Sun Life MFS International Opportunities Fund

Market review

Q3 2022 was the third consecutive quarterly decline for international equities. After declining 3.4% (net div. in CAD) in the third quarter, the MSCI EAFE Index has now depreciated 20.69% (net div. in CAD) through the first nine months of 2022. Following a rebound in the earlier part of the third quarter on hopes for a potential reversal in monetary tightening, international equity markets resumed their decline as central banks reinforced their determination to fight inflation despite growing recession risks. The rout was broad based as 10 of 11 sectors lost value in the index, with the steepest falls in Communication Services and Utilities. Energy was the only sector delivered positive return for the quarter.

Investors remained fixated on persistently high inflation and whether it has peaked. For perspective, in August US inflation was 8.3%, Eurozone inflation was 9.1%and UK inflation was 9.9%. Japan inflation was much lower than the others at 3.0% in August, but near its highest level in 25 years. While it is unclear whether inflation has, in fact, peaked, what seems indisputable is that inflation levels remain elevated. For this reason, central banks have been raising rates in 2022 to combat inflation. Nowhere has this been more pronounced than in the US where the Federal Reserve (the Fed) has raised interest rates five times (from 0.25% to 3.25%) over the past six months and has forecast rates to rise to approximately 4.5% by the end of 2022. Though other central banks have not been as aggressive in raising rates as the Fed has been, every developed market central bank apart from Japan has raised interest rates in 2022 to combat inflation.

While the effort to tackle inflation is ongoing globally, the drivers of global inflation have not been homogenous, with countries exhibiting vastly different drivers and levels as contributors to headline inflation as measured by the Consumer Price Index (CPI). The US is running above target and running hot for most categories while the EU has a large energy and food influence on overall CPI. Japan's inflation is muted compared to the US and EU with deflationary elements such as services. China's inflation is below target even with a food and energy spike, and this benign inflation environment has allowed the People’s Bank of China (PBoC) to ease monetary policy

slightly by lowering its policy rate and the one-year and five-year loan prime rates. Potential stimulus/re-opening of China, on the one hand, helps supply chain issues ease (deflationary) but also creates another lever to boost demand for resources (inflationary).

Western central bankers, particularly the US Fed's Powell, seem to fear being the central bank chief that let the inflation genie out of the bottle, which may take some pain to contain. A commitment to bring inflation back to target (e.g., 2% inflation in the US) presents the Fed (and other central banks) with a binary choice. Either keep the unemployment rate near its low and let inflation remain elevated or let the unemployment rate surge and bring back price stability. According to Jay Powell, “Higher interest rates and a softening labor market are painful. But they’re not as painful as failing to restore price stability and then having to come back and do it again.” To achieve the inflation target, the unemployment rate will likely increase. A decline in profits will likely be the mechanism for an increase in unemployment if firms are forced to shed workers. Most companies' earnings per share (EPS) fall because of an outright decline in revenues, and some are already feeling margin pressures. Also, the impact of rate increases has not yet flowed through the system. In general, it takes about six months for declines in leading economic indicators (LEIs) to be reflected in earnings, and LEIs are showing declines. Though most companies have not yet reported third quarter earnings results, it is worth noting that many companies reported resilient second quarter earnings results and net margins were near their highest levels in 20 years.

The prospects for recession are almost certain in Europe given the energy issues, but the question is how long this situation lasts. The damage to the Nord Stream pipelines means that a negotiated near-term solution is off the table. Many European/UK consumer are also being squeezed by other inflationary pressures such as increasing mortgage costs. Recession for the US seems likely, but generally the economy is more resilient to the impact of higher rates, and the US consumer looks a good deal healthier at present.

Portfolio Activities

During the third quarter, the team continued to build or initiate positions in high-quality businesses that they believed had attractive risk/return profiles while trimming or eliminating companies that had become more fully valued or were facing structural headwinds. Key trades during the third quarter included:

Adds/Buys

• The team initiated a position in Aristocrat Leisure, an Australian manufacturer of gambling machines. There are high barriers to entry for slot machine manufacturers given the scale needed to navigate the myriad gaming regulatory bodies in different jurisdictions. The business is less cyclical today given the growth in machine leasing over the outright sale of slot machines, which is dependant on the casino capex cycle.
• The team added to Assa Abloy and Experian driven by attractive valuations.

