- Strengthening currencies and economic growth have enabled international equities to maintain their performance advantage over the U.S.
- Europe remains a catalyst for the portfolio, with receding political risk and a healing financials sector driving the region’s results during the quarter.
- The disruptive potential of electric vehicles gained momentum as more manufacturers announced aggressive launch plans in the passenger, truck and e-bus segments.
Market Overview and Outlook
International equities built on solid year-to-date gains in the third quarter on continued positive economic and earnings results in Europe and emerging markets. A comeback for cyclical stocks caused international growth stocks to lag value in the quarter, with the MSCI EAFE Growth Index returning 4.94% compared to a 5.87% gain for the MSCI EAFE Value Index. This is a theme we monitor and report on regularly, and note that the value stock rally marks a reversal from the previous two quarters in which growth equities led. Meanwhile, the core MSCI EAFE Index returned 5.40%, while the MSCI Emerging Markets Index gained 7.89%.
Exhibit 1: International Growth Stocks Trailed Value for First Time in 2017
International markets have outperformed the U.S. this year, but this follows years of underperformance and fund outflows from those markets. 2017 has seen increasing investor flows into international equities and we could see that continuing for some time. Outperformance this year has been driven by both local market results and positive currency movements. At the beginning of the year, we felt that the U.S. dollar (USD) would weaken versus all major currencies and were most confident about renewed euro strength. Our target for 2017 was 1.20 for the euro versus the USD, which has been reached. A further rise could be expected toward the end of 2017 and into 2018 when the European Central Bank (ECB) reveals its tapering plans. We are constructive on the currency due to large interest rate differentials between the U.S. and Europe, something we are fairly confident will narrow in the near future. The ECB’s accommodative stance is too loose for countries in Northern Europe, where inflationary pressures are building. The GDP growth differential between eurozone economies and the U.S. has also diminished, providing additional support to the euro. We expect the differential in net profit margins should also begin to close, which could provide a further boost to European companies (Exhibit 2). Japan was the last country to join the major developed regions in monetary stimulus. The Bank of Japan is likely to stay on its current course and will be the last central bank to end quantitative easing.
Local market equity returns were strong this quarter, and while they aren’t as mispriced as they may have been previously, they are not expensive. We expect upside surprises from earnings revisions due to better economic development. After an initially strong reaction following the French Election, markets in Europe have since consolidated. There has been meaningful economic improvement in southern Europe and political fear is receding.
Exhibit 2: European Margins Have Room to Grow vs. the U.S.
We have long been overweight the European banking sector within our growth portfolio, part of our structural basket of stocks that we have expected would show significant earnings upside when Europe began to emerge from its crisis and interest rates began to stabilize and climb. Italy has been the market’s chief concern, but the rescue of two smaller Northern Italian banks by the government and consolidation of the stronger businesses into Banca Intesa closes the chapter on Italian banking concerns. Earnings have been depressed and valuations are low. However, with the need for additional capital behind the banks, a more consolidated and rational market, a renewed focus on cost cutting, the possibility of write backs to loan portfolios and, finally, an upturn in rates in 2018 and 2019 by the ECB, we believe this exposure will continue to provide significant upside to portfolios. In the third quarter, it was a meaningful contributor to performance.
We are underweight Japan as growth has been cheaper in other markets with a more certain and generally longer durability of growth. Japan has seen an upswing in earnings growth, but with uncertain durability. Prime Minister Abe has called an upcoming snap election, which presents potential risks should his gamble to reinforce his control over the party not work out. It remains to be seen if the female mayor of Tokyo can challenge his power in the Liberal Democratic Party. There are changes at hand that could benefit the economy, such as their guest worker program, which will allow an increasing number of foreigners and reduce labor shortages. The country’s mindset about profitability and corporate governance keeps continues to improve. We continue to evaluate new opportunities for the portfolio, and recently added AFLAC, an insurer whose business is primarily driven by their renewed focus and strength in the third sector insurance product market in Japan.
Emerging markets and the more commodity-exposed countries of Australia and Canada are dependent on China’s economic performance and demand for their products. This year’s Party Plenum, which will take place in October, will indicate the path of developments in China for the next five years. It appears Prime Minister Xi Jinping will concentrate power within his inner circle and continue to address the problems with China’s large state-owned enterprises, which are inefficient and represent significant wasted resources for the economy. The Chinese energy and material sectors, in particular, are dealing with massive overcapacity, which has to be eliminated over the coming years. In order to stabilize the financial system, access to inexpensive financing of inefficient projects with low returns must be curbed.
To identify promising investment opportunities, we dedicate significant research resources to studying what we view as important long-term growth trends in the global economy. Disruption is a theme we think about continually. In 2016, we discussed electric vehicle (EV) technology and argued that it could be disruptive to the traditional internal combustion engine (ICE) technology. The third quarter was notable for the breadth of events and announcements related to electric cars, trucks and buses from all of the major OEMs globally. Tesla delivered its first Model 3 and presented an aggressive production ramp-up plan. The Model 3 is a relatively affordable, long-range electric car that has collected an unprecedented number of pre-production orders. Its specifications seem very competitive in a price segment thus far dominated by the BMW 3-series. The apparent success of Model 3 and other Tesla models is one of the key drivers pushing traditional vehicle makers, especially in the premium segment, to develop competitive EV offerings. During the quarter, BMW, Volkswagen and Daimler announced their plans to accelerate the development of new EV models and presented more aggressive targets for EV model launches at the Frankfurt Auto Show. VW announced a new all-electric common platform that will be used across several of its brands. The company will invest billions of euros in “e-mobility” and targets 50 all-electric models by 2025. Daimler’s Mercedes unit has upgraded its 2025 EV target to 25% of overall volumes and discussed plans to invest in an electric charging infrastructure.
