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Commentary

Appreciation Strategy

Third Quarter 2019

Key Takeaways
  • 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.
  • The technology shift to 5G will create growth opportunities for cell phone makers and telecom services companies that appear only partially reflected in their stock prices.
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.

 

"We have attempted to lower risk by being careful about owning stocks with deteriorating stories."

 

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.

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 strategy of owning large, high-quality stocks is well-positioned for today’s market.

Portfolio Highlights

The ClearBridge Appreciation Strategy had a positive return during the third quarter of 2019, outperforming the Strategy’s S&P 500 Index benchmark.

On an absolute basis, the Strategy had gains in nine of the 11 sectors in which it was invested during the quarter. The main contributors to the Strategy’s performance were the consumer staples, industrials, communication services and information technology (IT) sectors. The health care and energy sectors detracted.

In relative terms, the Strategy outperformed its benchmark due to stock selection. In particular, stock selection in the industrials and consumer discretionary sectors contributed the most to relative performance. Conversely, stock selection in the IT sector and an underweight to utilities detracted.

On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Apple, Home Depot, Microsoft, Raytheon and Comcast. 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 exited positions in Bank of New York Mellon in the financials sector and SAP in the IT sector.

Scott Glasser

Co-Chief Investment Officer, Portfolio Manager
28 Years experience
26 Years at ClearBridge

Michael Kagan

Portfolio Manager
34 Years experience
25 Years at ClearBridge

Related Perspectives

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    PM Michael Kagan weighs recession risks and details how the defensive-led rally favored the Appreciation Strategy's approach in the third quarter.
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    2Q19 Commentary: Companies with strong prospects are seeing them reflected in their stock prices, but valuations alone have a poor record of forecasting returns.
  • Michael Kagan on AssetTV Active Masterclass
    The Appreciation Strategy PM highlights the benefits of active management during volatile markets and how fundamental research can help manage risk.
  • Appreciation Strategy
    1Q19 Commentary: A rebound in Europe and faster growth in China could lead to a positive earnings surprise later in 2019.
  • Appreciation Strategy
    4Q18 Commentary: During the quarter we saw some intriguing opportunities, reduced cash levels and added several new names.

Related Blog Posts

  • Past performance is no guarantee of future results.

  • All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC  nor its information providers are responsible for any damages or losses arising from any use of this information. 

  • Performance source: Internal. Benchmark source: Standard & Poor’s.