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Key Takeaways
- Signs of improving economic activity along with the election of a U.S. president with an explicitly pro-growth policy agenda led to a sharp reversal in sector performance.
- Rising rates tend to accompany periods of strong relative performance for value, small capitalization, emerging market and cyclically-oriented shares.
- Economic activity is showing signs of improving in Europe while Japan is experiencing a robust earnings recovery.
Market Overview
International stock markets had a difficult fourth quarter with a loss of 1.25% as measured by the MSCI All Country World Ex US Index. The developed market MSCI EAFE declined 0.71% while the MSCI Emerging Markets Index struggled to a loss of 4.16%. Value stocks soundly outperformed growth stocks with the MSCI EAFE Value Index (+4.17%) topping its growth counterpart by 970 basis points over the last three months.
Global equities were primarily driven by the dramatic reversal in share prices after the U.S. presidential election. The U.S. dollar (USD) also jumped by an average of over 7% relative to the world’s leading currencies. Taken together, North American markets dominated performance with Canadian and U.S. companies up approximately 3%. In USD terms, European shares ended the final interim off 0.4% with higher German, French, Austrian, Spanish and Norwegian stocks offset by losses in Belgium, Denmark, Finland, Switzerland and the Netherlands. Italian markets were particularly strong, rebounding by over 10% on partial resolution of uncertainty in the banking sector and political reform. Japan closed the last three months basically unchanged as an underlying 15% gain was completely wiped out by an equivalent drop in the yen.
Markets in Asia outside of Japan suffered from both a currency and stock price standpoint given concerns about the impact of a stronger dollar and tightening U.S. monetary policy along with President-elect Trump’s threats of broad import tariffs. Quarterly falls in China, Hong Kong, India, Malaysia and Singapore erased gains for the full year. South Korea, Thailand, Taiwan and Australia were also lower for the quarter but remained positive for 2016. Poor performance in developing Asian stocks along with a Trump-related plunge in the Mexican peso and shares weighed on emerging markets.
Signs of improving economic activity along with the election of a U.S. president with an explicitly pro-growth policy agenda led to a sharp reversal in sector performance. Rising interest rates fueled a 14% rise in global banking shares along with 7% to 9% gains in insurance and investment banking firms. As measured by the CRB index, commodity prices rose over 13% led by copper and oil while prices of steel and iron ore jumped by 40% or more. This resulted in outperformance by the energy, materials and industrials sectors for the quarter. One of the worst bond market corrections in history resulted in losses for interest sensitive real estate, telecom and utility companies. Defensive industries also experienced declines with consumer staples and health care stocks down by an average of 9%. Pharmaceutical and retailers did particularly poorly for the quarter due to structural concerns about pricing, regulations, import policies and technology driven competition.
Style and factor performance experienced an important shift in leadership during the quarter. The prior regime was dominated by low volatility, defensive quality, high dividend and strong momentum characteristics. By the middle of last year, companies displaying these metrics had become historically expensive and widely held in popular passive, quantitative and hedge fund portfolios. Post-election there was a dramatic reversal with outperformance by high beta, low quality, poor momentum and cyclical value stocks. The change was dramatic with a 14 percentage point move (from 5.7% behind to 8.4% ahead) in favor of value relative to growth on a trailing one-year basis between the third and fourth quarter. While this represented a four standard deviation event, a higher level of volatility is not unusual in the initial stage of a style reversal.
As highlighted in a recent Bank of America Merrill Lynch quantitative research note, stocks tend to experience a brief “beta” led rally where short covering and aggressive investor repositioning reward low quality and distressed value metrics. Specifically, this phase is dominated by low price-to-book stocks with unfavorable “value trap” factors such as weak balance sheets, poor underlying profitability, consistent underperformance and overall low quality. This is then followed by a much longer period where improving fundamentals such as superior earnings growth, rising returns on capital and increasing dividends become effective characteristics in addition to undervaluation.
Exhibit 1: Portfolio Implied vs. Expected Growth Rates
Source: ClearBridge Research, Bloomberg Estimates, InterSec Research.
In the context of our investment discipline we focus on a combination of factors that deliver the superior long-term returns of value while seeking to avoid unrewarded exposures to low quality, high volatility and poor cyclical timing. Our holdings clearly display the contrarian characteristics of depressed valuations, low expectations and prior underperformance. But as an active manager, we seek the exceedingly rare combination of undervaluation with significant long term growth potential as expressed by the “gap” between implied and expected long-term earnings growth (Exhibit 1). In sum, our multifactor approach faced some headwinds in the post-election “beta” rally, but is well positioned for the long-term recovery in global value stocks from the current historically depressed levels.
After a 35-year downtrend in global interest rates (Exhibit 2), the environment is becoming unfriendly to fixed income assets and more beneficial to real economic activity. Conversely, rising interest rates tend to accompany periods of strong relative performance for value, small capitalization, emerging market and cyclically-oriented shares. Also, as noted in a recent note by Nomura Research, these are also the conditions in which the cyclical downturn in active manager relative performance recovers.
Exhibit 2: Historical Interest Rates for 10-Year U.S. Treasury Note
Source: Bloomberg.
