MFS® International Equity Strategy - Quarterly Portfolio Update

Hello. My name is Chris Sunderland, I am one of the institutional portfolio managers on our International Equity portfolio. I'm pleased to report that the portfolio outperformed the EAFE Index in the second quarter of 2024.

While the EAFE Index declined slightly by about 0.4%, from a style perspective, value stocks modestly outperformed growth stocks in the second quarter. Despite these lackluster returns, there was no shortage of news in the second quarter as investors digested a variety of issues, including election results in India, Mexico, France and the UK, reduced expectations for central bank rate cuts following persistent inflation data, and the potential impact of artificial intelligence across many industries.

 By the end of the second quarter, the European Central Bank cut interest rates 25 basis points, from 4.5% to 4.25%. This marked the ECB’s first rate cut since raising interest rates from 0.5% to 4.5% over the prior two years. Meanwhile, the US Federal Reserve left interest rates unchanged at its June policy meeting and forecast only one interest rate cut in 2024. If you recall, at the start of the year, most economists were forecasting the Fed to cut interest rates between three to six times in 2024. While inflation levels have fallen significantly from their peak levels, they remain higher than the target levels set by the ECB and Fed.

 Taking a look now at the decomposition of returns in the market, I would point out that we noticed that earnings were the main driver of returns in the second quarter, and the highest quality companies led the market as well. These are typically tailwinds for our relative performance given our quality bias and focus on earnings. 

This chart shows the breakdown of returns over longer periods of time. Over the past one and three years, you can see that valuations (Forward P/E) have comprised a large portion of overall returns. Much of this is due to investor sentiment and expectations regarding inflation levels and interest rates, along with other geopolitical issues and the potential impact of artificial intelligence. But over longer periods such as 10 and 20 years, it’s been earnings and dividends that have driven returns, as one would expect. And it is over those longer periods of time that we focus our attention in identifying investment opportunities for your portfolio. 

As you know, we are bottom-up investors and do not reposition the portfolio around sentiment or macroeconomic forecasts. Instead, we believe the best way to add value for our clients over the long term is to invest in high-quality companies that take advantage of short-term volatility to adjust positions based on valuations. We believe this disciplined approach has added value for our clients over the long term despite the changing sentiment and macroeconomic news over the short term. 

Another topic I wanted to touch on is Japan. Performance was weak in the second quarter, down about 4%, but has been quite strong over the past year, up about 13%. And in particular, value stocks, led by mainly banks, have outperformed growth stocks by about 14%, as you can see on the chart, 20% versus 6%. There’s been a lot of optimism in Japan, and many companies have been proactively reducing their cross-share holdings while buying back stock. A renewed focus on corporate governance has reduced the valuation discount of Japan relative to other developed regions. Also contributing to the strong performance of value stocks has been the BOJ’s recent interest rate policy changes as well, that you can see on the right-hand side of that chart. 

However, again, our focus remains on the underlying quality of the businesses we own in Japan.  We have visited Japan several times over the past year, including meeting with Japanese banks, trading companies, auto manufacturers and many others. We think the market may be pricing in too much optimism as it pertains to those areas. And in some cases, banks and trading companies, ROEs, have declined recently, while the valuations have re-rated up significantly due to governance improvements and future rate expectations. At similar valuations, we have actually been able to identify higher quality and superior returning banks in Europe, for example, with lower overall risk.

And finally, we have entered a busy election season impacting countries that comprise almost 60% of global GDP. Significant changes have already occurred in the UK and in France and large EM countries. Of course, the impactful US election will be upon us in November, which is sure to be a wild card in terms of policy outcomes and their implications for inflation.

Historically, we find that the elections tend to create more market volatility and uncertainty than actually result in actual changes, especially in the near term, given the checks and balances in place and the slowness of the political process in general. We don’t expect individual elections to materially impact company profits over the next three to five years, which is our main investment focus.

One area that we believe the G7 countries really need to focus their attention are on fiscal deficits, which are roughly 2% to 3% of global GDP and are at higher levels now than before the pandemic. This needs to be managed down somehow over time, but markets do not appear to be overly concerned about this issue, at least for now. 

Investors currently remain focused on inflation data, which will determine the pace of how quickly central banks cut rates going forward. The market is currently forecasting the ECB, the Bank of England and the Fed to cut interest rates three to four times over the next 12 months. Meanwhile, more elections are on the horizon, including the critical US election in November. To be sure, there is no shortage of macroeconomic and political uncertainty in the back half of 2024.

As always, we avoid speculating on such uncertainties and election outcomes. Instead, we try to take advantage of short-term market dislocations by adding or trimming existing positions accordingly. We believe this approach has been effective in various market environments historically and should serve our clients well now given how much uncertainty exists today. And going forward, we will continue to invest in high-quality companies that we believe can grow earnings faster than the overall market while remaining disciplined on valuation.  

Thank you very much for taking the time to listen to the International Equity second quarter update.

 

Fundamental Equity Investment Strategies Details

 

The views expressed are those of the speakers and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. No forecasts can be guaranteed. Past performance is no guarantee of future results.

Important Risk Considerations:
The strategy may not achieve its objective and/or you could lose money on your investment.

Stock: Stock markets and investments in individual stocks are volatile and can decline significantly in response to or investor perception of, issuer, market, economic, industry, political, regulatory, geopolitical, environmental, public health, and other conditions.

International: Investments in foreign markets can involve greater risk and volatility than U.S. investments because of adverse market, currency, economic, industry, political, regulatory, geopolitical, or other conditions.

Please see the applicable prospectus for further information on these and other risk considerations.

The portfolio is actively managed, and current holdings may be different.

Index data source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

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