Sun Life MFS International Opportunities Fund

Market review

For the first quarter of 2022, all major stock benchmarks saw their biggest quarterly losses in two years in a volatile investment environment. Concerns over the potential need for a faster pace of interest rate hikes to combat higher inflation, and the economic implications of the Russian invasion of Ukraine weighed on both equities and bonds. Cyclically sensitive stocks underperformed as investors girded for a slowdown in growth. The steepest declines in the growth index came from the consumer discretionary sector. Worries over consumer spending led to declines for stocks such as retailers, while the war in Ukraine also exacerbated supply chain disruption, hitting the availability of parts for a wide range of products. Higher interest rate expectations took a toll on the information technology sector, while the typically defensive consumer staples, health care and utilities sectors outperformed the growth index. Utilities was the only sector with a positive absolute return for the period.

One major factor for the quarter was rising inflation as energy and commodity prices spiked. Higher commodity prices across the board have been feeding into concerns that inflation will not be quick to moderate. Central banks have so far suggested that they view inflation as the more pressing problem to tackle unless the growth outlook markedly deteriorates. The Fed raised the target rate by 0.25%, as expected, making it clear that further increases will be appropriate. Adding fuel to the fire that is higher inflation was the start of the war between Russia and Ukraine. Russia is a major energy and commodity producer and the escalation of the war exacerbated existing concerns over inflation pressures, as well as supply chain disruption, particularly through food and energy. Commodity prices moved higher in response to the war, raising concerns over business and consumer demand, policy tightening and the outlook for growth.

The Sun Life MFS International Opportunities Fund lagged the MSCI EAFE Index for the first quarter. The environment was markedly different from typical market corrections, which are generally concurrent with a weakening economy. On a historical basis, the Fund has always outperformed the index in quarters when the market declined by 5% or more, going back to at least 2003. In the first quarter of 2022, however, Energy stocks, which the Fund has limited exposure, led the market performance by a wide margin. Financials, where the Fund has a substantial underweight, outperformed as central bankers in the U.S. and U.K. are intent on raising interest rates to bring down inflation, even as recessionary pressures are increasing. Information Technology, the largest overweight in the portfolio, was the worst performing sector. Stock selection from communication services (Tencent Holdings), industrials (Schneider Electric), and materials (Linde PLC) sectors hurt relative performance. 

Significant transactions

Add/Buy

• The Fund initiated a position in ASML Holding, whose extreme ultraviolet (EUV) lithography machines are critical to cutting edge semiconductor chip manufacturing. The company has an effective monopoly that has sustained margins.
• The Fund added to SAP, Swedish Match and Schneider Electric at more attractive valuations following recent underperformance.
• The Fund added to Bayer on evidence of improving fundamentals, and optimism that the glyphosate litigation issues are close to finally being resolved.

Trim/Sell

• The purchase of ASML was funded by a trim to Taiwan Semiconductor Manufacturing. Although the team believes it is a tail risk, the potential for China to pressure Taiwan factored into the calculus.
• The Fund exited L’Oreal and trimmed Novo Nordisk due to valuation after strong performance.

Fund Positioning

The team’s focus on high-quality, above-average growth companies continues to drive portfolio positioning. They seek to invest in companies that have the potential to compound above-average growth at high returns. These companies typically are market leaders with durable business models that have experienced management teams and competitive advantages that should allow them to maintain higher returns and earnings growth than their peers. The team seeks to apply their buy criteria in a disciplined manner, irrespective of economic conditions. Combined with the long-term investment horizon, this typically results in very modest shifts in portfolio positioning from quarter to quarter.

As of March 31, 2022, the portfolio was most overweight consumer staples and materials. The team has long favored consumer staples companies that have strong brands, sustainable, above-average growth and geographically diverse revenue sources. Should inflation persist, they believe many of the consumer staples companies have pricing power. In particular, the Fund has an overweight to the alcoholic spirits industry which has generally been able to pass on price increases. Within materials, the primary exposure is in chemicals where the Fund owns industrial gas producers Linde and Air Liquide. These high-quality cyclicals have generated returns above their cost of capital and significant free cash flow over a full cycle. The Fund also owns specialty chemical suppliers Symrise and Sika. Lastly, we own Akzo Nobel, a global manufacturer of coatings and paint products.

The portfolio was most underweight information technology and communication services. The information technology sector comprised about 19% of the Growth Index at the end of the quarter, making it the largest sector of the index and the largest portfolio underweight. Aside from software, the portfolio has an underweight to many of the industries within the sector such as electronic equipment instruments and components, tech hardware and communications equipment. While the sector offers many businesses with attractive characteristics in terms of growth and returns on capital, the team struggles with current valuations, which is the primary reason for the underweight. More than half of the sector underweight is in semiconductors, where the Fund owns Taiwan Semiconductor and ASML. While many semiconductor companies do not look particularly expensive on forward earnings estimates, this is optically misleading since many of these companies are generating earnings well above normalized levels. On normalized earnings, the team believes many of these stocks look fully priced. In addition, there is a potential supply chain issue given that Ukraine is responsible for around 50% of the global supply of neon which is an important input for manufacturers. The Fund’s underweight to communication services is primarily the result of not owning many telecommunications companies that do not meet the minimum growth hurdles. Most of the communication services exposure is in the interactive media and services industry with companies such as Tencent and Naver.

The Fund continues to be underweight direct exposure to China. China lagged by a wide margin as daily new cases of Covid-19 spiked, and lockdowns were imposed in several cities, including Shanghai. Regulatory concerns relating to US-listed Chinese stocks also contributed to market volatility. The team worried about corporate governance and the structure of variable interest entities (VIEs).

With regards to the potential impact of higher inflation, the team continues to believe that buying businesses at attractive valuations with strong competitive advantages and pricing power is the best way to defend against rising inflation. That said, in recent years there have been a few additions to the portfolio that the team believes would be direct beneficiaries of higher inflation namely the gold company, Franco Nevada, as well as some recent purchases of stock exchanges, most notably Deutsche Boerse.

The macro environment is certainly changing. Following a decade of falling interest rates, we could be approaching a point of 'regime change.' Uncertainty is high, and risks are abundant, including the potential for continued inflationary pressure, fading stimulus potential for central bank policy mistakes, and heightened geopolitical risks. Investors should likely prepare for lower returns ahead as it seems unlikely the spectacular returns of the last decade will be repeated.