Portfolio Manager's Commentary
Second Quarter 2012
Investors shifted into a “risk off” mode in the second quarter as macro-economic data throughout the world continued to deteriorate. There are recessions across most of Europe, a softening economy in the U.S. in which gross domestic product growth is less than deficit growth, and slowing growth in emerging economies.
Fund Performance
Portfolio 21’s second-quarter performance trailed that of the MSCI World Equity Index, as returns were inhibited by a lower-than-benchmark allocation to U.S. equities. Being overweight cyclical economic sectors also detracted from fund performance. This was somewhat offset by an under-allocation to the energy and financial services sectors. Portfolio 21 lost 6.4% for the first quarter, while the MSCI World declined a lesser 4.85%.
Fund operating fundamentals tells a more heartening tale of performance. Portfolio 21 companies as a group have experienced above average earnings growth statistics, as well as higher returns-on-equity. Five-year geometric earnings growth for Portfolio 21 based on the latest company filings was 7.63%, compared with 6.22% for the MSCI World. Return-on-equity was 23.85% for Portfolio 21 and 22.26% for the MSCI World. Long-term earnings growth estimates are also above benchmark. Given the current structure of the fund and forward looking earnings estimates, the average price-to-earnings ratio of Portfolio 21 drops below that of the MSCI World over the next twelve months. For fiscal year 2014, Portfolio 21’s price-to-earnings ratio is nearly a full point below the benchmark, 10.49 versus 11.30. We believe this relatively conservative tilt will provide some stability amid economic calamity and the growth statistics leave the fund well-positioned once global equity markets turn higher ahead of economic improvement.
See Portfolio 21's complete standardized performance. Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling 877.351.4115.
Performance data quoted does not reflect the 2.0% redemption fee on shares held less than 60 days. If reflected, total returns would be reduced.
Sector Performance
The most dull and conservative assets outperformed during the second quarter as investors’ risk aversion accelerated. Nearly every MSCI economic sector lost value over the period as corporate profit growth slowed because of a slump in Europe and slowing growth in China. The telecommunication services and health care sectors managed to eke out a slight gain as investors emphasized conservation over growth. Telecommunication service stocks are perceived to offer stability during an economic downturn. Portfolio 21’s telecommunication service stocks underperformed the MSCI sector group due to a sharp decline in Telefonica shares over debt servicing concerns. The health care sector was boosted by the U.S. Supreme Court’s decision to uphold the Affordable Care Act, although U.S. managed care providers were the prime beneficiaries. Biotechnology stocks also performed very well over the period. Portfolio 21 healthcare stocks didn’t quite meet benchmark sector performance, owing to a first-quarter earnings miss at Waters and a delayed Food and Drug Administration (FDA) approval for a key drug at Baxter International. Fund healthcare stocks gained less than 1%, while the MSCI sector group returned just over 2%.
Overweighting cyclical economic sector detracted from fund performance during the second quarter. The materials and information technology sectors were the worst performing economic sectors within the MSCI World in the second quarter. The energy and financial services sectors weren’t far behind.
The materials sector was pressured by falling commodity prices. Commodity futures fell on concern that Europe’s debt crisis would worsen and economic growth in China would slow further. Cautious statements out of BHP Billiton, the world’s largest mining company, also played a part. BHP put the brakes on a plan announced by CEO Marius Kloppers in 2011 to spend $80 billion over five years to expand its iron ore, coal, energy, and base metals divisions, banking on continuing high demand from its main market, China. Portfolio 21 materials stocks performed better than the MSCI sector group as the economically resilient Ecolab more than offset metals-based Umicore’s decline.
Hopes for a surge in earnings for the technology sector faded during the second quarter, as did technology stock performance. Several earnings reports from prominent technology companies painted an uncertain picture of future technology spending. Portfolio 21 holdings were among those companies, including Autodesk and NetApp. Still, fund technology performance kept pace with the MSCI sector group.
The financial services sector lost in the second quarter after rating agency downgrades on financial services companies across the world. The focus was on banks and securities companies with global capital market operations, as part of its broad review to account for sluggish economic conditions and tougher regulations. Increased regulatory constraints are just beginning to impact large financial institutions. Higher capital requirements along with restrictions on proprietary trading will likely crimp earnings growth in the second half. Central bankers aren’t helping either. Federal Reserve officials affirmed their projection that subdued inflation and economic slack probably will warrant low rates through late 2014. That cuts into net interest margins for lenders. So far, bank earnings are raising plenty of questions and yielding few answers about the road ahead. Most of the big banks reported higher-than-expected revenue growth in the first quarter. While this seems positive, the banks exceeded revenue estimates mostly because they scaled down future loan loss coverage. Global investment banks are bracing themselves for a dismal second half, with further cuts in costs and staff, after a sharp drop in deal-making and capital markets activity probably pushed down fees in the second quarter. Portfolio 21 is underweight financials and fund performance was in line here, resulting in a positive contribution to portfolio return for the period.
The MSCI World Energy Index declined amid the transformation of an industry where growing consumption of energy has been met with even bigger gains in supply. Oil prices tumbled as U.S. inventories surged. Oil demand in the U.S., the world’s largest consumer, is expected drop for a second year in 2012. The U.S. Energy Information Administration raised its projection for global oil consumption this year but slashed its forecast for the pace at which demand will grow in 2013 due to expected "flat" demand from developed nations. Energy companies are the only U.S. industry where earnings forecasts have been revised from growth to contraction in 2012. There are no energy companies in Portfolio 21, therefore performance contribution was positive.
