“Insanity in individuals is something rare - but in groups, parties, nations and epochs, it is the rule.”
- Friedrich Nietzsche
- International value stocks trailed significantly during the second quarter and the portfolio was not spared due to our positioning in areas less correlated to the momentum trade.
- As value reached historical, recession-level gaps with other investment factors, global policymakers began to reverse course in favor of lower rates, higher inflation and increased fiscal spending.
- The portfolio is well positioned to take advantage of this reflation trend due to overweights to economically-sensitive sectors and regions.
After a relatively benign start to the second quarter in April, stocks plunged in May in response to a combination of new Iranian sanctions, an Italian budget conflict and President Trump backing away from trade negotiations with China and imposing tariffs. The global economy was already slowing due to acute uncertainty surrounding trade, fiscal, regulatory and monetary policies. A broadening trade war that also included threats to the international technology supply chain led companies to halt investments and hiring plans. Auto companies announced the largest number of layoffs since the 2009 financial crisis. Europe and Asia were especially hard hit as world trade growth turned negative. Earnings growth estimates, which had previously been showing signs of stabilizing, turned lower as more firms guided profit expectations downward and gave up on hopes for a second half recovery. Even in the U.S., leading indicators fell.
Bond prices rallied and sent interest rates down to levels approaching the 2016 lows while yield curves flattened or slightly inverted. Based on surveys, fund managers became the most pessimistic about earnings, stocks and economic growth since the global financial crisis. Central bankers around the world were still focused upon normalization of monetary policy and winding down their bloated balance sheets while the Chinese continued a program of modest stimulus measures but maintained a desire to rein in overall debt levels.
This mix of fear and uncertainty was particularly hostile to value stocks, especially in Europe and Asia. In fact, the performance gap between momentum and value style factors in the month of May ranged between 1,200 and 2,000 basis points depending upon region and specific metric. This was the largest monthly differential ever experienced according to global quantitative strategists. Barron’s featured a lead article entitled “Reversion to the Mean is Dead. Investors Beware.” By the end of May, value stocks were trading at their largest discount ever (Exhibit 1). The gap between the performance of low volatility, quality, growth and momentum factors and value were also the widest in history. Importantly, the correlation of value with these other metrics plunged to record lows while the relationship of these non-value factors hit new highs. Not only are these measures at extremes but are historically seen only well into a recession.
Exhibit 1: Global Growth-Value Spreads Widest in History
Then, just as investors poured money into bond, low volatility and quality ETFs, the markets reversed sharply with the MSCI All Country World Index posting the best June on record. Shocked by the previous weakness in markets and building evidence of an economic slowdown, both politicians and central bankers reversed course, walked back from trade conflicts, pledged to reduce rates and drive inflation higher, opening the door to increased fiscal spending. A new phase of global synchronized stimulus had begun. As a result, mean reversion enjoyed a sudden jolt of life. Sectors and regions most hurt by pessimism and uncertainty led 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. But the June rebound was not enough to offset the large relative underperformance of value in May and for the full quarter, value lagged growth by 278 basis points (Exhibit 2). The performance of our portfolios followed this pattern of a solid April, sharp relative fall in May and besting the benchmarks strongly in June. Our somewhat deeper and disciplined value positioning led to a generally larger decline in May and more vigorous rebound in June relative to both broad and style benchmarks.
Exhibit 2: MSCI Growth vs. Value Performance
The U.S. is taking the lead in this shift to debasement and reflation and the easing of monetary policy by the Federal Reserve will allow other central banks to reduce rates. In Europe, facing political instability, a weak economy and 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 in a region that is also seeing historically wide gaps between growth and value stocks (Exhibit 3). 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.
Exhibit 3: European Growth-Value Gap Near Historical Wides
Another key constraint to growth over the past decade has been the decrease in bank assets relative to reserves. In a fractional banking system, the central bank provides the base money supply, but lenders act to multiply these funds and boost the quantity of money. A contraction in monetary velocity reduced both economic growth and inflation since the global financial crisis. With reforms in Europe, including a long-needed restructuring of Germany’s Deutsche Bank, both loan growth and balance sheet leverage are likely to increase. China is also acting to expand lending to the private sector as well as build comprehensive debt and equity markets to fund both public and private investment. Japan, already at zero interest rates, is primarily focused upon improving efficiency in the service sector, encouraging a rise in immigration and tourism, rebuilding infrastructure for an aging population, continued corporate governance improvements and benefiting from strong growth in the ASEAN region.
While tensions between China and the U.S. have eased somewhat in the short term, the global trade system and architecture are irreversibly changing. Our sense is that the global trade system is evolving into three specific zones: Asia led by China, Europe and North America. America’s rivalry with China will continue for the foreseeable future and represents a new Cold War. As highlighted by Harvard scholar Graham Allison, the long history of a rising nation confronting a reigning power reaches a point where the decision is either conflict or acceptance. At the start of the 20th century the UK decided to not resist the rise of the U.S. but work together to shape a permanently changed world order. Greater cultural differences with China probably make this path more challenging and we expect the relationship to remain a source of volatility.
