Following the collapse of Silicon Valley Bank (SVB) and the subsequent turmoil to Credit Suisse, we have seen firsthand the crowd behaviour that can rapidly unfold with, in the case of SVB, nearly $42 billion withdrawn in merely one day. These two announcements created a ripple effect throughout the banking sector.
While the coordinated actions by central banks in the recent weeks helped restore confidence in the banking system and should prevent further contagion, tighter lending standards have potential impacts on local and regional economies, as well as various aspects of our global market outlook.
Reassessing the Global Outlook
As we settle into the second quarter of 2023, we reassess our projections for the remainder of the year and analyze how these implications will affect our outlook on risks of recession, central banks’ likelihood to pivot away from restrictive monetary policy sooner than expected, and revised corporate earnings expectations.
Despite the instability in the financial sector, the U.S. Federal Reserve and global central banks remain vigilant in their fight against inflation, as evidenced by the European Central Bank’s and Federal Reserve’s further rate increases in March. We believe the Fed will be reluctant to move back on its monetary policy settings by lowering interest rates. However, that does not mean it will not provide liquidity, which we have seen over the last several weeks.
In this tighter economic environment, the likelihood of recession is increasing. Banking stress is unambiguously negative because it creates difficulties in lending to small and midsize companies, which tend to utilize smaller banks. In the current environment, the balance sheets of many regional banks are suffering from the mismatch of assets and liabilities. As long as this mismatch persists, we can expect to see a curtailing of lending and other forms of credit activity.
As a result, we are likely to see a deceleration in economic activity. This slowdown in economic growth will also have downward pressure on corporate earnings. Our base case assumed a deceleration in corporate earnings through the third quarter, and we now expect additional downward pressure. How far it extends toward the end of the year, we believe it is still too early to tell.
We also think it is relevant to highlight China, given its earlier-than-expected reopening during the first quarter. While the reopening brought renewed optimism and the beginning phases of recovery, the pace of growth could be slow in the near term, given the time needed to repair consumer confidence. The government continues to deliver supportive yet measured initiatives on both fiscal and monetary fronts. The government is also keen to support consumption and youth employment.
Recent messaging has also indicated a boost in supportive measures in the private sectors and the platform economy, signalling the regulatory measures are easing and stabilizing, and a continued to push for technology advancement and energy transition. Additionally, the excess savings in China over the last two to three years should support the recovery of consumption, the property market and investment.
While U.S.-China relations and geopolitical risks have not abated and continue to weigh on market valuation, policy support, a stabilizing regulatory environment, and the potential for earnings recovery due to the reopening could be supportive for investors in 2023.
Importantly, from a style standpoint, the current economic backdrop is not necessarily hurtful. While we continue to evaluate where we may have earnings and growth sensitivities, we expect many of our companies to continue to grow and thrive. At the same time, whenever there is earnings risk and vulnerability, with an assumption of a slightly worsening backdrop, it is important to lean into competitive advantage strength and health as tools to navigate the slowing environment.
International Growth Fund
The Pembroke International Growth Fund performed inline with the MSCI ACWI ex-U.S. Small Cap Index during the one-year period ending March 31, 2023. Much of the underperformance for the year was front-loaded primarily in the first half of 2022, amid significant style headwinds driven by the sharp increase in interest rates. During the first quarter of 2023, the Fund outperformed the MSCI ACWI ex-U.S. Small Cap Index, despite continued style headwinds from lower valuation stocks.
From an attribution perspective, an underweight allocation to Energy coupled with negative stock selection within Consumer Discretionary and Financials detracted from performance. Partially offsetting these effects was the benefit of underweighting Real Estate and positive stock selection within Information Technology and Industrials.
During the 12-month period, Industrials exposure increased primarily through the purchases of Polycab India and Bufab. Consumer Staples exposure also increased through the purchases of Royal Unibrew and Sichuan Swellfun. These changes were offset primarily by a reduction to Consumer Discretionary exposure through the liquidations of Samvardhana Motherson and Uno Minda. Information Technology also declined, primarily through the liquidation of Ideagen.
From a geographic perspective, notable adjustments were an increase to Asia ex-Japan, offset by a decrease to the United Kingdom. The portfolio’s weighting in Emerging Markets approximated 26.6% at the end of the period, down from 27.2% on March 31, 2022.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
Within Information Technology, Melexis (“MELE”) helped boost performance. Melexis is a high quality, fabless semiconductor company driven by structural content gains from electrification, premiumization and ADAS (safety) applications. Ninety percent of its revenues come from the auto industry. The company is a long-term compounder with cyclical growth elements, given the nature of the autos cycle. The average new car can have up to 18 chips from Melexis, which has risen over the past five years.
Industrials stock selection was bolstered by Grupo Aeroportuario Del Centro Norte (“OMA”), the high-quality leading airport operator in Mexico. OMA has multiple avenues to enhance profitability relative to peers, including adding non-aeronautical sources of revenue and increasing international traffic through its airports. Investments in solar parks near airports have enabled OMA to reduce energy costs as the business faces inflationary pressures. The share price strengthened after OMA reported solid results for the fourth quarter of 2022, with a beat on revenue and adjusted EBITDA as the company continues to benefit from nearshoring trends and high margins despite inflationary pressures.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
Within Consumer Discretionary, MIPS (“MIPS”) was the largest detractor. MIPS (abbreviation for Multidirectional Impact Protection System) is the market leader in rotational motion protection technology used in helmets to reduce risk of brain injury caused by shearing or stretching of brain tissue during an impact. The company works with helmet companies to improve their products’ safety by inserting the MIPS’ Low Friction Layer during the manufacturing process of new or existing models. Following strong performance in 2021, the share price declined amid the broad market rotation into lower valuation companies.
Within Financials, India-based Aavas Financiers (“AAVAS”) was the largest detractor. Aavas is an affordable housing finance company, which spun out of AU Small Finance Bank. Despite reporting strong earnings results driven by solid loan growth across all segments, the share price declined alongside Indian financial peers due to the headwinds faced in the Financials sector following the demise of the Silicon Valley Bank and others.
Other Articles Of Interest
This report is for the purpose of providing some insight into Pembroke and the Pembroke funds. Past performance is not indicative of future returns. Any securities listed herein, are for informational purposes only and are not intended and should not be construed as investment advice nor is it a recommendation to buy or sell any particular security. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Pembroke seeks to ensure that the content of this document is correct and up to date but does not guarantee that the content is accurate and complete and does not assume any responsibility for this. Pembroke is not responsible for decisions or actions taken or made on the basis of information contained in this document.