Position Performance
Several Portfolio 21 stocks made significant positive contributions to net returns during the second quarter. Portfolio 21’s largest holding, Novo Nordisk, rose even as earnings growth slowed in the latest quarter, although margins remained strong. Novo Nordisk raised guidance for 2012 and is ramping its salesforce in U.S. to support new product launches. United Natural Foods climbed after the company beat third-quarter earnings expectations on strong sales momentum and operating margin expansion. The company is about to start the roll-out of its new warehouse management system, which should drive incremental savings going forward. Ecolab gained after reporting strong first-quarter sales and earnings, benefiting from the substantial contribution from its acquisition of Nalco. The stock was also boosted by an agreement to allow two entities controlled by Bill Gates to raise their stake to 25%. Shares of eBay appreciated double-digit percentages over the period. Its recent performance has been driven by improvements in marketplace trends and growth at payments segments. Sales and earnings were stronger than expectations with the upside driven by Paypal acceleration. Quanta Services rose on several transmission and power generation contract awards. The company also reported quarterly earnings that surpassed analyst expectations on robust revenues and margins, while backlog rose to another record. National Grid gained as investors sought safe-haven assets with geographic exposure in the U.S. and UK. Stronger than expected returns in the company’s U.S. business outweighed pending regulatory concerns in the UK. Roche, Novartis, Natura Cosmeticos, Vodafone, and Ormat also contributed positively to fund performance during the second quarter.
Several Portfolio 21 stocks acted as a drag on fund performance during the second quarter. Google’s stock was pressured by a new stock structure, which gives management more control, as well as Apple’s announcement of a new mapping service that replaces Google maps. Shares of Nike tumbled after fourth-quarter profit unexpectedly declined for the first time since 2009 as marketing costs increased and sales growth slowed. Recessions in parts of Europe and slowing growth in China weighed on future orders. Baxter International fell after the FDA asked for more information about a promising hemophilia treatment, known as HyQ. Eaton has fallen since the announcement of its acquisition of Cooper Industries as investors fear that the company is acquiring the business at the peak of the cycle and is therefore overpaying. Storage server maker and cloud computing company NetApp reported results that beat Wall Street forecasts, but its feeble outlook sent its shares diving. Cisco, Telefonica, Autodesk, Staples, and SKF also weighed negatively on fund performance during the second quarter.
Outlook
Global equity markets seem to be trading on hopes for additional monetary stimulus rather than expectations of profit growth or other fundamentals. We calculated that the amount of money thrown at rescuing the world economy since the “Great Recession” is probably more than $14 trillion, and the spigots are still open. All of this money helped to cushion the economic blow worldwide from collapsing house prices in the United States and parts of Europe, bank failures, and the steep contraction in business and household spending. With the U.S. recovery faltering, China slowing, and prospects for Japan and the eurozone worsening, there are growing calls for action from more central banks. With widespread signs of economic weakness, and further deterioration probable in the coming months, it is unlikely that we will experience meaningful economic traction this year. Once the troubled eurozone economies are able to realize deficit cuts without too much economic pain, and China is able to keep growth from slowing significantly, we could see improving economic fundamentals, possibly as early as 2013. Otherwise, we could be in for a longer period of sluggish global economic growth.
Over the next few quarters it is reasonable to expect the austerity push in Europe, the ongoing lack of clarity surrounding the regulatory and fiscal policy outlook in the U.S., and slowing growth in China to drag on demand. This will have a negative impact on corporate earnings and implies declining equity markets. However, in the current investment climate, weaker economic data has been followed by an aggressive monetary policy response from the central banks and a buoyant stock market reaction. It has become apparent that there's little global policymakers can do to counteract a global economic slowdown at present. But with all of the excess liquidity in the world economy, and the potential for more, it is likely just a matter of time before financial capital is effectively deployed and global economic growth rebounds. The question is—when will consumers and businesses feel confident enough to increase spending and investment.
Nobody knows when the crisis will end in Europe. Most predict it will get worse before it gets better. If Greece drops out of the euro currency group this year, as analysts worry it will, it could spread havoc throughout the financial system. And Europe's underlying problems—slumping economies, deep debt burdens and ever-rising interest rates—could take years to fix. The European Central Bank has indicated that it is now open to follow the path of the Fed and could provide upside in the near term.
The slowdown in Europe has been a greater drag on the U.S. economy than the softening in China to date. With the eurozone on the cusp of a deep recession, this trend may even become more pronounced. On the plus side, hydraulic fracturing has given the U.S. the world's cheapest natural gas, and has arguably been the greatest single stimulus to economic growth and competitiveness over the past few years. Cheap and plentiful energy supplies should continue to provide economic gas for some time to come. Assuming the U.S. escapes a double-dip recession, equity prices could trend higher, while interest rates stay stuck near zero.
The Chinese economy is expected to expand around 7.6% in the second quarter from a year earlier, its sixth straight quarter of slowing growth and its weakest performance since the 2008-2009 financial crisis. If the economy continues to weaken, and there is indication that the Chinese government could miss its official target, there will likely be more stimulus measures. An economy dependent on fixed-asset investment like China’s is at risk of prolonged slowing growth, even recession, as capital investment climate worsens.
Country Performance
World Equity Markets
Investors shifted into a “risk off” mode in the second quarter as macro-economic data throughout the world continued to deteriorate. There are recessions across most of Europe, a softening U.S. economy in which gross domestic product growth is less than deficit growth, and slowing growth in emerging economies. The MSCI AC World Index staged a rebound from period lows in June, after a dismal April and May, on speculation that central bankers would make further moves to stimulate the global economy, which suggests that the global economy can’t manage to grow without ongoing life support from central banks and governments. The MSCI World Equity Index depreciated more than 6% in the second quarter; the total return of the index was -5.36%.
