- More accommodative central banks and signs of progress in the U.S.-China trade dispute supported a continued rebound of global growth stocks.
- We believe our portfolio companies and the equity markets we target have and can continue to manage around the myriad geopolitical and global growth risks in the current environment.
- We increased our U.S. equity exposure through the purchase of several newly public companies, although we remain underweight the region.
Global equities delivered gains through an eventful second quarter where trade and central bank policy took center stage. The benchmark MSCI All Country World Index advanced 3.61%, the S&P 500 Index added 4.30%, the MSCI EAFE Index rose 3.68% while the MSCI Emerging Market Index edged 0.61% higher. Global growth stocks outperformed their value counterparts with the MSCI ACWI Growth Index up 4.90% for the quarter compared to a gain of 2.29% for the MSCI ACWI Value Index (Exhibit 1).
Exhibit 1: MSCI Growth vs. Value Performance
The ongoing trade dispute between the U.S. and China waxed and waned during the quarter - as it has for most of President Trump’s tenure - causing volatility to spike and then settle. A breakdown in trade talks in May led the U.S. to raise tariffs from 10% to 25% on $200 billion worth of goods, causing investors to flee risk assets. At the same time, the Trump administration also stepped up actions against Huawei, banning the Chinese telecom giant from doing business in the U.S. and effectively barring U.S. suppliers from selling to the company. In late June, however, Trump backtracked on the Huawei ban and delayed implementation of the latest round of tariffs following a meeting with his Chinese counterpart, Xi Jinping, at the G-20 summit.
As long-term investors, we never orient stock selection or portfolio construction around politics. Global trade tensions, as well as political flareups in local markets like Italy and other countries questioning their participation in the European Union, can spark extreme pessimism and sour investment sentiment. Perhaps the biggest impact from the ongoing trade dispute, as well as geopolitics in general, is on business confidence, which delays long-term capital spending plans. We are seeing it in the manufacturing indices, where almost all major international economies are below 50, indicating a shrinking of manufacturing activity. We acknowledge and closely monitor the near-term impacts of these uncertainties - Brexit being another current example - but longer term, we believe the companies we own and the equity markets that we target manage around these risks. We will be listening closely to what companies are seeing and noting in their outlooks as second-quarter earnings reports come in.
Our optimism is supported by central banks that have become more accommodative in the last several months. The U.S. Federal Reserve communicated the potential for an interest rate cut in the near-term should economic data weaken while ECB President Draghi continued to delay the wind down of its current quantitative easing measures. Should the Fed begin to aggressively cut rates, we could see a strengthening euro. It’s worth noting that the solid performance of the portfolio year-to-date has come with virtually no contribution from currency. China also remains aggressive in using stimulus measures to offset the headwinds to growth caused by trade and tariff actions. But this time the Chinese government is seeking to help the consumer, the state-owned companies and the private companies via tax cuts and lending facilities. Monetary conditions have improved over the course of the last few months, but we expect further stimulus.
"The U.S. market continues to trade at higher relative valuations than non-U.S. counterparts as earnings there are trending well above 2007 lows."
Meanwhile, valuations continue to look attractive across regions. European earnings remain nowhere near peak, creating the potential for multiple expansion. We also remain positive on the strength of the consumer, which is being supported by low unemployment and rising wages, especially in Asian markets where cosmetics, luxury goods and athletic apparel companies are seeing healthy demand. We recently attended a conference of global consumer staples companies where the tone was considerably more positive than the prior year. Companies pointed to relatively resilient demand, easing commodity prices and pricing power, particularly on the premium end. They also stressed the importance of renewed innovation, new products and re-engaging with customers to drive revenue growth.
Procter & Gamble, a name we have owned in the past, was repurchased during the second quarter. The market had been concerned about whether product innovation was possible at scale for P&G. There is ample evidence that the turnaround put in place by the company has impacted not only the cost side but is capable of driving renewed top line growth through new product development.
Considering the strength of the markets and higher global equity valuations, we continued to trim and sell positions that have reached our intrinsic value targets and look for new ideas. This is where our proprietary model is useful in pointing to overlooked ideas where conditions are improving and providing evidence of deteriorating fundamentals to avoid. The model is data rich; allowing us to see cross sector/country fundamental data and valuations and enabling strategic shifts when necessary, across the spectrum of growth.
