- Improving economic growth in developed and emerging markets and a broad earnings recovery drove performance during the quarter and should lead to international value stocks returning to favor.
- Cyclical sectors are driving the profit recovery, led by industrials, materials, information technology and financial companies.
- Portfolio positioning remains pro-cyclical, with significant exposure to financial shares and plans to increase exposure to select areas in Europe as well as Japan and the rest of Asia.
“A bend in the road is not the end of the road…unless you fail to make the turn.” - Helen Keller
During the second quarter, investors tended to favor the familiar relationships of the past decade with a preference for assets that do well in the context of stagnation, deflation and central bank-induced financial distortions. This included a feverish focus on companies related to the secular growth theme broadly defined as “The Internet of Everything.” The return to past market leadership overshadowed several signs that indicated the investment landscape is profoundly changing. We believe the two key shifts are a return to broad and healthy nominal global GDP growth, supported by the normalization of monetary policy, and stock prices driven by rising earnings and not just expanding valuation multiples.
Global economic growth improved virtually everywhere outside of the U.S. over the past three months. More than 85% of national business surveys are in expansion territory and world freight shipments grew by 14% last quarter. Emerging market GDP growth is now outpacing developed markets while China continues to confound the pessimists with a resilient domestic expansion. Japan, Europe and nearly all of Asia are now growing more rapidly than the United States. Central bank and government policies are increasingly favoring job holders over bondholders with a stated desire to create an “overshoot” on inflation. These conditions should lead to a reversal of the outperformance of deflation beneficiaries and an unwinding of the $23 trillion in U.S. dollar-denominated assets held by foreigners. Since the 2008 global financial crisis, investors have reduced exposure to equities and significantly increased bond holdings - these relative flows could begin to shift in favor of stocks. Eventually, investors will notice that we are already halfway through a lost decade in real bond returns as measured by the Bloomberg Barclays Global Aggregate Index.
While rising interest rates tend to weigh on stock valuations, companies with robust earnings growth can continue to drive a rise in equity prices. Fortunately, during the June interim the global profit expansion gained strength. Corporate earnings hit a record high in Japan and industrial profits in China grew by 23% compared to last year. Germany experienced its highest growth rate since reunification, with the rest of Europe’s seven-year downtrend in profit margins reversing to the upside. Adjusted for inflation, both earnings and margins are now falling in the U.S., but a weaker dollar and improving global activity should help limit the downturn. Cyclical sectors are driving the profit recovery, led by industrials, materials, information technology (IT) and financial companies. More defensive industries such as staples, telecommunication services and utilities are showing the weakest earnings revisions. Overall, the combination of improving global growth and a broad earnings recovery should result in the outperformance of value and non-U.S. stocks.
Investors have yet to embrace this point of view, with speculative long positioning in U.S. Treasuries at the highest level in the past 25 years while most cyclical and commodity-related investments have been shunned. Research on global mutual funds by Barclays found that correlations with factors such as low volatility are high and positive while showing minimal exposure to value and risk metrics. In short, it appears that a majority of investors are not well positioned for the changes we expect in the long-term global investment environment.
The MSCI All Country World Index delivered one of the strongest first-half returns on record with a gain of 11.5%. For the second quarter, global shares rose 4.3%, led by 6% to 8% gains in Europe and emerging markets. A combination of reduced political risk and improving economic growth fueled a solid rise in Austrian, French, Spanish, Italian and Dutch shares. Japanese stocks experienced a broad-based recovery, delivering a more than 5% gain that was bolstered by a 15% jump in exports and solid domestic demand. Asian developed and emerging markets rose an average of 8%, led by Chinese and South Korean stocks. Taiwan also outperformed, driven by strong demand for technology related goods.
Less than expected economic growth, falling commodity prices and rising political risks drove underperformance in the U.S., Canada, Australia, Russia and Brazil. Shares in the UK retreated sharply in June as parliamentary election results added to uncertainty surrounding the Brexit negotiations. British stocks still held onto gains of nearly 6% for the quarter, but trailed the rest of Europe.
"It appears a majority of investors are not well positioned for the changes we expect in the long-term global investment environment."
