- As value reached historical gaps with other investment factors, global policymakers began to reverse course in favor of lower rates, higher inflation and increased fiscal spending.
- Performance was hurt primarily by the portfolio’s exposure to China, where trade tensions continue to take a toll on smaller companies.
- Positive 2Q contributions from our real estate, materials and energy holdings and our pro-cyclical positioning bode well for a value comeback.
Trade tensions dominated global sentiment and stock performance in the second quarter. What began as a strong continuation of the first quarter’s market advances was met by an abrupt turn in early May. A combination of new Iranian sanctions, an Italian budget conflict and President Trump backing away from trade negotiations with China and imposing tariffs sent global markets into a tailspin. The global economy was already slowing due to uncertainty surrounding trade, fiscal, regulatory and monetary policies. A broadening trade war further threatened international supply chains and led companies to halt investments and hiring plans. Europe and Asia were especially hard hit during the month as world trade growth turned negative.
This mix of fear and uncertainty was particularly hostile to value stocks. By the end of May, value shares were trading at the largest discount ever. The gap between the performance of low volatility, quality, growth and momentum factors and value were also the widest in history while the spread between global growth and value was also nearing all-time levels (Exhibit 1).
Then, just as investors poured money into bond, low volatility and quality ETFs, the markets reversed sharply, and the MSCI ACWI Index (+6.5%) posted its best June on record. Shocked by building evidence of an economic slowdown, both politicians and central bankers reversed course and walked back from trade conflicts, pledged to reduce rates, drive inflation higher and opened the door t increased fiscal spending. Sectors and regions most hurt by pessimism and uncertainty led the recovery in June including shares in Europe, emerging markets and Asia, along with materials, industrial, consumer discretionary, financial and information technology (IT) companies. Value and high volatility generally outpaced momentum.
Exhibit 1: Global Growth-Value Spreads Widest in History
While encouraging, the June rebound was unfortunately not enough to offset value’s May underperformance. In total, the benchmark MSCI EAFE Small Cap index exited June with a 1.7% gain for the quarter, while the International Small Cap Strategy posted a decline for the same period.
The majority of the Strategy’s underperformance in the quarter can be traced to weakness in our Chinese holdings, where most of the trade uncertainty was centered. The MSCI China Index declined -4.0% for the quarter, with China small caps down over 8%, bearing the brunt of the overall risk-off sentiment. Man Wah, a Chinese furniture manufacturer, sold off on tariff concerns as 35% of its sales are to North America. CIMC Enric, a leading liquid natural gas equipment maker in China, suffered alongside declining oil prices and fears of declining gas demand associated with a potential economic slowdown.
These stocks are examples of the consensus fear towards China right now – that trade relations are irreversibly damaged, and China’s growth will permanently stagnate. We, however, have a much more sanguine view toward the situation and believe a trade agreement can be reached in a timely manner. Regardless of this tariff outcome, China has already pivoted in other directions, signing 24 new trade deals with 16 nations this year. It is also likely to expand fiscal stimulus in addition to reducing rates and reserve requirements while reversing the deleveraging policies of the past two years.
Another significant detractor was British apparel maker Ted Baker. Ted is an aspiring luxury brand well-known for its combination of classic tailoring with bold colors/prints and has been a strong growth story over the past three decades. However, the company encountered some challenges over the past year, ranging from weather to product assortment to a CEO behavioral scandal, which caused the stock's P/E multiple to more than halve. While we are disappointed at the performance, we continue to believe the brand is strong and has huge international growth potential. At 8x earnings, there is tremendous upside if the company can fix the product issues over the upcoming seasons. Additionally, at such low valuations, it could also be an attractive takeover target for a larger clothing brand.
"A weaker U.S. dollar would be supportive of growth in emerging markets, underpin commodity prices and raise inflation."
