International and Global Equity Strategies

As we head into the fourth quarter of 2022, slowing growth, high inflation and recessionary fears remain in the forefront. Particularly, the economic outlook over the next six months appears challenged in all three of the world’s principal demand centres, the United States, Europe, and China.

Europe is facing significant energy price shock as a result from the ongoing Russian invasion of Ukraine, China’s consumers are much more challenged than is generally appreciated due to the resurgence of COVID cases, and the U.S. economy is balanced precariously between peaking inflation and a determined Federal Reserve.

Recession

Whether the U.S. will roll over into a more normal expansion, growing at its pre‐COVID averages, or the consumers hit on the spending breaks and the economy decelerates into a recession, depends on how quickly inflation recedes and the U.S. Federal Reserve can reach its approximate target policy rate. With key indicators, such as the labour market, having yet to show a significant slowdown, it is likely that chances of a pivot to a less hawkish stance will remain low for the remainder of the year.

Within Europe, recession continues to appear more unavoidable. Simply put, Europe has been hit with a sudden and large energy shock. This is not so much about whether Europe will have enough gas to heat its homes this coming winter, but rather about its energy prices being much higher moving forward.

Additionally, while China appears particularly challenged due to ongoing COVID‐related disruption of the domestic economy, demand recovery is expected as zero‐COVID policy eases, which could begin as early as spring 2023. Early signs of gradual easing of monetary policy and increased fiscal stimulus are also supportive to growth recovery.

Inflation

Global inflation rates, which has been significantly influenced by Russia’s invasion of Ukraine, have continued to soar in 2022. As a result, Europe is only now reaching its pre‐COVID output trajectory, which is considerably slower as compared to the U.S. While European inflation is somewhat lower than in the U.S., high energy prices are driving inflation. We expect European inflation will peak when energy prices roll over.

In the U.S., slowing consumer demand and normalizing supply chains are beginning to exert downward pressure on inflation. Specifically, goods price inflation has already rolled over, although it will be many more months before the year‐over‐year rate reaches 2%. What is important to follow is the month-over-month consumer price index inflation rate: when we see benign monthly reading in the 0.3% range, inflationary fears will be behind us.

Growth

Corporate earnings growth, especially outside the U.S., continues to be widely expected to decelerate throughout the remainder of 2022, given the soaring inflation and macroeconomic uncertainty. While some of that expected deceleration has been reflected in multiple contraction, we expect negative earnings revisions to continue to put further downward pressure on multiples.

Additionally, we cannot discuss the economic outlook without mentioning the wild moves in the dollar exchange rates we have seen this year. Europe’s massive energy price shock and inflationary pressures have created large currency discrepancies. With the U.S. dollar at its strongest since the mid-1980s, the message from the foreign exchange markets is essentially that the U.S. economy is the most resilient in the face of current economic headwinds.

As we assess what could break the upward trend of the U.S. dollar, we think the likely scenario would require either an easing of natural gas prices in Europe, which are up nearly ten‐folds in a 12‐month period, or the Federal Reserve’s hawkish monetary policy tightening to push the U.S. into a recession, which would ultimately put downward pressure on the U.S. dollar.

International Growth Fund

The Pembroke International Growth Fund underperformed the MSCI ACWI ex‐U.S. Small Cap Index during the year‐to‐date period, as of September 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‐U.S. small cap space in the first half of the year.

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 and health care, coupled with an underweight allocation to energy, significantly detracted from performance.

As we continue to analyze the various market outcomes, and while uncertainty remains quite high, the underlying corporate performance of the portfolio holdings remains quite resilient, and their long‐term earnings power is likely to remain unchanged. Thus, our approach will continue to focus on bottom‐up fundamentals, understanding companies with differentiated business models, unique cultures, and durable competitive advantages as we navigate this complex environment.

