- The U.S. stock market was volatile in July and August but hopes for a trade settlement with China enabled it to rally in September to a new high.
- The trends for the world economies and U.S. manufacturing are concerning, but the U.S. consumer remains robust and this outweighs the negatives we see elsewhere.
- Our engagements across the food supply chain seek to reduce greenhouse gas emissions, improve efficient use of herbicides in agricultural production, scale sustainable packaging and smooth labor tensions and delivery logistics.
Market Overview and Outlook
Concern about economic growth dominated action in world financial markets during the third quarter of 2019. The U.S. stock market was volatile in July and August but hopes for a trade settlement with China enabled it to rally in September to a new high, rising 1.7% for the quarter. The U.S. Federal Reserve cut interest rates by 0.25% in both July and September. 10-year Treasury yields fell from 2.00% to 1.66% and the 10-year/3-month yield curve remained inverted. The U.S. dollar strengthened more than 4% and approached the highs it saw between 2015 and 2017. Despite the attack on Saudi Arabia’s main oil and gas processing plant, oil prices fell from $58.50 to $54.
As in the second quarter, defensive and interest-rate-sensitive stocks led the market. Utilities, REITs and consumer staples were the best performers, while the cyclical energy and materials sectors lagged. The big cap tech and FAANG stocks yielded their leadership positions during the quarter due to high valuations and concerns over regulatory risks. Health care stocks were hurt by Elizabeth Warren’s success at the polls.
It is always easier to make a cogent bear case for the economy, perhaps especially for us given our conservative approach to investing. The trends for the world economies and the U.S. manufacturing sector are indeed concerning. But it is important to remember that the U.S. consumer is three quarters of the U.S. economy. For the past 75 years it has always been the U.S. consumer that caused a U.S. and then a global recession, never the global economy that drove the U.S. The U.S. consumer remains robust and this outweighs the negatives we see elsewhere.
The world economy is having a tough time. Germany entered a recession and European economic data was soft during the third quarter. The European banks never fully recovered from the 2008 financial crisis and several large banks — Deutsche Bank, Unicredit and Societe Generale — are showing signs of distress. Chinese growth is the weakest it has been in several decades. Auto sales have declined for 15 straight months. During the last year the Chinese government has taken more than a hundred steps to shore up its economy. U.S. trade frictions hurt confidence.
We appear at last to be approaching a trade deal with the Chinese, with a meeting set between senior officials for mid-October. But trade uncertainty seems likely to persist. The WTO ruling against Airbus, allowing the U.S. to levy $7.5 billion of tariffs against EU products, could ignite a trade war with Europe if not handled carefully.
U.S. manufacturing numbers deteriorated during the quarter, also reflecting trade worries. Tariff uncertainties made it difficult for companies to commit to investment decisions. The September manufacturing PMI fell to 47.8, indicating a shrinking manufacturing sector. September services PMI fell to 52.6, the lowest reading since September 2016. The services employment index fell to 50.4, indicating services job growth has stalled. Services are 88% of the U.S. economy; the possible spread of manufacturing weakness to services must be watched.
U.S. employment data was excellent and housing strength suggests good consumer sentiment. In September the unemployment rate fell to 3.5%, the lowest since 1969. Payrolls grew 136,000, below recent levels but still indicative of a solid economy. Housing starts jumped to 1.36 million, the high for the cycle. Consumer balance sheets are in good shape, with debt to total assets the lowest since 1985 — and interest coverage even better, given low rates.
One consumer negative appeared during the quarter that needs to be monitored. While auto sales have held up near cycle highs, auto credit deteriorated during the past year and at an accelerating rate in the third quarter. Fitch subprime auto 60-day delinquencies of 5.9% were the highest since 1995. Seven-year loans have risen to 35% of total auto loans and 72% of auto loans are now longer than five years.
The elevated valuation of the U.S. stock market, in combination with weak manufacturing, makes it challenging for us to find new stocks to add to the portfolio. We have attempted to lower risk by being careful about owning stocks with deteriorating stories. The technology shift to 5G will create growth opportunities for cell phone makers and telecommunications services companies that appear only partially reflected in their stock prices. Medical device companies seem less threatened by pricing pressure than other areas of health care. Many other health care stocks seem hostage to the outcome of the 2020 election.
"We have attempted to lower risk by being careful about owning stocks with deteriorating stories."
As we stated last quarter, we still feel that the robust U.S. consumer will keep us out of recession in 2019. And the market’s technical picture is good. The market’s advance to all-time highs has been broad. The period after a yield curve inversion usually generates good stock market returns — especially if no recession occurs. However, the deterioration in the worldwide industrial economy must be monitored. We will be vigilant about any weakness in the U.S. consumer. The Appreciation ESG strategy of owning large, high-quality stocks is well-positioned for today’s market.
