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GMO International Active 1Q16 Commentary – The Brexit Debate

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GMO International Active performance update for the first quarter ended March 31, 2016.


The GMO International Active EAFE Strategy underperformed the MSCI EAFE index by 0.6 percentage points in the first quarter; the strategy fell 3.6% net of fees and the benchmark lost 3.0%.

GMO International Active – Regional Commentary

European equities have endured a poor start to 2016, a stark contrast to the first quarter of 2015 when Draghi’s QE package positively triggered the European markets.

Several factors help explain Europe’s struggling performance in the first quarter. Fears over the solvency of the Italian banks helped drag the European financial sector lower, with chronically weak results from the investment banks on the continent adding to the general sector malaise. Tensions also resurfaced between the IMF, Germany, and Greece when the IMF supported sizeable debt relief for Greece, a stance fiercely opposed by Germany. The debate is likely to become increasingly acrimonious ahead of Greece’s scheduled debt payment to the ECB of €2.2bn due July 20. A final factor afflicting European markets is the growing concern that the United Kingdom might vote to leave the European Union in the upcoming referendum on June 23. This “Brexit” scenario is worth exploring in more detail.

Despite endless debate on the subject of Brexit in both the business and mainstream media, and mountains of research positing the implications for the UK and the EU of an exit vote, some commentators still claim that the implications of Brexit are not discounted in financial markets. We believe that the markets have discounted the approximately 35% probability of an exit and the disruptive impact this could have on the UK economy in the short term. The 35% figure is the Brexit odds offered by a wide array of UK bookmakers. The pollsters point to a much closer result, with polls of polls pointing to the leave and stay camps at level pegging – albeit with a large undecided element (as much as 20% in some polls) potentially swinging the vote either way.

There are sensible reasons to side with the bookmakers. Not only do UK pollsters have a woeful track record in recent years, they specifically have underestimated the conservative tendency of the UK electorate, which has rarely favored radical change. This most recently occurred in 2015 when none of the mainstream pollsters predicted a Conservative majority in the election. We also note that referenda on large-scale constitutional reform in recent years (such as the Scottish independence referendum) have tended to side with the status quo.

To date, the Brexit debate seems to be having limited economic impact on the UK. Certainly, for this heavily services-dependent economy, an average first quarter services PMI level of 54 would indicate a slowdown to 0.4% growth in services output when compared to 0.8% in the fourth quarter of 2015. However, it is difficult to disentangle this from a generally soft patch in the global economy and jittery financial markets during the month.

The Brexit debate is undoubtedly impacting international investors’ appetite for sterling assets, especially those sensitive to the domestic UK economic outlook. These have performed far worse than similar continental European stocks, despite trading updates generally remaining robust. We hold several of these names in the portfolio, which has been detrimental to performance in the first quarter. We believe these assets (and sterling) are fairly discounting the odds of Brexit. Because we believe the vote will be to remain in the Union, which the market will view as the removal of a potentially damaging economic shock, those stocks are likely to perform well after the vote on June 23. In the event that the UK votes to exit, we think it is more likely to be a long-term mild negative than a calamity, but we agree with the consensus view that sterling would weaken. In the portfolio, our overweight position in the UK has detracted from performance in the year to date, in no small part due to the impact of the weakness of sterling, and this would be aggravated even further in the short term by an exit vote. Conversely, a vote to remain should provide a short-term boost from our sterling overweight.

One area where the possibilities of a Brexit do not appear to be adequately discounted is in the euro currency. The euro has enjoyed a period of strength after the Federal Reserve reigned in its expectations on the speed of US rate rises. If the UK – which is Europe’s second largest economy – did vote to leave the EU, it would undoubtedly create question marks about the viability of the whole European project and weaken the currency as a consequence.

GMO International Active – Country Allocation And Market Update

Country and currency allocation was 0.4 percentage points behind the benchmark. An underweight position in the Australian market and our positioning in Europe subtracted from returns.1

As discussed above, Europe struggled in the quarter with fears about banks, tensions between nations, and the looming possibility of Brexit.

