- Negative sentiment toward global equities fails to discount solid fundamentals in most of the regions and markets the portfolio targets.
- While most economies are coping with a withdrawal of quantitative easing, China is aggressively stimulating its economy, but we do not expect such actions to re-accelerate growth until mid-2019.
- The fourth-quarter correction provided attractive opportunities to increase our exposure to secular and structural growth companies.
Concerns about slowing global growth, tightening liquidity conditions and political rhetoric escalated through the final three months of 2018, driving global markets to sharp losses for the quarter and the year. The benchmark MSCI All Country World Index declined 12.75% in the quarter and finished down 9.42% for 2018. For the first time in a while, U.S. stocks underperformed their international counterparts with the Russell 3000 Index down 14.30% during the fourth quarter compared to a 12.54% loss for the developed market MSCI EAFE Index and 7.47% decline for the MSCI Emerging Market Index. Global growth stocks trailed their value counterparts with the MSCI ACWI Growth Index down 14.66% for the quarter compared to a loss of 10.74% for the MSCI ACWI Value Index (Exhibit 1).
Exhibit 1: MSCI Growth vs Value Performance
Market worries were manifested in outflows from equity funds and a higher than average amount of tax-loss selling in the quarter after multiple years of gains for global equities. Negative sentiment has exacerbated the underperformance of international stocks compared to the U.S. but as we discuss below, such pessimism fails to discount solid fundamentals in most of the regions and markets we target. U.S. stocks seemed to finally take on board the U.S. Federal Reserve’s rising stance on interest rates and liquidity withdrawal as quantitative easing moves to tapering (Exhibit 2). A more moderate earnings growth picture (trade squabbles, one-time impact from lower taxes) has emerged with higher rates, leading to a derating in the valuations of U.S. stocks, which comprise more than half of the portfolio’s allocation.
China has been the world’s growth engine for the last decade and the trajectory of its economy is perhaps the most important determinant dragging down international equity sentiment. Trade tensions with the U.S. have further raised scrutiny of the country, the policies of its government and the business practices of its companies. China reported year-over-year GDP growth of 6.5% in the third quarter, below expectations and its slowest rate since the global financial crisis, while its manufacturing sector contracted in December, falling to its lowest level in nearly three
Exhibit 2: Non-U.S. Equities Have Outperformed Recently
Commodity prices also derated on growth slowdowns globally. Brent crude prices retreated more than 30% during the quarter as OPEC production cuts were not enough to offset a supply glut
coming primarily from U.S. producers. Energy, an area the portfolio is underweight, was the worst-performing sector in the benchmark, declining 20.2%. Cyclical sectors tied to global growth have also been hurt by slowdown fears, with industrials and consumer discretionary stocks as well as information technology (IT) all underperforming.
Surprisingly, the portfolio’s financials held up better than the market for the quarter, as financial companies have been hampered by the macroeconomic environment in many geographies, including the U.S. The portfolio was correctly underallocated in banks and overweight stock exchanges and financial information service providers.
We have been in a global monetary regime unprecedented since the global financial crisis. The magnitude and breadth of quantitative easing (QE) certainly prevented more serious economic downturns, but now we equally have to cope with its unwinding. The U.S. has begun quantitative
tightening along with interest rate rises; Europe has stopped further easing and Japan has become more selective in its policy measures. China remains the only large economy that is increasingly stimulating. Their slowdown in 2018 as they restricted monetary policy has caused them to swiftly reverse course over the last two quarters. We expect further stimulus, but these programs take time to filter through to the economy and we do not expect Chinese growth to reaccelerate until the middle of 2019.
"Global markets are behaving like there is a recession ahead, but we believe such sentiment overlooks a solid foundation in many regions."
After strong relative performance in the first three quarters of the year the portfolio was not immune to the broad selling in international equities during the quarter. Modest underperformance relative to
the benchmark for the quarter was due to the derating of the FAANG stocks, especially Apple and Amazon.com, poor performance of some of our chemical names, a profit warning from online apparel retailer ASOS in the UK and a lack of exposure to the defensive real estate and utilities sectors, areas of the market that lack the growth dynamics we seek in companies.
With higher rates in the U.S. and a rising cost of capital, strong performance from small caps made them vulnerable to profit taking. Japanese industrial staffing firm TechnoPro Holdings and alternative
decking manufacturer Trex were impacted. Mindful of valuation, we sold one of our emerging growth names, Chinese gaming and technology company Tencent, during the quarter and bought Nintendo- a company where we believe the market is underestimating the upside to their new Switch franchise and software offering.
One emerging growth company that stood out in the fourth quarter was Tesla. The electric vehicle (EV) maker reported solid improvements in cash flow and earnings in its most recent report, validating that an EV maker can be profitable. We expect sales to ramp up from here as the company rolls out a high-priced version of its popular Model 3 sedan in Europe and China and introduces a lower-priced version of the Model 3 in the U.S. with less range. The company has three additional model prototypes in development that should provide access to new markets in the years to come. You can read more about the environmental benefits of EVs and their commercial adoption in our fourth-quarter ESG commentary.
