, and a management team with a long track record of valuation creation. Clicks’ compelling consumer value proposition is based on everyday competitive pricing, a differentiated product offer, and a highly accessible store network. We expect high-single-digit annual topline growth driven by unit expansion and market share gains. Due to its defensive product mix, Clicks should hold up well, despite a challenging near-term consumer backdrop in South Africa.

 

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