- Revised expectations for forward U.S. economic growth created volatility across the financial markets.
- Large capitalization technology stocks looked expensive and crowded to us during the third quarter, but recent declines and still healthy fundamentals have created attractive entry points.
- We are working with portfolio companies, both makers of EVs and those in the supply chain, to promote sustainable and fair production and consumption of EVs.
Market Overview and Outlook
The U.S. stock market experienced a difficult fourth quarter, falling -13.5%, and had its first down year since 2008 with a total return of -4.4%. The market came within a hair of technically being labeled a bear market (down 20% from the peak) before bouncing significantly after Christmas. Volatility, as measured by the VIX index, increased from near historical lows in 2017 to about average in 2018. Investors were dealing with various issues in 2018, including fears of a trade war with China, turmoil in the White House, weakness in international economic numbers and Federal Reserve policy that is perhaps more backward looking.
Revised expectations for forward U.S. economic growth created volatility across the financial markets. Yields on the 10-year U.S. Treasury fell from a high of 3.23% on November 8 to a low of 2.68% at year-end. The short-end of the yield curve inverted the last week of 2018 and again the first week of 2019. The 2-year to 10-year Treasury spread narrowed to only 12 basis points in early December, the tightest since 2008. An inverted yield curve has historically proved to be a reasonably good predictor of recessions. Oil prices peaked north of $75 in early October but cratered to the mid-$40s by year-end. Coming into the fourth quarter, oil markets had been anticipating shortages caused by new Iranian sanctions. Instead, the sanctions had little impact and weaker global economic results reduced demand expectations. The U.S. dollar increased from 1.16 Euros to 1.145 during the quarter, making a new high for the year but still trading within a narrow range.
The best performers in the fourth quarter were low-risk or defensive stocks. The strongest groups were the utilities, consumer staples and health care sectors, while the cyclical energy, materials, industrials and consumer discretionary lagged. For the year, the defensive utilities and health care sectors did well, but strong earnings growth enabled consumer discretionary and technology stocks to report gains as well. Large capitalization stocks significantly outperformed small, while highly leveraged companies and those with credit problems were among the weakest stocks in the market.
U.S. economic news started the quarter very strong but ended more mixed. While the U.S. consumer did well, manufacturing experienced some softness to close out 2018. Retail sales were outstanding, posting one of the best Christmas seasons in years. Car sales were steady above 17 million (seasonally adjusted annual rate), although results were boosted by high fleet sales. Housing slowed slightly but continued to grow. Unemployment claims bottomed for the cycle in September at 205,000 before rising to 231,000 by December — still a very low number. Job creation was terrific in December at 312,000 and average hourly wage growth picked up to 3.2%. Employment is the best single indicator of the health of the U.S. economy but tends to lag at the onset of a recession.
"We need to be mindful of credit problems and Federal Reserve policy."
The market was very concerned about the combined impact of Chinese trade friction, international slowing and Federal Reserve policy on the manufacturing economy. The December ISM fell sharply from 59.3 to 54.1 — still indicative of a growing economy, but the third-sharpest decline in the indicator in 20 years. We are most likely witnessing a growth slowdown from red hot conditions last summer, but we need to be mindful of credit problems and Federal Reserve policy. The BAA spread, a key indicator of credit stress, decisively broke out during the fourth quarter and is now above the average for the business cycle. Real interest rates of just above zero are not likely to retard the economy per se, but the narrow yield curve must be watched. The current Federal Reserve balance sheet reduction of $50 billion per month is a clear headwind, as is the decline in the money supply we saw in 2018.
Large capitalization technology stocks looked expensive and crowded to us during the third quarter, but recent declines and still healthy fundamentals have created attractive entry points. The big cap
pharmaceutical stocks looked very interesting six months ago. Even after their strong fourth-quarter performance, a couple of the names still look intriguing but overall the group looks fairly valued to us. In the materials sector we are interested in companies that benefit from lower raw material costs.
