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Commentary

Appreciation Strategy

First Quarter 2018

Key Takeaways
  • The market decline in late January was atypical in that it was led by the largest, most liquid stocks.
  • While consumer balance sheets are considerably stronger than in the past, corporate balance sheets deserve closer scrutiny as leverage has increased.
  • We believe the volatility experienced in the first quarter of 2018 makes the market more attractive as select security prices reflect a more appropriate level of risk.
Market Overview and Outlook

Volatility returned to the stock market in the first quarter of 2018 — ending a record period of 15 consecutive monthly gains — as higher interest rates, fears of increasing inflation and the specter of a possible trade war jolted investors. U.S. 10-year Treasury yields rose from 2.41% to 2.74% — almost touching 3% in mid-February — while the U.S. dollar fell modestly from $1.20/euro to $1.23/euro. Oil prices fluctuated within a range of $59 to $66, starting the quarter near the lows and ending near the highs. Despite the underlying market volatility, all U.S. economic data remained terrific.

Stocks rallied euphorically for much of January until stronger than anticipated wage inflation data resulted in macro funds and ETFs, which were betting on sustained low volatility, pulling back. The reaction snowballed into a 10% decline in the market. A rather quick market rally followed the correction until President Trump announced aluminum and steel tariffs; this generated broader concerns of an all-out trade war. Also, Facebook’s data breach increased the potential for greater regulatory scrutiny of privacy safeguards among the large technology companies, hurting sentiment for a group that considerably outperformed for the previous 18 months. Small cap stocks fared better than their large cap peers during the quarter. Most of this outperformance came after the tariffs, as small cap companies tend to have less exposure to international trade than large multinationals. The market decline in late January was atypical in that it was led by the largest, most liquid stocks.

Only two industry groups rose during the quarter: information technology (IT) and consumer discretionary. The overwhelming majority of consumer discretionary subsector gains were generated by Amazon and Netflix. Technology companies, especially those with exposure to the public and hybrid cloud, showed explosive growth. Market laggards were led by telecommunication services and consumer staples, both of which are sensitive to interest rates and inflation. Energy and materials gave back gains generated in the fourth quarter of 2017.

 

"While rumblings of problems in sub-prime auto and credit card loans have surfaced, overall credit conditions appear good."

 

First quarter U.S. economic data was healthy across the board. Jobless claims fell to 215,000, the lowest level since 1973. Fourth-quarter GDP was revised upward to 2.9%. Auto sales held steady in January and February at a 16.8 million SAAR, then lifted to 17.2 million in March on the back of increased incentives. The March Consumer Sentiment Index reading of 101.4 was the highest since 2004, while the ISM Purchasing Managers Index reading of 59.3% was one of the highest levels ever. Earnings growth for the market exceeded 15% in the fourth quarter of 2017 and is expected to accelerate to about 25% in the first quarter of 2018 on the back of lower corporate taxes.

Given the strong U.S. economy, financial markets are increasingly sensitive to accelerating inflation. A higher-than-anticipated increase in average hourly wages was the data point that sparked the market’s sharp decline in January and ignited an increase in U.S. 10-year Treasury yields. While inflation appears to be building, we believe the pace is moderate, as evidenced by the modest slowing in average hourly wage increases to 2.6% in February. As expected, the Federal Reserve raised short-term interest rates by 25 basis points at its March meeting. That said, Chairman Powell’s remarks were perceived as hawkish and market expectations for the number of rate hikes in 2018 increased from three to four. The 2-year Treasury yield now exceeds the S&P 500’s dividend yield and the yield curve is now the flattest it has been since 2007. In the past, an inverted yield curve has typically been followed by a recession.

We are watching for indications of late-cycle behavior in the fixed income markets. While rumblings of problems in sub-prime auto and credit card loans have surfaced, overall credit conditions appear good. While consumer balance sheets are considerably stronger than in the past, corporate balance sheets deserve closer scrutiny as leverage has increased. BAA credit spreads are still low in absolute terms but have widened after the very tight levels seen in January.

Increased volatility has started to create investment opportunities. Energy stocks are intriguing as the sector has underperformed the market despite a considerably stronger commodity price and lower-than-expected U.S. and international production. While many exploration and production companies have historically been poor allocators of capital (seeking growth at any price), we are seeing signs of improvement with recent implementation of incentives that reward return on capital. IT is also interesting, as the transformation from proprietary data centers to hybrid and public cloud systems with agile software is in full swing, creating healthy growth even for large companies. The market pullback and concerns over regulation may create attractive entry points into an area with great earnings growth visibility. Lastly, while consumer staples as a group continues to face growth challenges, there are a few companies with superior fundamentals and reasonable valuations.

We have been enthusiastic about economic fundamentals in the recent past but struggled with investment opportunities as valuations were high and the risk premium embedded in stock prices appeared too low. We believe the volatility experienced in the first quarter of 2018 makes the market more attractive as select security prices reflect a more appropriate level of risk. Technical fundamentals remain strong with healthy breadth and intact long-term trendlines. The Appreciation Strategy’s approach of owning large, high-quality stocks is well-suited for today’s market, offering good upside participation if the economy remains robust and preserving capital should the recent volatility continue.

Portfolio Highlights

The ClearBridge Appreciation Strategy had a negative return during the first quarter of 2018, underperforming the Strategy’s benchmark.

On an absolute basis, the Strategy had gains in three sectors in which it was invested during the first quarter (out of 11 sectors total). The main contributors to the Strategy’s performance were the IT, utilities and real estate sectors.

In relative terms, the Strategy underperformed its benchmark impacted primarily by stock selection. Stock selection in the consumer discretionary sector detracted the most from relative performance. Conversely, an underweight to as well as stock selection in the real estate sector helped relative performance during the quarter.

On an individual stock basis, the biggest contributors to absolute returns during the first quarter included positions in Adobe, Microsoft, Raytheon, Red Hat and Cisco. The greatest detractors from absolute returns were positions in Comcast, Exxon Mobil, Johnson & Johnson, Home Depot and Wells Fargo.

During the quarter, we established positions in Fastenal in the industrials sector, Phillips 66 in the energy sector, Air Products and Chemicals in the materials sector and Intel in the IT sector. The Strategy closed positions in Celgene and Amgen in the health care sector.

Scott Glasser

Co-Chief Investment Officer, Portfolio Manager
27 Years experience
25 Years at ClearBridge

Michael Kagan

Portfolio Manager
33 Years experience
24 Years at ClearBridge

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  • All opinions and data included in this commentary are as of March 31, 2018 and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge nor its information providers are responsible for any damages or losses arising from any use of this information. 

  • Performance source: Internal. Benchmark source: Standard & Poor’s. Neither ClearBridge Investments LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

  • Past performance is no guarantee of future results. Please see GIPS endnotes. Performance is preliminary and subject to change.