During the second quarter, we added to our allocations in secular growth companies, those with established market positions and more predictable earnings. This included the purchase of Interxion, a Dutch-based data center operator for hyperscale cloud providers. Cloud adoption is growing faster in Europe than the U.S. because companies there are further behind. Interxion has seen good growth and occupies a unique position in serving European enterprise customers.
Meanwhile, we reduced exposure to the riskier emerging growth allocation which has performed very strongly on the back of continued rate reductions. This activity comprised several sales and trims on large price moves and extended valuations, including exiting a position in e-commerce solutions provider Shopify.
In the weeks following their second-quarter IPOs, we purchased shares in Uber and Slack, both of which we believe are unique assets with long run potential both in the U.S. and globally. Uber has a sizable lead over its main competitor in the global rideshare market - 78% of Uber rides in 2018 were outside the U.S. - and we believe it is well positioned in the more competitive, but potentially very large, global food delivery market. These IPOs as well as several other new positions have raised our exposure to U.S. equities, although we remain underweight the region compared to the benchmark.
In addition, we initiated a position in Brazilian e-commerce and payments firm StoneCo. The company provides access to an improving Brazilian economy and the rising penetration of electronic payments, which at 30%, is low relative to more mature markets. StoneCo is disrupting the Brazilian merchant payments market, largely dominated by legacy incumbents, by providing more competitive pricing, better breadth of technology and services and higher quality customer service. These advantages have enabled it to maintain strong topline growth and high margins. The company has quickly grown to become the fourth largest acquirer of merchants with 6% market share and we believe they are well positioned to take their disruptive growth into adjacent markets like banking and lending.
The drawdown in the fourth quarter of 2018 had made us more positive on global equities at the beginning of the year, however we are now becoming more cautious with Manufacturing PMI indicators around the world taking a notable leg down. The upcoming earnings season could lead to increased volatility, especially for companies that disappoint or issue weak guidance, but we believe the global economy will continue to expand, although likely at a lower rate than previously thought. This environment should be supportive of growth stocks.
The U.S. market continues to trade at higher relative valuations than non-U.S. counterparts as earnings there are trending well above 2007 lows. We remain perplexed as to how the trade rhetoric will impact the U.S. economy, as it seems to have been ignored so far. We believe there will likely be some impact and, given the strength of the equity market, things feel extended.
While the macro cannot be ignored, we do not position the portfolio for macro performance but rather through stock selection as the dominant contributor to portfolio performance. We continue to seek out quality growers with good and increasing cash flow generation, which should help shield us from potential volatility. Cash flow is an underappreciated but very powerful weapon, particularly in downturns, as it allows management to buy back shares, pay dividends and have the opportunity to undertake M&A at lower valuations. Our portfolio as a whole maintains half of the debt levels on company balance sheets compared to the benchmark, which should offer greater flexibility should markets become turbulent.
The ClearBridge Global Growth Strategy outperformed the benchmark MSCI All Country World Index for the second quarter. The Strategy delivered gains across nine of the 10 sectors in which it was invested (out of 11 total), with the primary contributors coming from the financials, information technology (IT) and industrials sectors.
On a relative basis, overall stock selection was the primary contributor to performance. In particular, stock selection in the industrials, financials, consumer staples, and communication services sectors and an underweight to the energy sector drove relative results. Conversely, stock selection in the consumer discretionary and materials sectors detracted from relative performance.
On a regional basis, stock selection in North America, Europe Ex UK, Japan and the United Kingdom had positive impacts, offsetting weakness in emerging markets.
On an individual stock basis, the largest contributors to absolute returns in the quarter included Walt Disney, Microsoft, LVMH, Nintendo and Trex. The greatest detractors from absolute returns included positions in Umicore, StoneCo, TravelSky Technology, Tencent Music and Albemarle.
During the quarter, we added a number of new positions to the portfolio. In addition to the names mentioned, new additions included Nike in the consumer discretionary sector, Qualcomm in the IT sector, VAT Group in the industrials sector as well as Novo Nordisk and bluebird bio in the health
care sector. We also closed positions in Inditex and Victoria in the consumer discretionary sector, TravelSky Technology in the IT sector, Pioneer Natural Resources in the energy sector as well as Anheuser-Busch InBev and Kao in the consumer staples sector.