- Trade war concerns and signs of deteriorating global growth hurt value stocks in the export-driven economies of Europe, Asia and emerging markets.
- As experienced in a brief September value rally, major shifts in monetary and fiscal policy have the potential to spark a rotation into long-suffering assets overlooked by the dominant momentum trade.
- The large detachment of stock prices from underlying fundamentals is displaying signs of reconnecting, which should benefit the portfolio.
Elevated volatility during the third quarter — sparked by geopolitical tension adding to the ongoing U.S.-China trade morass — led to mixed results for international equities but failed to blunt long-standing trends favoring growth and momentum. The benchmark MSCI All Country World Ex-U.S. Index declined 1.8%, the MSCI All Country World Ex-U.S. Small Cap Index fell 1.1% while the MSCI Emerging Market Index retreated 4.3%. International markets experienced a sharp reversal of the crowded and correlated momentum leadership in September, but it was not enough for value stocks to outperform as the MSCI ACWI Ex-U.S. Value Index declined 2.8% compared to a loss of 0.9% for the MSCI ACWI Ex-U.S. Growth Index (Exhibit 1).
Exhibit 1: International Value Continues to Trail Growth
From a pure factor standpoint, value underperformed by an average of 200–300 basis points over the quarter while short-term price momentum posted gains of a similar magnitude. Trade war concerns and signs of deteriorating economic growth particularly hurt the prices of value stocks in Europe, Asia and emerging markets. Countries most dependent on exports and manufacturing such as Germany, Sweden and South Korea fell by 4% or more.
The underlying drivers were the strong gains of defensive companies relative to cyclical and financial equities (-3.6%). Economically dependent sectors such as energy (-4.6%), basic materials (-6.5%) and industrials (-2.5%) lagged. Falling interest rates and a flattening yield curve, meanwhile, led to lowered earnings expectations for banking and insurance shares. Utilities (+1.3%) and consumer staples (+1.5%) mirrored the rally in bond prices. One outlier was a powerful bounce in semiconductor makers as prices of memory chips began to stabilize. This helped Taiwan rise nearly 3% in a region severely impacted by a near 12% drop in Hong Kong shares and supported a 2.2% gain for information technology.
The protests and political crisis in the former British colony worsened into September with little sign of resolution. Along with uncertainty surrounding trade negotiations, this led to a nearly 5% drop in mainland Chinese markets. The outperformance of price momentum also provided a tailwind to cap-weighted benchmarks, value or growth, to the detriment of concentrated, style-pure active portfolios like the ClearBridge International Value Strategy.
Global asset markets have reached a level of herding that is historically on par with previous secular or generational shifts in the underlying investment landscape. Investors have crowded into a relatively small number of stocks, which has fueled the current dominance of growth and momentum. According to work by the researchers at Morgan Stanley, growth exposure of all equity funds is in the 97th percentile while value exposure is in the bottom decile (Exhibit 2). In addition to herding, there is also a worrying record-high correlation of a broad basket of factors such as growth, quality, low volatility and bond proxies. The relative performance and valuations of these closely linked asset cohorts are also at generationally wide levels, especially when compared to value stocks. When this dynamic begins to display the present extreme conditions, the odds of a phase change or transition rise significantly.
Exhibit 2: Factor Valuations Historically Skewed Toward Growth
While the exact timing and specific catalysts of the coming shift are difficult to predict, we can begin to observe some reasons why the “herd” could soon begin to stir. First, we are on the cusp of the most profound change in the overall monetary policy environment since Paul Volcker raised rates by 11 percentage points in 1980–81. In addition, the large detachment of stock prices from underlying fundamentals is displaying signs of reconnecting with some refreshing rationality in the technology sector.
The world is in a condition of paralyzing uncertainty. Long held global constructs and relationships have been upended by political turmoil in the U.S., China, Europe and Latin America. Companies have responded by reining in expansion plans and hiring while disruptions to the global supply chain from trade conflicts are causing a fall in profits. As a result, clear signs of a meaningful economic slowdown appeared during the third quarter with previously strong German and U.S. manufacturing sectors entering contraction as measured by the Institute for Supply Management PMIs. The direct reaction to rising economic pessimism has been record investor flows into bonds.
More importantly, politicians and policy makers were forced to confront the inability of lower rates to generate broad economic growth or the desired level of inflation. “Japanification” as a topic began to trend, especially in Europe, with the conclusion that monetary policy by itself had become ineffective, counterproductive or even socially regressive by adding to inequality. The inevitable path forward is a coupling of fiscal and monetary policy where central banks directly finance government spending. Central bank balance sheets will expand with the intention of funding targeted fiscal policies to put money into the real economy as opposed to primarily inflating asset prices.
The bull market in “deflation” and long-duration assets of the past decade leaves the herd poorly positioned for this shift to an aggressively inflationary and stimulative policy mix. As we experienced briefly in September, even a hint of these initiatives being implemented will lead to a dramatic rotation into long-suffering assets such as value stocks, commodities, cyclicals, financials, Europe and emerging markets.