Global policymakers have woken up to the critical nature of the crisis and are taking more dramatic steps. Another round of loosely correlated global stimulus is underway after the Federal Reserve extended its Operation Twist program. In the U.S., there is confidence Ben Bernanke will add the Fed's firepower to any liquidity push. ECB President Mario Draghi said the ECB "will continue to supply liquidity to solvent banks where needed" and central bankers in the UK, Japan, and Canada made similar pledges. European stability programs were expanded at quarter end to enable ECB bank and eurozone bonds buying and central banks across the globe cut interest rates during the second quarter.
North America
Money seeking a safe haven found it in America’s deep and liquid bond and equity markets during the second quarter, helping the S&P 500 Index outperform most major market counterparts. Still, U.S. stocks slid after the Federal Reserve signaled it may refrain from more monetary stimulus. A third round of quantitative easing now seems less likely, unless the U.S. economy takes a turn for the worse or the Fed becomes more concerned about the conditions in Europe. While monetary stimulus has had the desired result lower bond yields and higher equity prices the Fed's actions are not really fueling actual economic activity yet. While the U.S. may avoid a double-dip recession this year, the risks of a sharp slowdown are clearly growing. Fed officials lowered their estimate for U.S. 2012 GDP growth to 1.9% to 2.4%. Economists agree that tax hikes and spending cuts will drag down economic growth in 2013. The U.S. economy is facing a “fiscal cliff” looming in January 2013, when substantial spending cuts and tax increases are scheduled to go into effect unless Congress acts. The Congressional Budget Office (CBO) forecast the economy would shrink 1.3% in the first half of 2013 before expanding 2.3% in the second half if policy isn't changed. The CBO said that the economy could grow 4.4% in 2013 if this policy is changed.
The U.S. economy expanded at a 1.9% annual rate in the first quarter, after a 3% pace during the fourth quarter, as consumer spending more than offset lower government spending. While the economy has been growing for three years, the recovery is the worst in the post-war era. The sovereign-debt and banking crisis in Europe, as well as slowdowns in Brazil, China, and India, are combining to depress exports and suppress the U.S.’s economic recovery. The U.S. economy may continue to struggle for the next few quarters as some business owners wait for the national election before making investments. A drop in gasoline prices obviously helps with consumer finances. However, even with the drop in gasoline prices, consumers don't seem as much in a spending mood as they were earlier this year. Income growth is scant and the labor market is clearly deteriorating. Many are concerned that U.S. unemployment is now structural, stemming from technology advances and the lack of retraining. Portfolio 21 returns were inhibited by a lower-than-benchmark allocation to U.S. stocks. Furthermore U.S. stocks in the fund underperformed as a group due to a higher weighting of economically-sensitive holdings.
Canada’s economy is being hindered by a slowing global economy, which has cut prices of commodities, the country’s main exports. Canada reported that its economy grew at a 1.9% annualized pace in the first quarter, less than the central bank’s 2.5% April estimate, as consumer spending slowed. More recent data have shown domestic strength. Still, Canada faces a shock to its financial system and economy if Europe’s crisis worsens. While Canada’s financial system has fared well and conditions in the country remain stimulative, deepening turmoil in Europe may boost funding costs for the nation’s banks and generate losses from assets linked to the eurozone.
Europe
The Bloomberg European 500 Index fell on concern about unresolved problems in Greece and the lack of a comprehensive plan for the eurozone as a whole. The eurozone appears to be in a deepening and broadening recession. Europe’s economies are faltering as austerity measures across the region undermine hiring and consumer confidence. The unemployment rate reached the highest level on record and manufacturing output contracted for an eleventh straight month in June. The eurozone narrowly avoided a recession in the first quarter of the year, despite a raging debt crisis that's raising the specter of the breakup of the currency union. Germany, Europe's biggest economy, was behind the better-than-expected performance as strong export figures helped. Still, huge economic disparities exist across the single currency bloc. Of the euro's seventeen members, seven are in recession: Ireland, Greece, Spain, Italy, Cyprus, the Netherlands, Portugal and Slovenia. Portfolio 21 is equal-weight eurozone stocks and fund stocks performed better than their European peers. French and Dutch stocks in the fund outperformed the most.
The European Financial Stability Facility and its successor, the European Stability Mechanism, were expanded in scope to lend directly to banks and, via the European Central Bank, buy eurozone bonds in the primary and secondary markets. While that addresses some of the main problems in relieving Greece and other nations of onerous debt burdens, questions remain regarding implementation. The latest measures to address Europe's debt crisis are an important step forward, but more may be needed. There may be a limited break-up of the euro-zone, with Greece and one or two other smaller countries leaving this year or next. The hope is that policy-makers will manage the process well enough to keep the rest of the union together. However, the effects of a euro crash on the financial sector and the global economy would be destructive.
The IBEX 35 Index plummeted on concerns over Spain's ability to finance its deficit and debt with borrowing costs on the rise. Cheap money provided by the ECB’s two long-term refinancing operations cooled off Spain's borrowing costs, but the effect has faded and bond yields continued their climb in the second quarter. Spain is struggling to bail out banks that made reckless loans during a real estate boom and are now suffering mounting losses. Europe hopes that a bailout, worth up to €100 billion that will be distributed to Spain’s weakest banks, can resolve the problem. Spain is already struggling to sell its government bonds to anyone other than its own banks; the sudden increase in debt could completely cut it off from private financing. The Spanish economy has slipped into its second recession since 2009 and the government forecasts it’ll contract 1.7% this year, as the government implements deep measures in an attempt to rein in its budget deficit and win back investor trust. Portfolio 21 holds two Spanish stocks in the fund, Red Electrica and Telefonica, both of which declined less than the MSCI country group in the second quarter.