The ClearBridge Appreciation ESG Strategy had a positive return during the third quarter of 2019, outperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in nine of the 11 sectors in which it was invested during the quarter. The primary contributors to the Strategy’s performance were the consumer staples and information technology (IT) sectors. The health care and energy sectors were the main laggards.
In relative terms, the Strategy outperformed its benchmark due to stock selection and sector allocation. Stock selection in the consumer discretionary sector added the most to relative performance. Conversely, stock selection in the IT sector detracted from relative returns. In allocation, an underweight to the energy sector proved beneficial.
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Apple, Costco, NextEra Energy, Home Depot and Microsoft. The greatest detractors from absolute returns were positions in UnitedHealth, Pfizer, Facebook, Cisco and Walt Disney.
During the quarter, we initiated positions in Sherwin-Williams in the materials sector and Illinois Tool Works in the industrials sector. We closed positions in Bank of New York Mellon in the financials sector and SAP in the IT sector.
As recent growth of plant-based protein products suggests, there is an appetite for change in the food industry. Many consumers are seeking to reduce the environmental effects of meat production, or just eat less meat, and newly available burgers, hardly distinguishable from real meat but made with pea, soy or potato proteins, are proving to be a popular solution. But the development of plant-based proteins is just one example of how the food industry is being disrupted by innovation that may have environmental and social consequences.
From the field to the table, and increasingly from the restaurant counter to your door, the changing ways we produce, distribute and consume food are creating opportunities and presenting challenges for investors to consider. As an active owner of companies across the food supply chain, ClearBridge is finding economic opportunity in food industry innovation as companies seek to reduce greenhouse gas (GHG) emissions, improve efficient use of herbicides in agricultural production, scale sustainable packaging and smooth labor tensions and delivery logistics. At the same time, it is important to understand these dynamics in a balanced manner and to scrutinize evidence as it arises.
Changing Consumption Habits May Have Environmental Benefits
Arguments against the current amount of meat production focus on the role livestock plays in GHG emissions. One estimate — from a vast 2013 United Nations study and therefore potentially a conservative figure — puts the amount of carbon dioxide equivalent per year produced by livestock globally at 7.1 gigatons, or 15% of all human-produced GHG emissions (Exhibit 1). In addition to the release of GHG emissions, industrialized animal agriculture can also have other environmental impacts such as water contamination from waste (bacteria, chemicals, hormones and antibiotics). Concerns about environmental impact, negative health consequences, high resource use and animal welfare have even encouraged some countries to consider meat taxes, similar to taxes on alcohol and tobacco.
Exhibit 1: Global Estimates of Emissions by Species
The environmental benefits of plant-based meat products could be significant. A study by Beyond Meat and the Center for Sustainable Systems at the University of Michigan suggests a Beyond Burger generates 90% less GHG emissions, requires 46% less energy, has 99% less impact on water scarcity and uses 93% less land than an equivalent quarter pound of ground beef.
The excitement about plant-based proteins has encouraged traditional packaged food companies to take another look at reinvesting in their somewhat neglected veggie burger brands. Kraft Heinz has reformulated and rebranded its Boca Burger and Kellogg has updated its portfolio of plant-based protein products with the introduction of Incogmeato. ClearBridge holding Nestle is adding its own Awesome Burger to the lineup. Given Nestle’s scale and infrastructure as arguably the largest food company in the world, the impact of a plant-based meat product from the company could be considerable.
Additionally, several restaurants have been launching successful limited-time offerings in partnership with Impossible Foods (currently privately owned) and Beyond Meat. In another opportunity to scale plant-based protein, McDonald’s recently announced it will offer the P.L.T. (plant, lettuce and tomato) burger with Beyond Burgers.
At the same time, it’s important to acknowledge the environmental impacts of large-scale switching to plant-based proteins. These include deforestation, runoff of herbicides and pesticides into ground water and the dangers of monoculture farming, all of which should be considered before accepting meatless “meat” products as a panacea and monitored by investors for risks as plant-based protein businesses grow.
Similarly, the health benefits of switching to meatless burgers may not be so clear cut, as most meatless burgers are heavily processed and high in saturated fat and sodium. At the same time, part of the disruption in plant-based proteins is their increased ability to substitute for meats in vegetarian diets through the addition of vitamins and minerals, such as B12 and zinc (in the Impossible Burger), often found in animal proteins.