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

Partially offsetting underperformance was the benefit of overweighting and positive stock selection within Latin America. The share of Group Aeroportuario del Centro Norte (“OMAB MM”) in Mexico strengthened on solid Q2 results and positive outlook. OMAB is a quality airport operator with scope to grow traffic and profitability in excess of its peers in the intermediate term. The Mexican airport sector is an attractive space characterized by regional monopolies and favourable returns. OMAB has multiple avenues to enhance profitability relative to its peers, including adding non-aeronautical sources of revenue and increasing international traffic through their airports.

In the last quarter, Information Technology was also positive driven by Network International Holdings (“NETW LN”). Network International is the largest pan‐regional provider of digital payment solutions in the Middle East and Africa. The company is well positioned to benefit from strong secular growth drivers and attractive demographic conditions supported by four growth factors: attractive long‐term macroeconomic and socioeconomic trends, the move from cash to digital payments in some of the most underpenetrated markets, expanding payments markets (Saudi Arabia is a promising market which is not factored into management guidance), and increased outsourcing by banks. The company expects strong growth to continue into the second half of the year, despite a potential slowdown in e‐commerce growth in developing countries.

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 decline on lower than consensus operating profit is primarily due to an increase in costs in the fringe benefits segment of the business.

Health care stock selection was weak primarily due to Vitrolife (“VITR SS”). Specializing in invitro fertilization treatments and technology, Vitrolife represents a unique opportunity to participate in the early development of a highly innovative life science tools company that targets a large and attractive market that the company expects to grow by 5 to 10% annually over the long‐term. The company offers a compelling growth story, strong competitive advantages, and a highly innovative business culture that supports the attractive growth outlook. After a strong run in 2021, the share price declined alongside higher‐valuation health care peers amid the broad market rotation into lower‐valuation companies.

Global Equity Pooled Fund

The Pembroke Global Equity Fund is a Pooled Fund. This is a prospectus-exempt product that is only available to investors who meet the definition of an “accredited investor” under securities legislation.

The Pembroke Global Equity Pooled Fund is a diversified global equity strategy with exposure to Canadian, US, and international developed and emerging equity markets. The intent of the managers is to maintain diversification by region, by market capitalization size, by managers, and by passive and active strategies. The strategy is benchmarked against a custom index comprised of a 64% weight in the MSCI All Country World Index (ACWI) and a 36% weight in the S&P TSX Composite Index.

Over the twelve months ending September 30, 2022, the strategy reported a negative absolute return and a negative relative return compared with its custom benchmark, which also declined.

Over this one-year period, global equity performance was negative with very few exceptions. Against such a backdrop of widespread negative absolute returns, the performance of the Canadian equity allocation of the Fund was relatively strong. However, the passive exchange-traded fund (ETF) equity strategies generally outperformed the Fund’s active equity strategies, which are tilted toward growth. Finally, the Fund’s international equity strategy (see above) turned in the weakest performance, with northern European equities impacted by the war and political instability in the UK.  

The Pembroke Global Equity Pooled Fund invests in passive exchange-traded funds (ETFs) to achieve exposure in certain large capitalization liquid equity markets. During the twelve-month period ended September 30, 2022, the Fund held four equity market ETFs, including the iShares Core S&P500 ETF, the iShares S&P/TSX 60 Index ETF, the iShares Core MSCI EAFE ETF, and the iShares Emerging Markets ETF.

In total, the Fund’s allocation to passively managed ETFs was approximately 28% at the end of September 2022. In addition to the iShares S&P TSX 60 Index ETF, the Pembroke Global Equity Pooled Fund also achieves Canadian large capitalization exposure through its holding in the Pembroke Canadian All Cap Pooled Fund (see the article Canadian Equity Strategies).

By region, about 37% of the Fund was allocated to Canada at the end of September, about 35% to the US, nearly 11% to Europe, over 2% to Japan, and 14% to other regions. By sector, the Fund’s top exposures include the industrials, information technology, financials and consumer discretionary sectors.

 

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