Despite issues in Europe, the Pacific region underperformed in the quarter. Our long-term pessimism on China’s economic prospects remains as strong as ever, and the market continues to underperform both MSCI Emerging Markets and MSCI EAFE on one-year and year-to-date periods. Our main concern is that China is moving toward a substantial devaluation of its currency that could cause severe financial dislocation across the region. The small move in the Chinese yuan (CNY) last year that so surprised markets was just a taste of what could happen in 2016 if China’s authorities fail to achieve the impossible – controlling the exchange rate while easing monetary policy to cushion the ever-slowing economy. There is no historical precedent of which we are aware in which credit-led growth like China’s did not result in a painful economic adjustment, and the preponderance of data suggests the country is already well into an industrial recession. The conventional playbook for governments is to ease monetary policy to both provide liquidity to the financial system and allow for increased government spending. Our view is that while China can do this, and is indeed already doing it, it is incompatible with its fixed exchange rate policy. China’s M2 money supply has increased three times relative to the United States’ M2 in the past decade alone, yet the CNY has actually appreciated relative to the U.S. dollar during that period, quite a feat under most circumstances. We think this was made possible only by an unsustainable, bubble-driven demand for CNY from locals, carry traders, and other foreign investors. As China continues to print CNY in an attempt to stave off an inevitable credit deflation, odds are that the market should dramatically reassess the relative values of these two units of account. One only has to look at the oil market, where a few percentage points change in supply and demand led to a startlingly fast 70% fall in crude prices, to see where things could trend should demand for CNY move even a little. A similar move in the CNY hardly seems implausible, although we need only a fraction of that to recognize our long-held fears.

GMO International Active – Stock Selection

Stock selection lagged the benchmark by 0.1 percentage points in the first quarter. Holdings in Europe underperformed. This was somewhat offset by positions in Japan and the emerging markets.1

In Europe, holdings in AstraZeneca, Nokia, and Banca Popolare di Milano dragged on performance. UK pharmaceutical AstraZeneca issued its 2016 guidance, which confirms that income growth will not resume before 2017. For us, the company’s investment case is about one of the most undervalued pipelines in the industry. The company will have one of the fastest earnings growth trajectories among large cap pharma once it emerges from the Crestor patent cliff in 2017, driven by high margin oncology sales in particular. For Finnish company Nokia, the outcome of the intellectual property royalty agreement was below the market expectations. While the fourth quarter results were good and the integration of recent acquisition Alcatel Lucent is on track, the overall telco equipment market is expected to be down this year, which has dampened the short-term excitement on Nokia. We continue to own the stock as we believe that the company has a unique opportunity to grow earnings even in a soft end-market scenario. Reduction of costs as part of the Alcatel integration should allow the earnings to grow. With more than 30% of its market cap in cash, despite having increased its dividend and buying back shares, Nokia has further scope to increase shareholder returns. Banca Popolare di Milano is one the best capitalized cooperative banks in Italy, which is why we held it. However, the bank is currently being taken over by Banco Popolare, a larger cooperative bank. The stock has fallen as the ECB has requested the combined bank to shore up its capital before the merger. Taking into account the state of the Italian banking sector and Milano’s excellent performance in 2015, we decided to sell the name late in the quarter.

On the positive side, the Japanese telecom company Nippon Telegraph & Telephone (NTT) outperformed thanks to strong fiscal third quarter financial results and management making it clear that it is focused on delivering higher ROE and EPS growth. Its majority-held wireless subsidiary DoCoMo also indicated it would concentrate on shareholder return. Positions in emerging markets did well, especially Taiwan Semiconductor (TSMC), which re-rated as its highest technology products gained more traction with clients, indicating that the company has widened its lead over the industry. Despite a record high valuation for TSMC, its valuations are still modest for a company with its industry position and profitability.

GMO International Active – Currency And Hedging

Most of the benchmark currencies appreciated relative to the US dollar in the quarter. The exception to this was the UK pound, which fell 2.5% as investors worried about Brexit, however, the euro climbed 4.6%. In the Pacific, the Australian dollar gained 6.0%, and the Japanese yen climbed 6.6%.

GMO International Active

GMO International Active

GMO International Active

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