- Dividend Strategy continued to post solid returns during the second quarter, driven by strong gains in the financials, consumer staples and materials sectors.
- The Federal Reserve’s pivot toward accommodative monetary policy boosted markets but raises serious questions about the health of the economy and the role of monetary policy.
- While current trade conflicts may be resolved with new trade agreements, the apogee of globalization has passed and the world is entering a new era of increased nationalism and more restrictive trade.
Market Overview and Outlook
The stock market rose 4.3% in the second quarter and is now up 18.5% for the year. Dividend Strategy continued to post solid returns during the period, driven by strong gains in the financials, consumer staples and materials sectors. As we discussed in our first-quarter letter, the market’s rise has occurred despite a slowdown in the economy. Deteriorating economic fundamentals have driven the Federal Reserve to adopt a more accommodative stance and markets have cheered.
The market has now begun to price in two interest rate cuts over the next 12 months. The interest rate on the 10-year Treasury ended the quarter at 2.0%, down from 2.4% at the end of the first quarter and 2.7% at the end of 2018. While we welcome the rise in asset prices, we believe that economic concerns persist and further stock market gains are likely to be modest.
All else being equal, investors’ Pavlovian reaction to bid up the markets at the mere mention of lower rates makes sense. Mathematically, lower interest rates warrant higher asset prices. Further, lower interest rates should boost economic activity and thereby drive better growth and earnings.
After a decade of unprecedented monetary policy, however, we wonder if the knee-jerk rise in stock prices makes as much sense as it once did. Interest rates have been at ultra-low levels for 10 years, yet global economic growth has been unable to sustainably break out of the doldrums. Do central banks believe that cutting interest rates now will meaningfully boost economic activity? Or, are they more concerned with keeping capital markets from rolling over?
In our view, the need to cut rates to keep the markets afloat raises serious questions about the strength of the global economy and the role of central banks. We also wonder if a rate cut is the right tonic to fix what ails the economy.
"On average, our materials holdings have raised their dividends by 8% in the past year."
It seems to us that the biggest headwind to recent economic growth has been the escalation in trade wars. It goes without saying that lower interest rates do nothing to address these tensions. While these trade conflicts may be resolved with new trade agreements, we do not think the world will return to the laissez-faire trade environment that prevailed until recently. The political environment has changed (both in the U.S. and abroad) and the new nationalism underpinning current trade conflicts is unlikely to dissipate soon. This changing approach to trade is a paradigm shift for the global economy with many and varied ramifications. We feel confident that the markets have not adequately digested or priced in these changes as no one yet knows all the multi-variant ways this retreat from globalization will impact economies, sectors and companies.
In constructing our portfolios, we focus on the things we can control. We select world-class companies with dominant franchises, growing top lines, strong balance sheets, recurring revenues, high returns, prodigious free cash flow and growing dividends. For example, our focus on energy infrastructure companies such as Kinder Morgan and Williams, our two largest energy holdings, gives us exposure to companies with long-term contracts, predictable revenue streams and less sensitivity to commodity prices than the broader energy sector. These companies benefit from the growing volume of oil and gas production in the United States while being largely insulated from the ups and downs of commodity prices. As a result, while the energy sector has been one of the worst performers in the broad market of late due to concerns about slowing global growth, our energy holdings have outperformed the broad sector in 2019. Additionally, Kinder Morgan was able to raise its dividend by 25% in the second quarter, while Williams raised its dividend by almost 12% in the first quarter.
Our materials holdings are also making strong contributions. Here we are focused on relatively less cyclical coatings and specialty chemical companies that have dominant market positions, high returns and strong free cash flow, such as Linde, an industrial gas provider to a variety of industries and a top contributor in the second quarter. On average, our materials holdings have raised their dividends by 8% in the past year.
After a strong start to 2019, the market’s rise has continued, albeit at a slower pace. In a lower-growth world characterized by increased volatility and uncertainty, we continue to believe that a diversified portfolio of high-quality companies with the ability to raise their dividends on a sustainable basis is a good place to be.
The ClearBridge Dividend Strategy outperformed its S&P 500 Index benchmark during the second quarter. On an absolute basis, the Strategy had gains in nine of the 11 sectors in which it was invested for the quarter. The main contributors to Strategy performance were the financials, consumer staples and information technology (IT) sectors. The industrials and energy sectors, meanwhile, detracted from absolute results.
On a relative basis, stock selection added to performance for the quarter. In particular, stock selection in the consumer staples, financials and IT sectors contributed positively to relative returns. An overweight to the financials sector and an underweight to the health care sector also proved beneficial. Conversely, stock selection in the industrials sector detracted from relative performance, as did an underweight to the IT sector.
On an individual stock basis, the largest contributors were Blackstone, Microsoft, American International Group, Walt Disney and MetLife. Positions in 3M, Bank of New York Mellon, Qualcomm, Alphabet and United Parcel Service were the main detractors from absolute returns in the quarter.
During the quarter, we exited positions in Costco in the consumer staples sector, Wells Fargo and Bank of New York Mellon in the financials sector and AT&T in the communication services sector. The portfolio received but did not retain shares of DowDuPont spin-offs Corteva (CTVA) and Dow (DOW), and we exited our position in the remaining DuPont de Nemours (DD) business. In addition, Blackstone converted from a limited partnership structure to a C-corporation structure.