Japanese stocks were hurt by a confluence of natural disasters that clouded economic data and domestic consumption measures. Domestic confidence, natural disasters and weather issues aside, employment trends, confidence and spending remain firm; unemployment is at a record low. While external demand is weakening, the government is working to keep the domestic economy moving ahead with infrastructure spending plans — the pending consumption tax hike is likely to keep domestic spending conditions in good shape for the first half of the year. However, natural disasters did impact tourist trends and spending, pulling down results for cosmetics and skincare maker Shiseido, one of the portfolio’s largest holdings.
Despite a difficult performance environment, the fourth-quarter correction did offer opportunities to purchase quality growers at a discount. We increased the portfolio’s exposure to secular growth stocks, companies with a consistent record of earnings and cash flow growth, with the addition of
L’Oreal, Roche and IHS Markit. L’Oreal, in the consumer staples sector, operates a much broader cosmetics portfolio than Shiseido with mass brands like Maybelline as well as premium lines like Lancome. The French firm is the largest and most profitable cosmetics maker globally with a solid record of accretive acquisitions and marketing that elevates regional brands into global ones while
maintaining a strong cash position.
Roche, in the health care sector, is a Swiss biopharmaceutical firm that had sold off on patent concerns of its key oncology drugs. While the patent concerns are known quantities, the company’s new product pipeline is underappreciated. The purchase of Roche is part of an effort to increase our pharmaceutical exposure within health care as stocks have sold off and we continue to research new opportunities in the sector.
IHS Markit, in the industrials sector, is a provider of business and information services to enterprise customers across transportation, financial services, energy and similar industries. The company operates a diverse set of businesses with consistent growth and high barriers to entry, including the CarFax vehicle history service, and produces geological reports that are a standard research tool for oil & gas exploration and production companies.
In addition to emerging growth and secular growth companies, we also target companies that are structurally changing their forward earnings profiles, relative to their recent history, and that we believe underestimate their growth prospects. Nintendo, in the communication services sector, was a fourth-quarter addition in our structural growth bucket. The video game maker introduced a new console last year, but the market has been pessimistic about its ability to keep up with its in-country
competitor Sony. While the stock has lagged, we think Nintendo’s growth is just starting to accelerate in hardware and software.
Being conscious of valuation, and remaining disciplined when stocks reach our price targets, is one of the key ways we manage risk in the portfolio. After selling and trimming several of our higher-risk or more expensive portfolio holdings that had run up in the first half of 2018, the recent correction provided a chance to revisit some areas and add to existing holdings like social platform Twitter, telecom Verizon Communications and luxury goods maker Burberry Group at more attractive prices.
Given the experience during the global financial crisis and the length of the economic recovery, global markets are behaving like there is a recession ahead. We believe such sentiment overlooks a solid foundation in many regions and in many cases a lack of recovery to previous economic performance prior to the crisis. The strength of the dollar and the reduction of dollar liquidity by the Fed is certainly one reason for underperformance in emerging markets, coupled with negative trade rhetoric. Europe’s political headaches are lessening with Italy having worked out a budget compromise with the EU and Germany electing a new leader with a policy approach similar to that of Chancellor Angela Merkel. The wildcard in Europe remains the ultimate outcome of Brexit.
M1, a measure of global money supply, is at its lowest levels in some time, meaning a lot of cash is not where it needs to be. Companies in both Europe and Japan are cash rich with historically low leverage and we would like to see them put that capital to use in productive ways such as share buybacks or M&A. European companies have been revising earnings expectations upward, yet their equity markets are still down. Given the amount of cash on balance sheets, we believe earnings will be better than forecasts. We continue to be positioned in companies with pricing power and strong balance sheets that are oriented toward increasing shareholder returns.
As volatility has risen, investors have continued to sell out of emerging market and European-focused strategies in favor of the perceived safety of the U.S. But as we have discussed, non-U.S. markets, which constitute half of the portfolio, have more headroom for improvement across measures ranging from valuation to leverage to economic policy than the maturing U.S. market. Among our U.S. holdings, we are increasing exposure to stocks that fit in our secular growth bucket and able to generate organic growth without the benefits of ample liquidity.
The ClearBridge Global Growth Strategy underperformed the benchmark MSCI All Country World Index for the fourth quarter but outperformed for the year and longer time periods. The Strategy suffered losses across the nine sectors in which it was invested (out of 11 total), with the primary detractors coming from the IT and consumer discretionary sectors.
On a relative basis, overall stock selection and sector allocation detracted from performance. In particular, stock selection in the consumer discretionary and materials sectors and a lack of exposure to the real estate and utilities sectors hurt relative results. Stock selection in the financials and energy sectors and an underweight to energy were the primary contributors to relative performance.
On a regional basis, stock selection in Europe Ex UK and Japan as well as an underweight to emerging markets weighed on results, while stock selection in North America, emerging markets and Asia Ex Japan had a positive impact.
On an individual stock basis, the largest contributors to absolute returns in the quarter included Petrobras, HDFC Bank, Tesla, Merck and Coca-Cola. The greatest detractors from absolute returns included positions in Apple, Amazon.com, ASOS, Worldpay and Shiseido.
During the quarter, in addition to the names mentioned above, we added new positions in Pfizer in the health care sector, Comcast in the communication services sector and Inditex in the consumer discretionary sector. The Strategy also closed several positions, the largest being adidas in the consumer discretionary sector, Ping An Insurance in the financials sector, Petrobras and Suncor Energy in the energy sector and ICON in the health care sector.