These fundamentals lead us to remain pro-cyclically positioned from a sector standpoint with significant exposure to industrials, materials and technology firms. We expect better consumer spending conditions around the world in 2017 but are underweighted in both retailing and auto makers as structural challenges threaten to drive profits and cash flows lower. E-commerce continues to gain share over traditional stores as many of the largest department store chains reported a disappointing holiday season. Car makers face potentially peak demand in the U.S. and the massive costs of electric drive train development on top of rising costs to support legacy vehicle offerings. We are focusing on the innovators within the auto business that are in markets with substantial room for cyclical recovery and may add to the group early in 2017. Our largest single sector exposure is to financial firms, given the positive impact of better economic growth and a steepening yield curve.
Regional Outlook
On a country and regional basis, Europe is bouncing off of relative price lows last seen in the 1970s relative to the U.S. with valuations that reflect a large discount for both political and economic uncertainty. Economic activity is showing signs of improving, especially in the weaker peripheral countries and earnings revisions have turned significantly higher. The weaker euro and likely loosening of fiscal policy should combine to produce better than expected domestic demand on the Continent. Europe remains our largest regional weighting.
While the most pessimistic forecasts for the UK economy have been proven wrong so far, Britain faces significant political challenges from the implementation of Brexit. PM Theresa May will need to balance the disruptive aspects of leaving the EU with the demands of anti-European hardliners. This will all be happening as rising inflation and interest rates crimp consumer incomes with household leverage at record highs. Clearly the plunging pound has improved the outlook for tourism and export industries, but with one of the largest current account deficits in the world, the UK economy could prove surprisingly volatile over the next 12 months. We are keeping our exposure modest with fundamentally strong companies that can weather short-term challenges.
"Rising rates tend to accompany periods of strong relative performance for value, small cap, emerging market and cyclical shares."
Japan has begun to outperform in the past six months, even in dollar terms, as the central bank has effectively rendered local government bonds unattractive to investors. Combined with the strongest earnings recovery in the world, record share repurchases, solid dividend increases and better regional economic activity, we expect this trend to continue. Consumers are also enjoying rising wages and 1% mortgage rates while a newly invigorated affinity for foreign tourists boosts demand at hotels and retailers. Valuations remain attractive and we expect to increase our holdings in Japan over the next few months.
Asian shares suffered in the final quarter of 2016 while currencies in the region fell back to the lows of the 2009 global financial crisis. As a result, the region is trading well below 10-year averages relative to book value and earnings. Profit and cash flow growth is expected to be strong in 2017 but this is clearly not reflected in these near record low relative valuations. Investor concerns are primarily related to the never ending forecast for a Chinese led crisis and the pain of a rising USD on foreign currency borrowers. China continues to balance the pain of structural reforms with strong growth in the domestic consumer economy and higher value added manufactured goods. We continue to emphasize the “new” sectors in China that will benefit from the rising incomes of over 500 million affluent and aspirational millennial consumers. The rest of Asia is a mix of commodity and technology exporters with solid exposure to rising local infrastructure and consumer demand. We expect to gradually increase our weightings in the region during the year. Most of our commitment to emerging markets in the portfolio is held in China and South Korea given our constructive outlook for the region.
Portfolio Highlights
The ClearBridge International Value Strategy outperformed its MSCI All Country World Ex-US Index benchmark for the fourth quarter. On an absolute basis, the Strategy had gains in five of the sectors in which it was invested for the fourth quarter (out of 11 sectors total). The largest contributors to performance were the financials, industrials, and materials sectors. The information technology, consumer discretionary, and real estate sectors were the primary detractors.
On a relative basis, performance was driven by sector allocation and stock selection. Strong stock selection and an underweight allocation in health care contributed the most to relative performance for the period. An underweight allocation and stock selection in the consumer staples sector also contributed to relative returns. In addition, stock selection in the industrials sector boosted relative gains. On the negative side, stock selection and an underweight allocation in the energy sector detracted the most from relative performance during the period. The consumer discretionary and real estate sectors also detracted from relative performance driven by stock selection.
On a regional basis, stock selection in Europe Ex UK contributed the most to relative performance. Within the region, the strongest contributor was France. Additionally, stock selection and an underweight allocation in Emerging Markets also contributed to relative performance over the period. China helped relative gains in the region. Conversely, stock selection and an underweight allocation in North America were the primary detractors from relative performance over the period. In North America, relative underperformance was driven by our exposure to Canada.
On an individual stock basis, the largest contributors to absolute returns in the fourth quarter included BNP Paribas SA, Barclays, Banco Santander, AXA, and Incitec Pivot. The biggest detractors from absolute returns included positions in Ambarella, Amec Foster Wheeler, Sony, Tarkett, and Indra Sistemas, SA
During the fourth quarter, the Strategy initiated positions in Royal Bank of Scotland, Sensata Technologies, Cielo and CNH Industrial and closed a position in Lixil Group.
Sean Bogda, CFA
Portfolio Manager
24 Years
experience
9 Years
at ClearBridge
Paul Ehrlichman
Head of Global Value, Portfolio Manager
34 Years
experience
9 Years
at ClearBridge
Safa Muhtaseb, CFA
Portfolio Manager
29 Years
experience
9 Years
at ClearBridge