On a better note, we had many positive contributors during the quarter, especially in the real estate, materials and energy sectors. Publity, a German real estate manager, was our leading contributor for the quarter. The company continues to benefit from its strong asset portfolio and robust demand for German commercial real estate. Avance Gas, a liquid petroleum gas shipper which we had acquired at prices equivalent to fractions of its asset value, also delivered strong gains in the quarter. It appears the liquified petroleum gas downcycle is nearing an end, and we look for lower fleet growth combined with stronger end demand to lead to a recovery in spot rates over the next few years. Additionally, our basket of gold producers, including Novagold, Centamin, and Alamos Gold, saw strong appreciation alongside gold’s breakout above $1,400/oz. Gold and gold stocks appear to be sensing the coming global stimulus and reflation, which would be strong fuel for the portfolio overall.
Outlook and Positioning
Several powerful fundamental catalysts and structural changes support a shift towards a value led market. Policy is shifting as the real economy is favored over the financial markets. Normally as central banks reduce short rates, the yield curve steepens, and looking at the recent breakdown of the U.S. 30-year Treasury, this may have already begun. Gold and gold stocks have also broken out to multi-year highs in relation to bonds, stocks and other commodities - usually a harbinger of rising inflation. In general, commodity prices are the lowest they have been since the 1970s so any change in trend would be lasting and powerful.
With Europe facing political instability, a weak economy and the threat of a trade conflict with the U.S., the consensus is moving away from balanced budgets and austerity. Leaders supported by French President Macron are slated to head up the ECB and the European Commission, which significantly increases the odds of meaningful reforms and the establishment of a closer “fiscal union.” This would tend to accelerate the rebalancing in the eurozone between the strong economies of the North and weaker peripheral countries. Sharply undervalued Italian shares and European banks stand to benefit from any signs of a closer and more pro-growth union. President Trump has recently been vocal about wanting a weaker U.S. dollar which would be supportive of growth in emerging markets, underpin commodity prices and raise inflation. China is also likely to expand fiscal stimulus in addition to rate cuts already implemented.
Given this narrative is consistent with our view over the past year, the portfolio did not see much change with respect to sector or regional weightings. We had several stocks hit price targets, which we exited opportunistically, while also pruning the portfolio of other names which we believed were not executing per our investment thesis. The proceeds were reallocated to our highest conviction holdings, as well as the addition of several new ideas, mostly in Europe. Overall, we remain overweight economically sensitive sectors such as industrial and materials, which we believe will be the prime beneficiaries of upcoming reflationary policies. Conversely, we continue to avoid the crowded and expensive safety trades in IT, health care and real estate. From a geographic perspective, we maintain an overweight to emerging markets, particularly China, South Korea and Brazil.
It appears the world is embarking on a new cycle of synchronized monetary policy easing and fiscal stimulus. U.S. federal spending hit a new record high in June with nearly every country planning to follow America’s lead. Against this backdrop, international small cap value stocks represent one of the few truly diversifying and high expected return asset classes left in the world.
The ClearBridge International Small Cap Strategy underperformed its MSCI EAFE Small Cap Index benchmark for the second quarter. On an absolute basis, the Strategy had gains in four of the 11 sectors in which it was invested. The primary contributors to performance were the real estate and materials sectors.
In relative terms, overall stock selection and sector allocation detracted from performance. Stock selection in the consumer discretionary, IT, financials and industrials sectors, as well as an underweight to IT, hampered relative results. Conversely, stock selection in the real estate, materials and energy sectors contributed to relative performance.
On a regional basis, stock selection in the United Kingdom and Asia Ex Japan, as well as an overweight to emerging markets and underweight to Europe Ex UK, hurt results while stock selection in Europe Ex UK proved beneficial.
On an individual stock basis, Publity, Novagold Resources, Avance Gas, China Lesso Group and DeNA were the greatest contributors to absolute returns during the quarter. Positions in Ted Baker, SBS Holdings, CIMC Enric, Ontex Group and Man Wah were the largest detractors from absolute performance.
In the second quarter, we initiated four new positions in Eurobank Ergasias in the financials sector, Koninklijke VolkerWessels in the industrials sector as well as GVC Holdings and Nexen Tire in the consumer discretionary sector. We also closed a number of positions, the largest being Duratex and Nippon Shokubai in the materials sector, Grivalia Properties in the real estate sector and Luxfer Holdings in the industrials sector.