Trims/Sells

• The team trimmed Canadian National Railway and added to Canadian Pacific Railway, reflecting the team’s higher conviction in the former following its successful acquisition of Kansas City Southern.
• The team made several trades to existing holdings in the Industrials sector, trimming Ritchie Brothers Auctioneers after a strong performance.
• The team sold out of Australian independent oil and gas producer Santos. The position was in the portfolio as the result of an all share offer for the previous holding of Oil Search, and the team had less conviction in the attractiveness of the combined assets of the business
• The team also trimmed Reliance Industries after strong performance. The Indian company has delivered strong results in its oil exporting business.

Fund Positioning

As investors enter the fourth quarter, the global economy should continue to slow while some economies could enter recession. The magnitude of this potential recession will partly depend on the effectiveness of measures deployed by policymakers to reduce the impact of the energy crisis on households and businesses. Central banks, confronted with the biggest inflation shock since the 1970s, will probably continue to prioritize the fight against inflation over supporting growth.

The market environment is certainly challenging. To name a few, potential headwinds include earnings risk from margin headwinds, expectations for continued central bank hawkishness, European growth risk from surging energy prices and China growth risk from adherence to the zero-Covid approach. With so much uncertainty in the near term, the team remains focused on doing what they do best: invest with a long-term horizon and use short-term market volatility as an opportunity to add and trim (or start and eliminate) positions. They have a clear strategy of seeking to invest in companies with sustainable growth, returns and cash flow generation through the cycle but with an added focus on downside risk management and assessing risk that others often seem willing to overlook. Longer term, the team continues to believe that stock selection will be the key component of generating alpha and avoiding significant drawdowns.

From a portfolio construction perspective, the Fund seeks to invest in companies that the team believes have the potential to compound above-average growth at high returns for many years into the future. Conceptually, the team segments the growth investment universe into three distinct groups with a 5– to 10-year perspective. One group is the structural compound growers. These companies have exhibited above average revenue or earnings growth over 5 to 10 years and the group consists of many quality companies. The team seeks to own companies that meet their investing criteria and trade at reasonable valuations. The next group is the cyclical growers. These companies may exhibit above average growth but are subject to cyclicality due to economics or the business model. The group is comprised of many quality companies which the team values on mid-cycle earnings power and returns. Most of the portfolio consists of holdings from the first two groups. Typically, a valuation trade off exists between structural growers and mid-cycle fundamentals of cyclical growers. The Fund is currently overweight the structural compound growers which have tended to be more defensive. The last bucket are the speculative/hyper growth companies. Growth for this group is relatively high, many firms may not be profitable, and the group has fewer quality companies. These names have tended to trade at elevated valuations. The challenge is to find companies that meet the Fund’s criteria at reasonable valuations. The portfolio has generally held a small weight in speculative/hyper growth compared to the other groups.

The portfolio was most overweight Consumer Staples, Materials, and Information Technology. The team has long favored Consumer Staples companies that have strong brands, sustainable, above-average growth, and geographically diverse revenue sources. Many of the Fund’s Consumer Staples companies have been able to pass along input costs increases and continue to exhibit pricing power. Within Materials, the Fund’s primary exposure is in chemicals where, for example, it owns Industrial gas producers Linde and Air Liquide. Air gases improve energy efficiency and help eliminate or reduce carbon emissions. Linde supplies products that help their industrial customers become more efficient and reduce their own environmental footprint. Although the industrial gas companies are large emitters of carbon, they help to decarbonise their clients supply chain and save millions of tons of carbon from being released. For example, they provide oxygen used in blast furnaces to enable more efficient steel manufacturing and krypton used in double glazed windows to help insulation. Within Information Technology, aside from Software, the team dislikes other industries including semiconductors driven by valuation risk. While the sector offers many businesses with attractive characteristics in terms of growth and returns on capital, the team was cautious of current valuations.

The portfolio was underweight Financials and Communication Services. The Fund does not favour European banks due to their complicated business model and over-leveraged balance sheets. The team particularly struggles with European banks because their core business of lending is fundamentally commoditized and will likely only becoming tougher as fintech disruptors grow. While they have certainly recapitalized following the GFC, they remain highly financially levered business models. They also continue to see growing government intervention and they remain systemically linked in a highly indebted global system. The Fund’s top 3 Financials holdings were AIA Group Ltd, a Hong-Kong based American multinational insurance and finance corporation, HDFC Bank, India’s leading private sector bank, and DBS Group Holdings, a Singapore multinational banking and financial services corporation. The Fund’s underweight to Communication Services is primarily the result of telecommunications companies that do not meet the minimum growth hurdles and limited exposure to owning many interactive media and services names.

The Sun Life MFS International Opportunities Fund outperformed its benchmark, MSCI EAFE Index for the quarter.