After a strong start in early 2023, international equity markets fluctuated in the first quarter, driven by shifting interest rate expectations. The MSCI EAFE Index (C$) rose 8.3% over the first quarter.
Gains were largely front-loaded into January on hopes the U.S. Federal Reserve (the “Fed”) would pivot to slowing interest rate increases. The index was buoyed by receding recession worries in developed markets and long-duration, growth-oriented stocks benefited from lower bond yields amidst the largest quarterly decline in yields since the pandemic in early 2020. The U.S. Treasury yield curve remained inverted, although yields fell across most of the curve. Other supportive factors during the quarter were continued excitement over China reopening and mild winters in both Europe and the U.S. Headwinds over the period were the concerns over the collapse of Credit Suisse and failure of two U.S. regional banks.
Most sectors in the index rose over the quarter, most notably economically sensitive areas like Information Technology, Communication Services, Consumer Discretionary and Industrials, which were all up double digits in Canadian dollar terms. Yet, it is noteworthy that despite the deteriorating economic backdrop, these sectors have rallied over this period. Within Information Technology, stocks of semiconductor companies rose by double digits amid signs inventory levels are improving in certain segments of the market. Consumer Discretionary stocks also posted significant gains amid sentiment that a recession may be avoided this year. LVMH shares advanced after the luxury goods giant reported record-high revenue of $86 billion (USD) in 2022, driven largely by the return of international travel and tourism.
Economic growth and employment data came in stronger than anticipated for most of the quarter, and optimism was fueled by the notion that the Fed was nearly done tightening, mortgage rates were falling, employment remained healthy and nothing in the economy had broken. This stronger growth was illustrated by the rebound in the U.S. and European composite Purchasing Managers’ Index (PMI) business surveys since the start of the year, in particular the services component as the manufacturing component in most countries signals a contraction. Lower energy and oil prices have probably played an important role in the improvement in business sentiment, along with the reopening of China. As equity prices increased, optimistic investors crafted a wide assortment of bullish narratives including the “no landing” economic scenario. In March, the collapse of Credit Suisse and two U.S. regional banks sent fears of contagion through the markets. Since then, at the margin, the market appeared to increasingly consider the risk of recession.
While non-economic factors, particularly China’s abrupt reopening and mild winters in Europe and the U.S., may have contributed to a stronger-than-expected start to 2023, most economic indicators point to recession for developed market countries. At this point, three key ingredients for a recession are in place. Synchronized global central bank tightening has occurred with aggressive Fed tightening. Spikes in food and energy inflation are apparent and banks are tightening lending standards. Historically, this combination has always led to a hard landing or recession. Further, the global debt burden is at record levels as measured by a steadily rising global debt-to-GDP ratios over the past decade which may weigh heavier in a higher rate environment.
With the lagged effects of higher interest rates, equity returns are likely to be impacted by whether earnings can remain resilient. Margins for the index appear to have come off peak levels and the question will be to what extent earnings per share (EPS) growth declines. There are inevitable consequences when it comes to slower economic activity and declining company earnings. Declining EPS can set the stage for weak markets and a deterioration in employment trends.
The Sun Life MFS International Opportunities Fund (the “Fund”) outperformed the EAFE Index for the first quarter. Relative performance was primarily driven by Fund investments in the Information Technology, Consumer Discretionary and Energy sectors.
- An overweight position in Information Technology, the best performing sector in the index, aided relative returns
- Stock selection in Consumer Discretionary contributed to relative performance
- Underweight positions in Real Estate and Energy, both weaker-performing sectors in the index, contributed to relative performance
- Stock selection in Health Care detracted from relative performance
- A combination of both stock selection and an overweight in Consumer Staples detracted from relative performance
One of the biggest concerns for the sub-advisor (MFS Investment Management), and their base case, is the likelihood of recession and the corresponding impact on company earnings. The debate is around how much a fall in earnings has been priced into valuations as a recession edges closer. From their bottom-up perspective, the market seems in denial about the level of economic stress increasing in international equity markets.
While there are some positive narratives in the marketplace, market concerns revolve around a higher-for-longer Fed in response to sticky services inflation and a tight labour market, tighter credit conditions following recent banking sector turmoil, downside risks to consensus earnings estimates as margins continue to revert, eroding excess savings/consumer balance sheet cushions, geopolitics and de-globalization. The total amount of global debt has only increased through the COVID pandemic which makes the effects of quantitative tightening quite unpredictable. The likely solution to these current scenarios probably involves some level of economic and market pain before it resolves.
With such uncertainty in the near term, MFS remains focused on doing what they believe they do best: investing with a long-term horizon and using short-term market volatility as an opportunity to add and trim (and start and eliminate) positions. MFS has a clear strategy of investing in quality companies with durable 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, they continue to believe that stock selection will be the key component of generating alpha and seeking to avoid significant drawdowns.
MFS continues to see economic stress increasing in international markets, and believe the portfolio is well positioned from their defensive positioning given the increasing risk of recession and their valuation investment discipline in a potentially slower growth, more volatile market environment.