The formation of a coalition government has reduced the chances of Greece exiting the eurozone, but the political situation remains precarious. A new administration in Athens, and signs that European Union leaders are willing to loosen Greek austerity measures, failed to convince bond investors that the country will be able to return to the market before its second bailout ends in the next three years. Germany signaled it may be willing to grant Athens more time to meet its fiscal targets to avert a catastrophic euro exit. Although giving Athens an additional year to achieve its deficit reduction goals means increasing the size of the eurozone’s bailout, which would raise the commitment by countries such as Germany, the Netherlands, and Finland where voters are deeply reluctant to approve further funding. Either Greece is going to leave the eurozone, or it's going to have to accept austerity as a price of remaining a member. While a departure would generate chaos in the short term, a newly traded drachma would be able to devalue against other currencies and return Greece to growth. The Greek economy has shrunk more than 13% over the past three years and the Athens stock market has lost more than two-thirds of its value. Portfolio 21 does not invest in Greek assets.
Italy’s debt dynamics are precarious and Italian asset prices reflected concern during the second quarter. Italy’s national debt is 120% of its GDP, second only to Greece among eurozone countries. Moody’s Investors Service downgraded the credit standing of 26 Italian banks in May and Moody’s warned that Italy’s most recent economic slump was creating more failed loans and making it very difficult for banks to fund via short-term borrowing. Because they have yet to experience a colossal real estate bust, Italian banks have long been viewed as healthier than their bailed-out counterparts in Ireland and Spain. But as economic activity came to a near-halt, rising bad loans and a possible flight of deposits are posing a new threat to banks that already were barely getting by on thin cushions of capital. Portfolio 21 divested its sole Italian stock holding, Enel Green Power, due to financial trouble at its parent company.
The German economy is clearly slowing down and a contraction in the second quarter is possible. Germany's manufacturing sector shrank in June at the fastest pace in three years, with new business intake dropping for the 12th month running. Industrial production and factory orders are trending lower, unemployment climbed for the fourth month this year, and business confidence fell to the lowest in more than two years in June as the worsening sovereign debt crisis clouded the economic outlook. Germany helped the euro area avoid its second recession in three years in the first quarter as growth in the region’s largest economy offset contractions in peripheral countries. Growth was mainly driven by net trade as exports rose. German stocks in Portfolio 21 performed in line with the MSCI country group as Henkel outperformed and Siemens underperformed.
France’s GDP failed to grow in the first three months of the year and the Bank of France predicted that Europe’s second-largest economy may shrink in the current quarter for the first time since the nation exited recession in 2009. The lack of growth means that budget cuts will probably have to be deeper than previously estimated. The recently sworn in President of France, Francois Hollande, wants to grow Europe out of its financial problems. However, this means stimulating economies, a process that requires deficit spending. French stock returns in Portfolio 21 were better-than-benchmark thanks to a strong showing from L’Oreal and Unibail-Rodamco.
Swiss economic growth unexpectedly accelerated in the first quarter to the fastest pace in one and a half years, led by consumer demand. Economists had forecast the economy would stall. The economy may struggle to gather strength after the euro region’s fiscal crisis pushed countries from Italy to Spain into recessions, eroding export demand. Swiss National Bank Vice President Jean-Pierre Danthine said that while the franc ceiling introduced by the central bank in September has decreased recessionary risks, policy makers are ready to take further measures if needed. Economists expect Swiss GDP to rise 0.9% this year and 1.9% in 2013 as consumers step up spending and exports rebound. Portfolio 21 is overweight Switzerland and fund stock performance was driven by positive returns from Roche and Novartis.
Sweden’s bonds have offered a haven from Europe’s debt crisis as investors turn to markets backed by healthy public finances. Government debt is predicted to narrow to 34.6% of GDP this year, compared with a euro-area average of 90.4%. Sweden escaped a recession last quarter after consumers and businesses drove growth in the largest Nordic economy. Annual GDP growth accelerated to 1.5% from a revised 1.0% at the end of 2011. This shows that Sweden is incredibly resistant and not just an export-country, but also a strong domestic economy. Swedish economic growth is expected to pick up to 3.3% in 2013, according to government forecasts. Denmark will also outgrow the euro region average this year and next, even as the Nordic country fights to contain the fallout of a burst property bubble and regional banking crisis. The Organization for Economic Cooperation and Development predicted in May that GDP will expand 0.8% this year and 1.4% in 2013. Portfolio 21’s Swedish stocks underperformed as industrial company stocks suffered after the recovery in the Swedish industrial economy leveled off. Copenhagen listed stocks in Portfolio 21 outperformed. Fund Swedish stocks underperformed the MSCI country group by a hair, as a result of a sell-off in industrials, while fund Danish stocks returned more than MSCI peers thanks to another solid showing from Novo Nordisk.
The FTSE 100 Index dipped after the UK economy fell into its second recession since 2009 in the first quarter amid spending cuts. Government spending cuts along with anemic wage growth are squeezing consumers, creating a drag on the recovery and the prospects for growth are cloudy. UK manufacturing has fallen more than economists forecast, pointing to continued weakness in the economy at the start of the second quarter. The International Monetary Fund has called on the Bank of England to cut interest rates and resume printing money to boost demand in the economy. The Bank of England is putting together a plan to inject inexpensive liquidity into the banking system to increase loans and avert a credit crunch. Portfolio 21’s UK stocks bested their MSCI counterparts by a wide margin as National Grid, SSE, and Vodafone appreciated.
