International developed equity markets posted positive returns for the third quarter on a local currency basis.  However, these gains were offset by a stronger dollar, resulting in a modest loss for U.S. investors on a currency translation basis.  International equity returns remain positive on a year-to-basis, and valuations remain reasonable within the asset class – vs. their own history as well as relative to U.S. markets.

The push-pull dynamic in the global equity markets continue – as sluggish global growth trends are offset by easy money via accommodative central bank policies.  The market has seen a proliferation of negative interest rates – there is now $14 trillion of global debt with negative yields.  In some cases, investors in negative-yielding paper actually have a profit on their investment, as rates in some regions have gotten more negative since the debt was issued.  The preponderance of sub-zero rates has resulted in an array of mixed consequences for consumers.  For example, a bank in Denmark is now offering borrowers a 10-year mortgage at -0.5%; you read that correctly – borrowers are essentially being paid to take out a loan via having to pay back less than they were loaned.  In a reverse example, a Swiss bank introduced a 0.6% charge in certain situations where clients deposit more than 500,000 Euros.  One objective of negative rates is to incent economic output; however, it appears that the opposite has occurred.  Although domestic bond yields remain positive, the prospect of negative yields arriving in the U.S. has been raised more recently.

Observations from the Road

As a fundamental investment manager, Cambiar places a high degree of importance on our internal research efforts.  A thorough understanding of a company’s financials is crucial; however, that is just the starting point.  There are many other facets to the research process, including meeting with management, having a good understanding of the industry dynamics, an analysis of the competitive landscape, etc.  The objective is to build a 360-degree assessment of our companies.

While the team can build earnings models and read corporate filings in the office, we believe it is also important to spend time in our companies’ home markets.  Travel itineraries will include industry conferences, onsite meetings with management, interactions with policymakers, as well as more informal takeaways gathered via social interactions within the community.  On this basis, we thought it would be helpful to share some general observations from the team on recent travels to Europe and Japan.

Europe

European equities have compiled a poor cumulative return record – not just in recent years, but for most of the past decade.  Europe suffers from a lack of internally- generated growth, as much of its growth comes from exports and the manufacturing infrastructure, inventories, and tooling needed to export.  For this reason, it is not all that surprising that a sharp deceleration in global trade owing to trade wars and ongoing uncertainty about the timeline of any resolution has disproportionately impacted Europe vs. other regions.

Investor mindsets are often limited by this top-down view.  We feel this is incorrect, as there are a lot of high-quality companies in Europe – who long ago adapted to the realities of having limited home markets in which to do business.  European companies have excelled over the years in uniquely crafted products, from luxury goods to medical technologies to consumer products.  The accompanying brand heritage often leads to high margins and business returns.  Generally speaking, the better companies and brands are moving forward, irrespective of negative news headlines.

One pervasive theme from recent travels is attunement to ‘green’ efforts.  European companies have always had an obligatory slide or two in their decks on ESG initiatives, but the more recent tone is vastly more sincere – particularly on the topic of carbon emission reductions.  Europe is well-ahead of the U.S. in terms of implementing aggressive tax regimes to tax carbon as a negative economic externality – with varying degrees of impact to industries such as surface transportation, power plants, and agriculture.  While there is a disproportionate amount of public policy-oriented towards changing carbon habits, methane emissions from cattle is almost equal to the CO2 impact of cars.  No significant investment takeaways, although current holding DSM recently commercialized a feed additive that reduces cow methane emissions by 25%.

Regarding autos, this industry remains paramount in importance to Germany – as approximately 1 in 8 Germans owe their employment to something directly or indirectly linked to the auto industry.  Their move a few years back to focus on diesel vs. battery-electric vehicles has been the wrong decision, and partially reflected in the low valuations for OEMs.  As a new design typically takes 4-7 years before scale production, Germany is clearly in catch-up mode on the EV front.

Japan

In addition to numerous company meetings, the time spent in Japan was used to get a sense of the pending value add tax (VAT) hike, inside views on the Japan-South Korea trade war, and related impact on economic growth conditions.  The global slowdown in economic activity has affected the Japanese economy, with growth slowing to a crawl in the second quarter (0.3% quarter-over-quarter).  Given the deceleration in growth, a raise in the consumption tax seems like poor timing.  It is clear that both fiscal and monetary stimulus will be required to help Japan offset these two headwinds.

The most recent increase brings the sales tax to 10%, vs. 5% in 2014.  Tax hikes have historically been associated with market underperformance.  Although consensus anticipates a drop in demand after the tax is implemented followed by a subsequent recovery, Cambiar’s analysis points to a 9-12 month post-period before the drop is recovered…thus patience may be the prudent choice.

Given the backdrop trade wars and weak external demand, Prime Minister Abe has said that his government is ready to take “all possible steps” if the tax hike appeared to further impair economic growth.  Action will likely be forthcoming, as the signs are not good: the Bank of Japan’s Tankan Survey of Manufacturing Sentiment hit a six-year low in the July-Sept quarter, and the Japanese Cabinet Office’s assessment of the economy indicates that economic conditions worsened in September, increasing the odds of a recession.

Investment implications – Nothing immediately actionable.  The International portfolio is currently underweight Japan, and takeaways from Cambiar’s visit is unlikely to materially alter this view.  The team will take a wait-and-see approach to companies that are more sensitive to domestic consumption in light of the recent tax hike.  Export-facing companies have underperformed due to slowdown in global growth – Cambiar will continue to monitor for signs of stabilizing demand.  Acyclical companies such as healthcare should be less impacted.