From a sector standpoint the strongest performance was posted by IT stocks due to robust profit growth in social media, e-commerce, software and semiconductor companies. This attracted substantial capital into these areas as investor excitement grew over the idea of a secular up cycle in technology demand. Improving consumer and business spending helped the performance of luxury goods, housing related and industrial product makers. Financial stocks were mostly lower for the quarter until a rout in the bond markets in late June fueled a strong rebound. The rise in long-term interest rates that benefitted banking and insurance companies conversely hurt the performance of utility, telecommunication and real estate equities. Media and retailing firms also lagged for the second quarter as disruptive technology and new entrants left these industries with potentially obsolete assets.
Tightening monetary policy in China and delays to President Trump’s tax cuts and infrastructure spending plans sent commodity prices lower. As a result, metals, mining and basic materials shares underperformed. By far the worst losses were experienced by energy stocks. Oil supplies from non-OPEC countries continued to offset efforts to restrain production. Additionally, technological innovations are acting to extend the life of existing wells while also lowering energy consumption, creating a challenging environment for oil prices.
Style and factor performance for the second quarter was led by the metrics of high displayed growth, price momentum and quality characteristics such as high return on assets. Strong earnings revisions also resulted in solid relative performance. Value factors such as low price-to-cash flow, book value, earnings and sales all detracted significantly from returns. As measured by the MSCI indices, international value stocks lagged growth by 2.7% and on a global basis by 2.8%. While small cap stocks outperformed large companies for the quarter by approximately 2%, the small value cohort underperformed large cap benchmarks.
Given a recovering global economy and rising global profits, we expect a resumption of the outperformance of value stocks after the correction experienced during the first half of 2017. Portfolio positioning will remain pro-cyclical with significant exposure to financial shares leading to the desired positive correlation with interest rates. Within Europe, we are beginning to increase holdings of domestic demand beneficiaries at the expense of global exporters given the recent strength of the euro. We also expect to steadily add to Asian and Japanese shares due to a combination of attractive valuations and improving economic growth. We believe China is likely to continue to navigate a period of transition and reforms without a crisis.
The U.S. dollar appears to have entered a period of weakness which will tend to help emerging market shares and limit downside in global commodity prices. In the UK, we are somewhat concerned about the level of consumer debt and pressure on the domestic economy due to Brexit-related disruption, but expect Britain to avoid a recession. Tourism-related firms and exporters stand to benefit from weakness in the pound and the recovery in Europe. Energy and retailing stocks have fallen significantly and we are exploring new ideas in these sectors while watchful of potential value traps due to the secular disruption facing these firms. With the exception of select health care stocks, defensive company shares remain both expensive and growth challenged. In sum, we are well positioned for a normalization of interest rates and a more balanced, fundamentals driven world.
The ClearBridge International Value Strategy outperformed its MSCI All Country World Ex-US Index benchmark for the second quarter. On an absolute basis, the Strategy had gains in nine of the sectors in which it was invested (out of 11 sectors total). The main contributors to performance were the industrials and financials sectors.
Relative to the benchmark, overall stock selection contributed to performance for the quarter but was partially offset by sector allocation effects. In particular, stock selection in the industrials, real estate, materials and financials sectors drove relative results. On the negative side, stock selection in the consumer discretionary sector, an overweight to materials and underweight to IT hurt relative returns.
On a regional basis, stock selection in Europe Ex-UK and an overweight to the region were the greatest contributors to relative results over the period. An underweight to North America also aided performance. Stock selection in Asia Ex-Japan, meanwhile, detracted from performance.
On an individual stock basis, the largest contributors to absolute returns in the second quarter were Europcar Groupe, A.P. Moller – Maersk and Safran in the industrials sector, thyssenkrupp in the materials sector and BNP Paribas in the financials sector. Honda Motor and Prada in the consumer discretionary sector, Coca-Cola Amatil in the consumer staples sector as well as Duratex and Incitec Pivot in the materials sector were the largest detractors.
During the second quarter, the Strategy established positions in UniCredit and Standard Life in the financials sector, Telecom Italia in the telecommunication services (telecom) sector and Prada in the consumer discretionary sector and closed positions in Capcom in the IT sector, Deutsche Telekom in the telecom sector and H. Lundbeck in the health care sector.