"New business models like car sharing and self-driving are well suited for an electric vehicle platform."
Several companies also announced plans to introduce electric trucks. Daimler unveiled its new Fuso eCanter, an electric light-duty truck that would be supplied to UPS among others. Ryder announced a partnership with EV startup Chanje to offer a rental fleet of medium-duty electric trucks. Finally, Tesla announced that it would present a prototype of a heavy-duty electric truck in October this year. On the electric bus front, privately held Proterra agreed to supply the New York City MTA with several purely electric city buses. Proterra claims that its EV buses are more economical than compressed natural gas and diesel buses due to lower maintenance and operating costs.
It is still early days, with EVs only accounting for about 1% of passenger vehicle sales globally, but EV technology is rapidly improving and sales are accelerating. Lithium-ion battery costs, down over 70% since 2010 according to Bloomberg, are expected to decline much further due to massive investments in new battery capacity, especially in Asia. A political and regulatory push for cleaner transportation has intensified recently as countries like Norway, France, the UK and even China are contemplating plans to ban sales of new diesel and gasoline cars over the next 20 years.
Other business and technological forces that support EV’s penetration are also in play. New business models like car sharing are well suited for an EV platform due to superior charging and maintenance economics. Self-driving and connectivity technologies are also rapidly improving and these technologies are much more complementary to an electrified driving platform than an ICE platform. By now, not only are technology giants like Google and Intel intensively working on autonomous technologies, but most car companies are also going all in. In the third quarter, the alliance of Renault, Nissan and Mitsubishi announced it would introduce a fully autonomous vehicle by 2022. The alliance will also become an operator of robot-vehicle, ride-hailing services which would be a departure from the traditional business model of just selling cars. Uber and GM have also announced plans for autonomous fleets to consist mostly of electric vehicles.
Clearly a continued shift to EVs would require significant investments along the entire supply chains of battery materials, electric motors and power electronics among others. We have identified several undervalued high-quality companies that benefit from growth driven by EVs. SQM is a leading low-cost producer of lithium compounds for rechargeable batteries. Electrification of transport will require substantial increase in volume production of lithium over the next few years and SQM has large, low-cost resources that could meet that growing demand. Another holding, Belgian company Umicore, is a technology leader in recycling of battery materials as well as in production of cathode materials used in rechargeable batteries. The company recently announced plans to substantially boost capacity in cathodes to meet demand from Asian manufacturers supplying the Chinese market for electric city buses and passenger cars. Another holding, Aumann, is a German-based manufacturer of specialized machinery that automates the assembly of electric motors. Vehicle manufacturers need to purchase and install Aumann manufacturing lines long before actual EV models are introduced to the market.
"One big earnings catalyst is still to come: the end of quantitative easing by the ECB."
We target three defined growth segments in our portfolio - secular, structural and emerging - and these EV-related companies all fit into our structural growth category. These are firms with established businesses that will have very different forward earnings growth, due to the increase in their businesses from the development of electric vehicles. They will have strong top-line growth, but are not “new” companies and as such, we believe they have a somewhat de-risked investment profile, with strong top-line growth. Advanced Accelerator Applications, a French specialty pharmaceutical company and new addition to the portfolio earlier this year, is an emerging growth company at a critical point of its pipeline development. We believe the company’s scientific innovation can transform its earning profile while providing an innovative cancer therapy to patients. The company has developed a radiopharmaceutical, Lutathera, to treat neuroendocrine tumors. The drug has successfully completed a pivotal phase III trial and we expect broad label FDA approval in the coming months for inoperable neuroendocrine tumors, which we believe can transform the company’s earnings profile as it targets an underappreciated growth market.
We will continue to take a diversified, valuation-sensitive approach to growth investing and believe the portfolio is well positioned to participate in the opportunities that an improving global economy and a mindset of innovation among international companies can provide.
The ClearBridge International Growth Strategy had a positive absolute return for the third quarter and outperformed the benchmark MSCI All Country World Ex-U.S. Index. The main contributors to performance were the information technology (IT), financials and consumer discretionary sectors. The primary detractor was the utilities sector.
On a relative basis, the Strategy outperformed its benchmark primarily driven by positive stock selection effects. Stock selection in the IT, financials, health care and consumer staples sectors contributed the most to relative performance for the quarter. In addition, an overweight to the IT sector also contributed to relative results, as the sector outperformed the broader index. Meanwhile, stock selection in the utilities sector and an underweight to the energy sector detracted somewhat from relative performance.
On a regional basis, stock selection effects across Europe ex UK, the United Kingdom, emerging markets, and Japan contributed the most to relative returns for the third quarter.
On an individual stock basis, the largest contributors to absolute returns in the third quarter included ASML, Alibaba Group, Shiseido, Sociedad Quimica Y Minera De Chile and Adient. The greatest detractors from absolute returns included positions in Shimano, Coca-Cola Amatil, Allergan, Direct Engine and TravelSky Technology.
During the quarter, we added new positions in Givaudan and Umicore in the materials sector, Ping An Insurance in the financials sector and Localiza Rent A Car in the industrials sector. The Strategy also closed positions in Taiwan Semiconductor and Broadcom in the IT sector, AXA in the financials sector, KDDI in the telecom sector, Orocobre in the materials sector and Lululemon Athletica in the consumer discretionary sector.