We were quite nervous about the market a quarter ago, but at least from a valuation standpoint we feel better now. During the fourth quarter we saw some intriguing opportunities and added several new names. That said, we continue to feel that a conservative stance is most appropriate at this time. We are late in the economic cycle. Growth in 2019 will be significantly lower than last year even if the Federal Reserve is able to engineer a soft landing. The Appreciation ESG strategy of owning large, high-quality stocks is well-suited for today’s market, offering upside participation if the economy remains robust and preserving capital should a trade war erupt or should the Fed’s tightening result in an inverted yield curve.
The ClearBridge Appreciation ESG Strategy had a negative return during the fourth quarter of 2018, outperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in two sectors in which it was invested during the quarter (out of 11 sectors total). The positive contributors to the Strategy’s performance were the real estate and utilities sectors.
In relative terms, the Strategy outperformed its benchmark impacted primarily by stock selection. Stock selection in the communication services, financials and health care sectors contributed the most to relative performance. Conversely, stock selection in the energy sector dampened relative returns, but was offset by our underweight to that sector, which contributed positively.
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Merck, American Tower, Aetna, Procter & Gamble and CME Group. The greatest detractors from absolute returns were positions in Apple, Microsoft, Costco, Home Depot and JPMorgan Chase.
During the quarter, we established positions in Amazon.com in the consumer discretionary sector, W.W. Grainger in the industrials sector, Unilever in the consumer staples sector and salesforce.com in the information technology (IT) sector. We closed positions in Broadcom in the IT sector, Citigroup in the financials sector and Fastenal in the industrials sector. Our shares of Aetna were converted to shares of CVS following CVS’s acquisition of Aetna and were retained.
Carbon emissions from vehicles contribute significantly to global warming, and the transportation sector is one of the larger contributors to greenhouse gas emissions (GHG) in the U.S. As institutional investors seek to offset and mitigate the rising levels of carbon and other GHGs, electric vehicles (EVs) are an increasingly viable solution. With sales of EVs growing faster than predicted a few short years ago, the outlook for EV production and adoption is becoming increasingly robust.
We think greater consumer and commercial adoption of EVs will bring environmental benefits as well as financial opportunity for both manufacturers and users and throughout the EV supply chain. It will also involve environmental and social challenges, and we are working with the companies we own, both makers of EVs and those in the supply chain, to help make sustainable and fair production and consumption of EVs possible.
Commercial Adoption of EV Will Be a Watershed
Much of the focus until now has been on consumer adoption of EVs. But there is reason to shift focus to commercial adoption, because as total cost of ownership for an EV falls, EVs are becoming more feasible for commercial use. Shareholders of both fleet buyers and manufacturers are poised to benefit from greater commercial adoption.
ClearBridge holding United Parcel Service, for example, is currently buying a fleet of 1,000 electric vans from Workhorse, a U.S.-based manufacturer of electric delivery and utility vehicles, part of an electrification effort that includes converting up to 1,500 delivery trucks to battery electric and initiating purchase of 125 Tesla Semi trucks and Daimler electric trucks. FedEx has also recently ordered 1,000 electric vans from California-based Chanje for use in commercial and residential pick-up and delivery in California.
Commercial adoption should help the bottom lines not just of logistics companies, but also of large consumer staples companies heavily dependent on transportation. Freight costs are one of the greatest areas of cost inflation among consumer staples companies such as ClearBridge holding Pepsico, which is ramping up its electrification efforts with 100 Tesla Semis on order. Other major consumer staples companies with Tesla Semis on order include Walmart and Sysco. As manufacturers continue to consolidate production in larger, more efficient plants, and retailers carry less inventory and demand delivery within ever more narrow time windows, transportation logistics become an increasingly important competitive advantage.
"Shareholders of both fleet buyers and manufacturers are poised to benefit from greater commercial EV adoption."