Developed Asia
The Nikkei 225 Stock Index was among the worst performing of the major market equity indices during the second quarter, despite Japan’s economy expanding at a faster than estimated annualized pace of 4.7% in the first quarter. GDP was boosted by reconstruction spending. The government’s ¥20 trillion in spending to rebuild areas devastated by the disaster has supported three straight quarters of economic growth. The risk now is that Europe’s debt crisis and strength in the yen will cut exports and damp the recovery as the boost from public spending fades. Economists expect growth to slow to 2% in the second quarter and 1.6% in the third, supported by domestic demand. Japan’s Prime Minister Yoshihiko Noda risks stalling the economy in 2014, when the first increase will take effect, by pushing through a higher sales tax that may curb consumption. Population decay will also inhibit growth. Japan’s population fell by a record last year, underlining the struggle to boost growth and rein in soaring welfare costs in the world’s most rapidly aging society. Japan faces a shrinking workforce as 2012 marks the first year the nation’s baby boomers are set to retire. Japanese GDP has contracted three of the past four years and policy makers have said low growth is mainly the result of demographic changes. Fitch cut Japan's sovereign credit status to A+, the lowest level among global ratings agencies, as a political stalemate dims the chance that the country can curb its snowballing debt. Fitch warned further downgrades were possible unless the government takes new fiscal policy measures to stabilize public finances and its ratio of debt to GDP. Gross public debt is expected to reach 223% of GDP next year, up from the projected 214% in 2012. Portfolio 21 is underweight Japanese stocks, while fund stocks outperformed the benchmark.
Singapore’s economy grew by a better-than-forecast 10% in the first quarter, spurred by an upturn in the manufacturing sector. Asia’s 10th largest economy relies heavily on manufacturing, which accounts for about 27% of GDP. Singapore’s rebound prompted the central bank to unexpectedly tighten monetary policy by allowing faster currency gains to contain inflation. However, exports have recently dropped amid a decline in demand from China. A stronger Singapore dollar, the best performer in Asia this year, may also weigh on export orders as the currency appreciation makes the island’s goods more expensive overseas. The FTSE Straits Times Index returned a negative 3.10% during the second quarter. Portfolio 21’s Singapore stock performance was much worse, inhibited by an 11% drop in value of Capitaland.
South Korean officials are trying to sustain momentum in Asia’s fourth-biggest economy after the fastest growth in a year in the first quarter, boosted by government spending and investments by semiconductor chip makers. However, an index of manufacturers’ confidence fell to the lowest level in four months in June, and a gauge of non-manufacturing companies also declined. A slowdown in China and the European debt crisis are clouding the outlook for exports, which account for about half of GDP. The Bank of Korea lowered its economic growth forecast for this year to 3.5% on slowing exports. South Korea plans to boost public spending by more than $7 billion this year to support the flagging economy as it faces strong headwinds from Europe’s debt crisis and China’s economic slowdown. Portfolio 21 holds shares of Samsung Electronics. The stock fell less than the KOSPI Index of the Korean stock exchange, losing 5.80%, versus a near 8% drop in the index.
Australia’s economy is forecast by the International Monetary Fund to overtake Spain as the 12th biggest this year. GDP expanded at a 4.3% annualized pace in the first quarter, the fastest since the third quarter of 2007. Driving Australia’s economy is demand from developing nations, including China and India, for iron ore, coal, and natural gas. However, Australia’s central bank cut interest rates in June, citing Europe’s crisis and moderating growth in China. Portfolio 21 does not hold any Australian stocks at present.
Emerging Economies
Investors fled the BRIC (Brazil, Russia, India, and China) equities in the first quarter after Brazil’s consumer default rate rose, prices for Russian oil exports fell, India’s budget deficit widened, and Chinese home prices slumped. Many are bracing for more losses as economic growth slows. Economists have long suggested that strong growth in Brazil, Russia, India, and China will compensate for feeble growth in developed economies, but that idea is increasingly being questioned. If Greece leaves the eurozone this year there could be a sudden stop in capital flows to emerging markets.
The Bovespa Index declined more than 15% in the second quarter as economic growth in Brazil has been growing more slowly than anticipated. Policy makers have reduced the benchmark Selic rate by 400 basis points since August, while banks cut their lending rates to help boost economic growth that slowed to 2.7% last year from 7.5% in 2010. Brazil’s central bank signaled it will continue to cut interest rates to bolster a sluggish economy, as Europe’s debt crisis worsens and inflationary risks remain low. The government has also unveiled additional spending stimulus measures and cut taxes on industrial and consumer goods, including automobiles, to stimulate consumer spending. The government has said that rising real wages, falling interest rates and low unemployment will continue to drive domestic demand and accelerate economic recovery in the remainder of the year. Economists expect the Brazilian economy to grow just over 2% this year and around 4% in 2013. Brazilian stocks in Portfolio 21 outperformed the Bovespa thanks to an 18% rise in Natura Cosemeticos shares.
India’s benchmark stock index fell to near its lowest level this year as the rupee’s decline to a record renewed concern the government will find it difficult to control inflation and the fiscal deficit. Standard & Poor's cut India's credit rating outlook to negative from stable, reflecting the toll that hefty fiscal and current account deficits and political paralysis are exacting on the economy. The negative outlook jeopardizes India's long-term rating of BBB-, the lowest investment grade rating. India has no sovereign global bond issues, but a downgrade would increase borrowing costs for local companies and make it harder to refinance debt, and may have a further chilling effect on foreign investor confidence in the country in general. The Reserve Bank of India slashed its benchmark interest rate, seeking to bolster growth with the first reduction since 2009. Inflation might limit the room for further cuts. India’s economic growth weakened to a nine-year low in the first quarter, hurt by an investment slowdown. The Reserve Bank projects 7.3% growth in 2012-2013, driven by the spending power of 1.2 billion people. Portfolio 21 doesn’t hold any Indian stocks.