Fortunately, the shift in world trade, with the exception of the U.S., has been towards lower tariffs and expanding free movement of goods, people, capital and services. China has signed 24 new trade deals with 16 nations this year. The eurozone recently completed the largest trade agreement in history with the leading economies of South America that eliminates $4.5 billion of tariffs and encompasses 800 million people and nearly 25% of global GDP. Japan also entered into a broad-based agreement on tariff reductions and free trade with Europe. In the short term, disruption of long-established supply chains will weigh on corporate profits and delay investment spending, especially in the IT sector. President Trump may react to the slowing U.S. economy by reaching a deal with China but there is a growing risk he turns his focus onto Europe, specifically Germany. Europe actually has the largest trade surplus in the world at more than $600 billion dollars but bashing the Continent probably resonates less well with American voters given the substantial existing commercial and cultural ties.
Positioning and Outlook
A number of potential negative developments could end the rally in global stock prices. In the UK, Brexit remains a mess as an emotional decision has morphed into a political battle. Our base case remains that the normally rational British reach a compromise with the EU and exit in an orderly
fashion but the likely new Prime Minister, Boris Johnson, is reducing the odds of this every time he speaks. While bond investors would likely benefit from a downturn in the global economy, the fiscal position of the U.S. is becoming more troubling. Record high spending and deficits means the U.S. will account for 75% of all new sovereign debt issuance this year just as a mountain of corporate debt needs to be refinanced. Bonds rates in Europe are also at historic lows so any signs of reflation and rising growth could cause a sudden sell off in credit markets. Rising tensions in the Middle East combined with little excess capacity and declining U.S. shale investment might lead to a spike in energy prices that hurts consumer incomes and raises inflation beyond the central bank’s comfort zone of 2%. Lastly, a deeper economic downturn would prove harmful to nearly all markets given the high degree of leverage in the system.
The world has started a new cycle of synchronized monetary policy easing and fiscal stimulus. Federal spending in the U.S. hit a new record high in June with nearly every country planning to follow the American lead. Europe, ground zero for stagnation over the past decade, is likely to meaningfully embrace expanding government efforts to bolster economic growth and reform the still hampered banking system. Combined with expansionary policies in China, Japan and continued solid growth in the developing nations, we believe both nominal GDP growth and inflation are poised to recover from the current uncertainty-induced economic air pocket. Most investors are not positioned for such an outcome but instead concentrated in a highly correlated, expensive and crowded long duration bet that the stagnation and deflation of the past decade continues indefinitely. As a result, value stocks represent one of the few truly diversifying and high expected return asset classes left in the world.
"While tensions between China and the U.S. have eased somewhat, the global trade system is irreversibly changing."
Our value investing process is highlighting this historic opportunity to build a portfolio of real companies with tangible assets that are producing significant free cash flows, dividends and long-term earnings growth but priced well below any measure of intrinsic value. Specifically, we are focused on exposure to economically sensitive shares in the consumer discretionary, materials, energy and industrial sectors. Defensive and expensive industries such as staples, utilities, real estate and communication services are relatively underweight. From a geographic standpoint, Europe and the UK represent the largest exposures followed by emerging markets. Japan remains the largest underweight as the combination of yield, valuation and growth potential continues to be superior elsewhere. We suspect that future investors will regret not being well positioned for the battle against deflation akin to that of not buying the U.S. long bond in 1982 at a 15% yield as the policies to defeat “stagflation” were put into place. It took an entire generation more than a decade to fully embrace the fundamental shift in the investment environment but those that did were well rewarded.
The ClearBridge International Value Strategy underperformed its MSCI All Country World Ex-U.S. Index benchmark for the second quarter. On an absolute basis, the Strategy had gains in four of the nine sectors in which it was invested. The primary contributors to performance were the industrials and materials sectors.
In relative terms, overall stock selection detracted from performance but was partially offset by positive sector allocation. Specifically, stock selection in the consumer discretionary, communication services, energy, financials and consumer staples sectors hampered relative results. Conversely, stock selection in the materials sector and a lack of exposure to the real estate sector contributed to relative performance.
On a regional basis, stock selection in Europe Ex UK, emerging markets and the United Kingdom hurt results while stock selection in Japan, an underweight to Japan and an overweight to Europe Ex UK proved beneficial.
On an individual stock basis, Novagold Resources, Schneider Electric, Hitachi, Newcrest Mining and Standard Chartered were the greatest contributors to absolute returns during the quarter. Positions in Teva Pharmaceutical, Baidu, Encana, Imperial Brands and Royal Bank of Scotland were the largest detractors from absolute performance.
In the second quarter, we initiated positions in Komatsu in the industrials sector and Drilling Company of 1972 in the energy sector. We also closed a number of positions, the largest being Novartis and Teva Pharmaceutical in the health care sector, Royal Dutch Shell in the energy sector, Duratex in the materials sector and Reckitt Benckiser in the consumer staples sector.