Commercial vehicles remain an underappreciated source of net-environmental benefit and investment opportunity. We encourage a diversified fleet and view several portfolio companies taking advantage of the increased feasibility of EVs in their operations as significant progress in moving toward sustainable transport.
Supply Chains Present Challenges
While EV adoption has clear environmental and economic benefits, there are also challenges, such as eliminating or minimizing the environmental and social impacts of sourcing critical metals used in batteries. EV batteries contain lithium and cobalt, metals whose production can present several supply chain risks, including environmental damage, forced labor and poor health conditions.
We are partnering with our portfolio companies both to establish responsible and efficient sourcing practices and to reduce reliance on rare earth minerals through innovation.
ClearBridge holding Umicore, for example, is a global materials technology and recycling company based in Belgium. During the year ClearBridge hosted several meetings with Umicore management, engaging the company on several ESG-related topics. One key area of focus in 2018 was the company’s approach to sustainable procurement and ethical sourcing of raw materials. Umicore has been a worldwide leader in the recycling, transformation and marketing of cobalt since 1912 and is aware of the risks that are linked to the sourcing of cobalt.
Umicore not only manufactures cathodes for batteries, it also has a large recycling operation that provides some of the materials needed for cathodes and reduces the impact of materials sourcing by getting some materials like cobalt from internal recycling operations. Umicore is investing in battery recycling technology, which has the potential to be a large business for the company in the future. Where recycling has not been firmly established, Umicore has established top sustainable policies for ethical sourcing of cobalt. These include supply chain traceability to track the origin of cobalt raw materials at the mine level, plant visits and red flag checks that eliminate suppliers engaged in any of several unacceptable practices.
Innovation also provides a path to solving EV supply chain challenges. In a ClearBridge visit with Tesla management in 2018, for example, we noted how Tesla is reducing its reliance on cobalt through the adoption of batteries from Panasonic that use more nickel in the cathode and more silicone in the anode material. We also discussed the eventual need for end-of-life battery recycling as part of the manufacturing facilities and observed Tesla Gigafactory’s integrated recovery systems, which recover energy and save costs through regeneration braking in drivetrain testing and wastewater recovery.
Well-to-Wheel, EV Benefits Add Up
Another challenge is the concern that the total carbon profile of EVs is potentially still significant, given the energy and resources required to build and power EVs. Often, however, these concerns are grounded on incomplete information. Examples of EV energy and resource use, for example, often focus on the energy and resources required to make batteries, but they ignore a comparison to the energy and resources required to make traditional powertrains.
A complete vehicle fuel-cycle analysis, or well-to-wheels analysis, however, shows numerous clear benefits of EVs, such as the elimination of tailpipe emissions from population centers. While the life cycle impact of EVs compared to ICEs on climate should consider the nature of the electricity charging EVs (electricity may be generated by coal, for example, counteracting environmental gains of EVs), this impact is positive under any electric grid scenario. There are many academic studies comparing the EV versus ICE impact on the environment throughout the life cycle of a vehicle: from materials extraction to end-of-life recycling. One study concludes that even in the “dirtiest” grid (coal power) a fully electric fleet would result in 25% GHG emission reductions versus a diesel fleet (Exhibit 1).
Exhibit 1: EV Climate Impact Beneficial Under Any Energy Mix
EVs represent a compelling business opportunity for portfolio companies that can also have significant environmental benefits, and institutional investors are playing a growing role in pushing EVs forward. ClearBridge is a long-standing member of the Investor Network on Climate Risk (INCR), which has organized biennial summits on climate change at the United Nations for institutional investors to convene on how to apply private capital solutions to global warming. Both business opportunities and environmental benefits look poised to increase as EVs are adopted for commercial use. Commercial adoption should also reinforce the need for innovation in battery technology, reducing the need for rare materials and increasing the effectiveness of battery recycling. We will continue to engage with our portfolio companies to foster greater consumer and commercial EV adoption and address the challenges that the EV supply chain presents.