The Shanghai Stock Exchange Composite Index and the Shenzhen Stock Exchange Composite Index both ended the quarter in positive territory, despite disappointing data, on the hope that the poor first-quarter showing would be enough to spur more assistance from Beijing. After three decades of 10% annualized growth in GDP, the Chinese economy is braking. Chinese GDP increased 8.1% in the first quarter, the smallest gain since 2009. China’s slowdown may deepen as policy makers unwind the excesses of a record credit boom. The World Bank cut its 2012 China growth forecast to 8.2%, the least since 1999. It said a gradual slowdown was unfolding amid a sharp deceleration in investment growth, softening consumption growth, and weak global demand. China's mixed message about economic stimulus suggests the government is trying to avoid fueling inflation and stressing local-government finances, as it did with a massive stimulus program in 2008. The government is trying to strike a better balance between stabilizing growth in the short term and adjusting structure in the long term. China’s central bank pledged to ensure adequate availability of cash in the financial system. In June, China also cut borrowing costs for the first time since 2008 and loosened controls on banks’ lending and deposit rates. However, optimists may be placing too much faith in the ability of Chinese policy makers to cushion the world’s second-biggest economy from slumps in investment and real estate, the largest drivers of growth. China’s manufacturing activity continued to deteriorate in June and investment in real estate, which directly accounts for about 13% of GDP, has dropped precipitously in the past few months. Portfolio 21 has positions in two Hong Kong listed stocks, China Mobile and MTR Corporation, both of which outperformed the Hang Seng Index.
Currency Performance
North American Currencies
The U.S. dollar appreciated against major market currencies, with the exception of the Japanese yen, as central banks rebuilt foreign exchange reserves at the fastest pace since 2004. Reserve banks crowded out private investors seeking U.S. dollars, boosting demand even as the Federal Reserve considers printing more currency. While the Fed has created more than $2 trillion under its stimulus programs since 2008, the flows signal that there may actually be a shortage of dollars to meet demand as Europe’s debt crisis deepens and the global economy slows. Portfolio 21 is underweight U.S. dollar denominated assets as the fund holds a higher than benchmark concentration of foreign stocks.
Longer-term structural issues could begin to weigh on the U.S. dollar at some point. The nation's Social Security and Medicare programs are sliding closer to insolvency, presenting serious fiscal challenges for the retirement programs as baby boomers begin to retire. The trustees of the Social Security program reported in April that the program projects a $165 billion deficit in 2012. The CBO warned that U.S. debt will exceed the size of the nation’s economy in 25 years if the federal government doesn’t chart a “sustainable” fiscal course. In its 2012 long-term budget outlook, the CBO indicated that extending current tax rates and rising healthcare costs would push the debt to almost 200% of GDP in 2037. Still, the U.S. is a long way from being viewed similarly to the peripheral eurozone nations.
Canada’s dollar weakened versus its U.S. counterpart on speculation the worsening European debt crisis is hampering demand for the nation’s raw materials. The currency declined against the majority of its major peers on concern that crude oil, the nation’s biggest export, will weaken below $80 a barrel.
European Currencies
The euro slipped toward a near two-year low against the dollar on concerns about Spain's and Italy’s soaring borrowing costs. The euro depreciated 5% against the U.S. dollar in the second quarter. Worries over the implications of Greece’s potential exit from the shared currency also contributed to the decline. Many traders expect further downside in the euro as they fear troubles at Spanish banks may continue to complicate Madrid's efforts to rein in its debt and austerity-driven spending cuts and drag the region into recession. Portfolio 21’s exposure to the euro is equivalent to the MSCI World Equity Index at 13%.
The Swiss National Bank said last September it wouldn’t allow its currency to appreciate beyond 1.20 per euro. Since then, the franc has traded between 1.2474 and 1.1990. The Swiss central bank pledged to keep defending its franc cap and left borrowing costs at zero to protect the economy from euro crisis related risks. Portfolio 21 is overweight the Swiss franc, attributable to sizeable positions in Roche and Novartis.
The British pound has become a favorite refuge from the resurgent European debt crisis. The sterling was the best performing European currency during the second quarter, although it still managed to log a near 3% decline on the U.S. dollar. The pound fell after the UK economy unexpectedly slipped back into recession and later rallied after minutes from the Bank of England’s latest meeting showed the central bank was less inclined to expand its bond-buying program. Portfolio 21 is underweight the British pound.
The Swedish krona slumped against the dollar as investors dumped less liquid currencies amid crisis concerns. The Swedish krona strengthened against the euro after a government report showing the economy returned to growth in the first quarter boosted demand for the country’s currency. The krona lost 4.4% on the U.S. dollar. Portfolio 21 is overweight the Swedish currency. Swedish companies account for a significant part of the fund’s European industrial sector exposure.
The head of Denmark’s central bank warned that the Danish krone is coming under intense pressure from investors seeking a haven in Europe and betting that the currency’s peg to the euro could be cracked by the crisis. Denmark’s central bank lowered its benchmark rate by 0.15%, easing policy for the second time this month to defend the Nordic country’s currency peg. Denmark’s debt yield has sunk to record lows as investors fleeing the euro area turn to markets backed by fiscal discipline. Demand for kroner helped send two-year yields below zero as investors pay the government to hold its bonds. The central bank signaled last week it is willing to let rates go negative to defend the peg. Portfolio 21 is overweight the krone due to positions in Novo Nordisk and Novozymes.
