Financial markets remained turbulent through the second quarter of 2022. Looking to the balance of the year, we expect a number of the macroeconomic and market trends to persist, at least for the near future. However, we feel the market impacts of these factors are waning, and the potential for a deep or prolonged recession is still unlikely.
Our assessment of a post-pandemic world has changed based on the implications of Russia’s invasion of Ukraine, where the risk of higher prices and lower growth have increased. US inflation is expected to peak later this summer and to roll over much more gradually than previously thought. Within Europe, the peak is expected to come later, as compared to the US, as energy and commodity prices continue to drive inflation. We also continue to monitor wage growth, a key variable, which currently remains negative in real terms and has not added to inflationary pressure at this point.
The rising rate and strong dollar backdrop can also be problematic for emerging markets, but every cycle is unique, and our outlook remains region and country specific. The major Latin America and the Middle East countries are actually well positioned for the environment. In Asia, India may be more vulnerable given the country’s commodity dependence, and the generally high market valuation.
The mixed outlook for China is interesting. We have begun to see some easing of the COVID lockdowns, which will lead to accelerating demand. However, the low vaccination rate amongst the older population as well as the potential for a resurgence and its effect on growth remain at the forefront. The regulatory overhang and heightened geopolitical risks also continue to weigh on sentiment, though the recent regulatory cycle has peaked. Conversely, we think the Chinese government’s focus on stable economic growth will lead to moderate fiscal stimulus and potential for monetary easing, in stark contrast to many other major countries. Valuations here are far more attractive.
Corporate earnings growth, especially outside the US, is widely expected to decelerate throughout much of 2022, yet we have seen very few negative revisions. Given the persistent inflation and macro-economic uncertainty, we expect that to change with second-quarter corporate reports and the related outlook commentary. While some of that expected deceleration has been reflected in multiple contraction, negative earnings revisions may continue to put further downward pressure on multiples.
International Growth Fund
The Pembroke International Growth Fund underperformed the MSCI ACWI ex-US Small Cap Index during the year-to-date period as of June 30, 2022. 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-US small-cap space.
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. From an attribution perspective, weaker stock selection within industrials, coupled with an underweight allocation to energy and an overweight allocation to information technology, significantly detracted from performance.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
Partially offsetting underperformance was positive stock selection within consumer staples, driven by Proya Cosmetics (“603605:C1”). We expect Proya to be one of the key beneficiaries of the domestic substitution trend within China’s cosmetics and beauty industry, which is currently dominated by overseas brands. The company should continue gaining share in this highly fragmented market. The share price strengthened after the company reported strong gains during its 2021 fiscal year, primarily attributed to its continued new product launches and expansion into increased online purchases.
Utilities stock selection was also positive, driven by a strong performance from EDP Renováveis (“EDPR: PL”). EDP Renováveis is the fourth-largest wind and solar energy producer globally (ex-China) and a pure-play renewable energy producer. The renewables outlook is looking better than ever, not only due to ongoing decarbonization initiatives, but also due to the factors that have come to the forefront this year, such as the Russian invasion, a push for energy independence and the need for off-takers to have price stability.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
Industrials weakness was primarily due to Japanese professional services company Benefit One (“2412: JP”). Benefit One is a provider of HR-related services, in the form of outsourced fringe benefits. A structural tightening of the Japanese labour market has increased the need for employers to attract hires using the types of services offered by Benefit One. Future regulatory changes should also drive increased demand. As the business has a fixed cost base and low variable costs, operating leverage is high, supporting a rate of profit growth at the top end of the peer group. The share price declined primarily on lower than consensus operating profit, due to an increase in costs in the fringe benefits segment of the business.
Health Care stock selection was weak primarily due to InMode (“INMD: US”), an Israeli-based medical device company. InMode has developed proprietary minimally invasive and non-invasive technologies for various aesthetic applications including fat reduction, skin tightening and muscle toning. While the company is currently focusing on the medical aesthetics market, the products are applicable in a wide array of indications, such as women’s health, ENT (Ear, Nose and Throat) and ophthalmology, which could significantly expand the targeted market. After a strong run in 2021, the share price weakness and multiple compression have been largely due to continued rising interest rates, recessionary concerns, and supply chain challenges. Despite the difficult backdrop for small-cap healthcare in particular, we remain optimist about InMode’s fundamental outlook.
Other Articles Of Interest
Disclaimer
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.