Precision Agriculture Reduces Herbicide Use
In a recent engagement with the management of ClearBridge holding John Deere, we discussed how companies in the agricultural supply chain are using technology to improve food production. Deere is a leader in precision agriculture, which applies new technologies in planting, spraying and irrigation tasks to yield more harvest and use less water and pesticides. Its AutoTrac steering system, for example, reads the soil and steers planters to nearly eliminate overlapping passes on the field, reducing unnecessary fuel, seed and chemical use. Similarly, Deere has a technology that improves spraying precision and reduces double-spraying. Its ExactEmerge planter is designed to increase the accuracy of spacing, depth and population of seeds, making for larger and more efficient yields.
In 2017 Deere acquired Blue River Technology, a small company applying machine learning, computer vision and robotics to agriculture. Blue River’s precision sprayer, currently in development, uses computer vision and artificial intelligence to precisely spray herbicides only where they are needed. The sprayer is expected to reduce herbicide application rates by over 30% for all major crops, including a 90% reduction for cotton — in our meeting we learned of one field trial for cotton in which herbicide consumption costs declined to $25,000 compared to $250k the previous year. It is slated for a potential 2021 launch.
Since some of Deere’s farm equipment innovation relies on connectivity, the lack of broadband coverage in rural areas has been a challenge. ClearBridge holding Microsoft’s FarmBeats program is offering one solution in this regard by helping farmers improve their digital technology. FarmBeats is an Internet of Things (IoT) platform that uses unused TV white spaces to create broadband links between a farmer’s home internet connections and a solar/battery-powered IoT station on the farm. Greater internet connectivity on the farm better enables technology-enhanced solutions and, ultimately, more efficient and sustainable agriculture.
Big Things Could Come in Small Packages
Adapting to fast-changing tastes has typically been difficult for larger, more established players in the food industry, but some are becoming nimbler to better compete with startups and are adding the power of scale to innovation. Nestle’s Yes Bar, for example, is a vegan-focused snack bar with plant-based protein designed to appeal to health- and environment-conscious consumers. To meet this market Nestle developed a sustainably sourced recyclable paper wrapper, the first of its kind that can be used in the high-speed flow wrap machines necessary to produce the product at scale. The paper wrapper also guarantees product quality and freshness over its shelf life. The push from smaller disruptive forces helped enable a confectionary packaging innovation that greatly reduces plastic use in the food industry.
Food Along the Last Mile
The technological disruption that brought us rideshare companies like ClearBridge holding Uber is also enabling a large platform for online food delivery aggregators. For companies with both rideshare and food delivery businesses, the proportionate role of food delivery is increasing (Exhibit 2).
Exhibit 2: Food Delivery Increasingly on the Menu
This is not surprising: food delivery sales in the U.S. for online aggregators are taking off. We are now at $20 billion in gross annual sales, just counting DoorDash, Uber Eats, Grubhub and Postmates, to name four of the larger players (Exhibit 3). Sales through these platforms are growing at around 60% year over year. While this is small compared to overall U.S. restaurant sales (which are an estimated $800 billion a year, including delivery, dine in and drive through), the total pie of digital-enabled delivery is slated to grow.
Exhibit 3: U.S. Online Food Delivery Is Growing Steadily
At the same time, as online food delivery aggregators are offering enhanced convenience and expanded food selection to consumers, new questions have arisen about food safety and protection for drivers and couriers in the gig economy. Food safety questions run the gamut from whether drivers can maintain correct hot or cold temperatures for food in their cars to concerns around food tampering from couriers. Labor questions surround benefits and pay for delivery drivers and couriers, most of whom are working part-time.
Ultimate success of online delivery companies may depend on the strength of partnerships with restaurants, in effect bringing drivers’ incentives into closer alignment with those of the restauranteurs, and the ability to leverage technology to reduce food safety incidents and improve delivery efficiency. ClearBridge holding Grubhub looks to be well-positioned in both regards. Through our regular engagements with Grubhub, we remain in active dialogue on best practices with regards to both food safety and labor relations.
Consumers Are Playing an Increasing Role
The role of the consumer in these changing dynamics should not be forgotten. Consumers voting with their wallets have been successful at changing, or at least helping steer, a whole industry, and this has occurred largely only in the past few years. While a common criticism is that more sustainably sourced foods are usually more expensive and more available to affluent consumers, this situation may be changing, if slowly. ClearBridge holding Costco, is both the largest warehouse food retailer in the U.S. and a top organic food retailer. Given its scale, Costco is making organic and natural food products more price competitive, helping to overcome some cost barriers. At the same time, shopping for organic or sustainably sourced products can be confusing. For example, little consensus and few useful laws regarding organics labelling make determining which products are truly organic a challenge.
From production to consumption, food covers many industries and offers ClearBridge many avenues for understanding and engaging with companies we own both on best practices and on disruptive innovations that are both offering economic opportunities and potential solutions to pressing environmental problems. We continue to work with our portfolio companies to create more ways in which consumers and investors can truly change the food landscape.