Yen
The yen was the best performing currency in the second quarter, rising nearly 4% on the U.S. dollar. Investors pushed the yen toward a post-World War II high, countering attempts by the Bank of Japan to weaken the currency. As long as Europe remains in a state of confusion, the yen may continue to be bought for its relative safety. The yen tends to strengthen during economic and financial turmoil because while it has the world’s most debt, the current-account surplus makes the country less reliant on foreign capital. Portfolio 21 is underweight the yen.
Emerging Currencies
The largest emerging markets are inhibiting portfolios and profits as their currencies depreciated the most since at least 1998 during the second quarter. Of the BRIC currencies, the real, ruble, and rupee have weakened the most among developing-nation currencies, while the yuan has depreciated more than in any other period since its 1994 devaluation. Just three months ago, emerging nations were intervening in foreign exchange markets to make exports more competitive. Now they are selling dollars to stem currency declines and mitigate inflation. Portfolio 21 has direct exposure to the real through several equity holding domiciled in Brazil, but no direct exposure to the ruble, rupee, or yuan.
China's central bank doubled the trading band within which the yuan can fluctuate against the U.S. dollar. Under the policy, the yuan can rise and fall as much as 1% from the daily rate fixed by the People's Bank of China, the first widening since 2007.
Brazil’s government and central bank, worried by the damaging economic impact of high interest rates and an overvalued currency, took steps over the last year to weaken the real and loosen monetary policy. Brazil is rolling back curbs on foreign capital after the real posted the biggest loss of any major currency this year. The real weakened more than 9% against the U.S. dollar in the second quarter.
India’s leaders are worried about the pressure the rupee's collapse is putting on businesses trying to pay off foreign loans. The Indian rupee has borne the brunt of sharp fall in capital inflows due to concerns over proposed changes to India's tax laws. These have exacerbated jitters over India's wide fiscal deficit and the current account deficit. The rupee lost 8.5% against the U.S. dollar in the second quarter. India's central bank moved aggressively to halt a sharp slide in the rupee, imposing foreign-exchange restrictions on companies and tightening trading rules for banks, but analysts said the measures may not be enough to reverse the currency's trend.
Trading Activity
We established several new positions during the second quarter. We bought shares in Xylem, a pure play water company and a recent spin-off from ITT. Xylem has a strong global presence with a large distribution network. Growth has accelerated in both energy and emerging markets where the need for water infrastructure is booming. We believe the company will also be able to increase margins as its revenue base expands. We also diversified our financial holdings by initiating a position in Jones Lang LaSalle. Jones Lang is a financial and professional services firm specializing in real estate. The company offers integrated real estate and investment management services on a local, regional, and global basis to owner, occupier, and investor clients. We like the fact that they can handle all of a customer’s real estate needs and that they have global reach. We diversified our healthcare holdings by adding Covidien and Quest Diagnostics to the fund. Covidien is a niche product company that invests heavily in research and development and has a direct sales presence in over 50 countries. Covidien is a market share leader in nearly all of its product lines and some newly released products have the potential to contribute significantly to growth. Covidien’s impending pharmaceutical spin-off should unlock value, as the company ex-pharma will have higher margins and growth rates. Quest Diagnostics is the leading independent provider of diagnostic testing, information, and services in the U.S. The company generates about 90% of its revenue through clinical testing, anatomic pathology, esoteric testing, and substance abuse testing at its national network of 2,000 patient service centers. With health care costs continuing to increase, providers are looking to Quest to provide preventive screening to lower costs over the long term. The company’s recent acquisition of Celera increases its presence in the growing field of gene-based testing. We added two companies in the electric utility infrastructure field to the fund, ITC Holdings and Quanta Services. Investing in electric utility infrastructure is our preferred way to participate in renewable energy growth. The electrical grid is in need of upgrading, and the increasing penetration of variable and distributed resources, such as solar and wind power, require further grid improvements to link them to end users. ITC Holdings operates the largest independent electricity transmission company in the U.S. ITC also develops new transmission through ITC Grid Development. The company has announced a merger with Entergy Corporation’s transmission assets that, pending regulatory approval, is expected to close in 2013. ITC is widely recognized for the emission reduction progress made at its network and operations. Quanta Services is the largest specialty contractor serving electric and natural gas utilities, providing engineering, procurement, construction, and maintenance services, as well as Dark Fiber leasing and telecom and network infrastructure services. Electric power and telecom projects are benefiting from Recovery Act stimulus. As this stimulus fades, the company’s natural gas segment should pick up as shale and Canadian oil sands drive pipeline build-out. Quanta is also diversifying its power plant construction services into small simple cycle and combined cycle gas turbine power plants. Furthermore, the Renewable Portfolio Standards implemented in 30 states across the U.S. should continue to drive Quanta’s renewable energy business. Finally, we established an initial position in Unilever. We have been watching the company for a while and have been impressed on all fronts. Management is clearly focused on the long-term and the CEO, Paul Polman, is an outspoken advocate for sustainability in all areas of the company. We have been unintentionally underweight consumer staples in the fund and Unilever will help fill the gap.