After two weeks of strong value stock performance in September the financial media was buzzing with stories that it was “just a blip.” But as researchers at Goldman Sachs pointed out, “Sharp momentum drawdowns similar to the one that has taken place in the last two weeks usually mark the end of the momentum rallies rather than tactical buying opportunities.” This conclusion was based upon their study of the 14 most significant momentum drawdowns since 1980. Looked at from the perspective of the outperformance of value stocks, the reversal relative to momentum was the largest since the market lows of 2009. We believe this is an early sign of the coming long-term shift in market leadership. In a herded state, phase changes usually are sudden, unexpected and powerful as investors stampede out of the crowded and expensive trades. As a disciplined and focused international value manager, we are well-positioned for such an environment.
"The pain of international value investing over the past cycle is equally matched by the extraordinary opportunity afforded by current investor herding."
Adding to the pain of being a pure, disciplined value manager over the past couple of years has been the frustrating disconnect of stock prices and company fundamentals. This is not to dismiss the fact that we have made some mistakes. But even where we have been invested in companies with solid earnings, dividends, sales growth and margins, those stocks have generally lagged the market and underperformed momentum/growth equities.
Shares of portfolio holding Maersk, for example, are generally flat year to date despite the Danish shipping company expanding margins by close to 20% as it benefits from increasing shipping rates and improving demand for commodities. Maersk also spun off its drilling division in the second quarter to increase shareholder value yet continues to trade at a historical discount to the value of its assets. With significant shipping capacity being taken out in 2020 due to sulfur pollution regulations and global trade still growing, the company is well-positioned to improve results from here.
European banks have been ground zero for negative sentiment toward value stocks, which overlooks strong performers like portfolio holding Bawag Group. The high-quality Austrian bank is adept at acquiring poorly run, overcapitalized banks in Germany and Austria and increasing efficiencies. Bawag is growing earnings at a 10% rate, pays a 6% dividend and is buying back 10% of its outstanding shares. Despite these actions and no credit quality issues, it trades at just 7x earnings.
As the third quarter ended, however, there were signs that investors were beginning to take a more rational and fundamental view of companies like Maersk and Bawag. Similar to the sudden shift surrounding the collapsed leveraged buyout of UAL back in 1989 that ended the junk bond era, our current cycle has WeWork and its failed IPO. Initially accorded a valuation of $47 billion, the situation moved quickly from “changing the world” to changing the CEO. Quite simply, the offering plans were undone by a focus on profitability and corporate governance. This technology backlash is causing investors to look at other leading disruptive firms with renewed analytical vigor. Concerns surrounding the rising competition in areas of video streaming, cloud computing and loss-making e-commerce companies are rising. Given that technology startups spent about $44 billion on cloud computing and digital advertising last year, a less accommodative environment for capital raising could be challenging to the entire tech ecosystem.
While negative for many of the leading momentum and growth stocks, the strong free cash flows, dividends, discounted assets and resilient profitability of value companies will benefit from closer fundamental scrutiny. This has begun to generate merger and acquisition activity from both private and strategic investors. We expect this trend to accelerate as both capital and companies remain cheap, especially non-U.S. cyclicals and financials.
Positioning and Outlook
The pain of international value investing over the past cycle is equally matched by the extraordinary
opportunity afforded by current investor herding. This is primarily driven by policy uncertainty and pessimism about the global economy. Most international equity markets offers valuations, yields and long-term growth potential at levels seldom available to investors. Specifically, our portfolios retain a
pro-cyclical bias with relatively high weightings in materials, industrials and financials. The correlation with highly inflated bond prices is intentionally negative with no exposure to real estate and utilities. We also continue to focus upon improving the long-term upside, margin of safety and current income profile with every decision. Our sense is that the policy, economic and corporate profit environment is on the cusp of a profound shift that will favor international value stocks. The herding evident in the markets could lead to value being one of the last truly diversifying asset classes with high return potential left in this extended cycle.
The ClearBridge International Value Strategy underperformed its MSCI All Country World Ex-U.S. Index benchmark for the third quarter. On an absolute basis, the Strategy had gains in three of the nine sectors in which it was invested. The primary detractors from performance were the financials and industrials sectors.
In relative terms, overall stock selection and sector allocation detracted from performance. Specifically, stock selection in the financials, industrials, consumer discretionary, IT and energy sectors as well as an overweight to materials hampered relative results. On the positive side, stock selection in the communication services and materials sectors contributed to relative performance.
On a regional basis, stock selection in Europe Ex UK, emerging markets and the United Kingdom and an underweight to Japan hurt results.
On an individual stock basis, Vodafone Group, Anheuser-Busch InBev, Infosys, Bouygues and Roche were the greatest contributors to absolute returns during the quarter. Positions in CYBG, Banco Santander, CIMC Enric Holdings, Atos and Kion Group were the largest detractors from absolute performance.
In the third quarter, we initiated positions in Samsung Electronics in the IT sector and Sanofi in the health care sector. We also closed positions in Rio Tinto in the materials sector, Anta Sports in the consumer discretionary sector and Allergan in the health care sector.