We sold some fund holdings in the second quarter as we cut risk from the portfolio. We sold our small position in Schnitzer Steel. We were concerned that the company’s business model is fundamentally deteriorating due to an increase in Asian scrap. We sold Electrolux on valuation concerns. The stock was trading a sizeable premium over its chief competitors, Whirlpool and LG, and a weaker krona will weigh on margins in the near term. Furthermore, appliance sales in Europe and the U.S. remain under pressure and demand is likely to weaken in Latin America and Asia as emerging economy growth slows. We sold SMRT Corp as company’s latest capital expenditure plan puts the dividend in jeopardy. SMRT is boosting spending amid a government inquiry into a rail system breakdown in December and subsequent service disruptions. Our investment thesis was predicated on increasing commuter traffic, a stable share price, and a high dividend payout policy, which was implemented under its previous CEO. While we remain optimistic about commuter traffic, a stable share price and the current dividend policy are at risk. We sold Cia Saneamento Basico do Sao Paulo (SABESP). SABESP faces significant regulatory risk. Any further appreciation, or depreciation, will be mostly related to the expected Regulatory Asset Base, which will be shortly announced by the State Water Regulator. We prefer to take our stake off the table in anticipation of an unfavorable tariff reset. We also sold Hyflux as earnings are choppy and dependent on large long-term contract wins, which have been elusive in recent times. Furthermore, some projects in the Middle East and North Africa have been cancelled due to unrest in the region. We sold our position in Enel Green Power. Financial troubles at its parent, regulatory risk, lower oil prices, and slow economic growth will likely continue to plague the company in the near term. Having built up goodwill over decades through community work, dependable products, and the textbook handling of the 1982 Tylenol crisis, Johnson & Johnson has fallen hard. Recent years have been filled with ongoing drug recalls, manufacturing gaffes, lawsuits, and government probes. It became obvious that management was oblivious to the systemic nature of the problems and had no plan in place to deal with them. We sold our Bank of New York Mellon (BNY) position due to a progressively challenging operating environment and increasingly apparent poor governance practices. Low rates have forced BNY to waive fees on money market funds, accept declining yields on its portfolio, and endure a drop-off in securities lending revenues. Furthermore, revenue from foreign exchange trading declined significantly from a year earlier in the face of investor litigation. We sold Cree following the sudden departure of the company’s CFO. Notwithstanding our skepticism around the outgoing CFO, Cree continues to grapple with weakness in the LED lighting market, pricing pressure, and excess inventories. We sold our stake in Sonoco Products. The stock has hardly budged since we initiated a position four years ago. At current levels, Sonoco shares are not particularly cheap or expensive and the opportunity to invest elsewhere outweighs the possibility of the stock breaking out of its tight trading range. We sold Vestas on validation that the company cannot compete with Chinese turbine makers on price. SolarWorld was sold for similar reasons. We sold our stake in Kurita Water Industries. We had expected the company to benefit from clean-up and rebuilding after last year’s natural disaster, particularly in its soil and groundwater remediation business. While Kurita has seen some improvement here, it has been overshadowed by lackluster growth elsewhere, attributable to a lull in Japanese semiconductor and LCD company capital expenditures. The company has not been able to gain traction outside of Japan, which we view as a necessity to ensure long-term profit growth. Finally, we sold Potlatch, which was our play on timberlands and sustainable forestry. Potlatch’s structure as a real estate plus wood products company makes financial metrics hard to fully comprehend. Furthermore, weaker cash flows may pressure dividend policy and long-term growth is dependent on a sustained recovery in the U.S. housing market, which could still be a ways off. We will be evaluating other timberland related investment opportunities in the near term.
The information provided herein represents the opinion of the Portfolio Manager of the Fund and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
Past performance does not guarantee future results.
Holdings are subject to change and are not recommendations to buy or sell any security. See complete fund holdings information.
The MSCI World Equity Index is a capitalization weighted index that monitors the performance of stocks from around the world. MSCI World Energy Index is a component of the MSCI World Index and represents the energy securities defined by MSCI. The MSCI All Country World Index is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world and includes both Developed Markets and Emerging Markets. The S&P 500 Index is a broad-based unmanaged index of 500 stocks, which is widely recognized as representative of the U.S. equity market. The IBEX 35 Index is a market capitalization weighted index comprising the 35 most liquid Spanish stocks traded on the Madrid Stock Exchange. The FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. The Nikkei 225 Average is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange. The Straits Times Index is a modified market capitalization index comprised of the most heavily weighted and active stocks traded on the Stock Exchange of Singapore. The KOSPI Index is the index of all common stocks traded on the Stock Market Division of the Korea Exchange. The Bovespa Index is a gross total return index weighted by traded volume & is comprised of the most liquid stocks traded on the Sao Paulo Stock Exchange. The Shanghai Composite Index is a capitalization-weighted index that tracks all A-shares and B-shares listed on the Shanghai Stock Exchange. The Shenzhen Composite Index is a market-capitalization weighted index that tracks the performance of the A-share and B-share lists on the Shenzhen Stock Exchange. The Hang Seng Index is a freefloat-adjusted market capitalization-weighted stock market index that is the main indicator of the Hong Kong Stock Exchange. One cannot invest directly in an index.
Earnings Growth is a measure of growth in a company's net income over a specific period, often one year. This is not a forecast of the Fund's future performance. Earnings growth for a Fund holding does not guarantee a corresponding increase in the market value of the holding or the Fund.
Return on Equity is the amount, expressed as a percentage, earned on a company’s common stock investment for a given period.
The Price to Earnings (P/E) Ratio reflects the multiple of earnings at which a stock sells.
Moody's Investors Service, Standard & Poor's, and Fitch are ratings companies that assign a rating to a company's or country's debt based on its analysis of the issuer's credit worthiness. The highest rating given is AAA and the lowest is C.
Gross Domestic Product (GDP) is commonly used as an indicator of the economic health of a country, as well as to gauge a country's standard of living.
Cash flow is revenue less operating expenses including interest expenses and maintenance capital spending. It is the discretionary cash that a company has after all expenses and is available for purposes such as dividend payments, investing back into the business or share repurchases.
