- The U.S. equity market delivered modest gains in the third quarter, led by more defensive, yield-driven sectors.
- The portfolio saw positive contributions from industrials, materials and cable companies.
- We continue to position the portfolio to reduce cyclicality and emphasize the higher quality companies we own, with a focus on consistent free cash flows.
Market Overview and Outlook
The U.S. equity market delivered modest gains in the third quarter, overcoming trade tensions and concerns about slowing global growth with a little help from the Federal Reserve. The broad market S&P 500 Index rose 1.7% for the quarter and has gained 20% for the year to date. While the year-to-date performance is impressive, one needs to keep in mind the sharp selloff in late December 2018. On a trailing 12-month basis through September 30, 2019, the S&P 500 returned a more modest 4.25%.
Economic growth expectations remain one of the key drivers of market performance. In that vein, slowing economies in Europe and China, coupled with weaker manufacturing readings in the U.S., have been on investors’ minds in recent months. U.S.-China trade talks are adding a layer of uncertainty and contributing to market volatility. In its efforts to calm the markets and sustain economic growth, the Fed reversed its course and cut the federal funds target rate for the first time in a decade in July and again in September. The cuts left the target rate at a range of 1.75%–2.00% and brought the Fed in alignment with the accommodative stances of other global central banks. The European Central Bank cut its deposit rate to -0.50% and restarted its asset purchase program in September.
The U.S. economy is holding up relatively well, however, despite trade tensions and some signs of slowing economic activity. U.S. GDP grew at 2.0% in the second quarter, well ahead of other developed countries. Unemployment remains low, wages are rising, and credit conditions remain strong. The consumer outlook is mixed but positive, with tariffs weakening confidence, according to the University of Michigan Survey of Consumers, but not enough to prevent growing retail spending, as of August data. Manufacturing has slowed, with ISM manufacturing PMI reading at 47.8 in September, the weakest showing since early 2016. Volatility picked up in August as recession fears drove bond yields lower. The yield on the 10-year U.S. Treasury note fell as much as 55 basis points in the quarter, hitting as low as 1.46% and inverting the 2-year/10-year yield curve before picking back up and ending the quarter at 1.66%.
More defensive or yield-driven stocks performed well, with utilities, real estate and consumer staples sectors leading the market. Meanwhile, the more economically sensitive energy sector was under pressure during the period, despite a temporary surge in oil prices as some Saudi supply came offline. Typically viewed as economically defensive, the health care sector continues to be under pressure due to increasing concerns regarding potentially changing policies. This is particularly true with several Democrat candidates advocating either a single payor or government option as an alternative to private health insurance.
"Cable holdings continue to perform well, driven by the growth of high-margin broadband services."
Managed care companies have borne the brunt of negative sentiment toward the private health insurance market, and portfolio positions Anthem and UnitedHealth, which otherwise have performed well over recent years, have pulled back. CVS was a notable exception, delivering better than expected financial results. Our relative underweight in yield-oriented sectors such as utilities, real estate and staples was a modest drag on performance.
Our stock selection in materials and industrials contributed positively to relative performance, while both sectors lagged the broader market. A leading producer of aggregates used in construction, Martin Marietta Materials has been enjoying a strong pricing and volume environment. Its domestic focus has somewhat shielded it from global trade concerns. In the industrials sector, UPS executed well during the most recent reported quarter as it enjoys early benefits of its multi-year $21 billion transformational program aimed at automating its sorting facilities. Cable holdings such as Comcast and Charter continue to perform well, driven by the growth of their high-margin broadband services, which are partially offset by ongoing cord-cutting.
As in recent quarters, portfolio activity has aimed to reduce cyclicality and improve the quality of the companies we own.
During the quarter we initiated three new positions: Edison International, Enterprise Products Partners and Apple. Edison is the second-largest electric utility in California and has good growth prospects. While the company’s financial exposure to previous wildfires remains uncertain, recent California wildfire legislation provides greater clarity regarding potential future events, which should be a long-term positive for the company. Enterprise Products Partners is a leading midstream infrastructure company that transports and processes natural gas liquids (NGLs) typically used as feedstock by the growing petrochemical complex. It has a strong balance sheet and consistent cash flows. We find Enterprise trades at an attractive valuation relative to other yield-oriented sectors of the market. Apple’s iconic devices and loyal customer base create a unique ecosystem supporting a growing and relatively more stable services revenue stream. In addition, we expect Apple to leverage its strong iPhone franchise and benefit from the transition to 5G over the coming years. The company has a very strong balance sheet and generates solid free cash flow.
We exited three positions during the quarter. We continued to reduce our exposure to the financial services sector by selling our positions in MetLife and Capital One Financial. We’ve been disappointed by the fundamental performance and lack of pricing power of the oilfield services companies in our portfolio over the last few years. As a result, in addition to selling out of remaining Halliburton shares in the second quarter, we exited Schlumberger during the third quarter.
Amid trade uncertainties, slower business growth and a market near all-time highs, we continue to maintain a disciplined investment approach that focuses on competitively advantaged companies with strong franchise characteristics capable of generating superior returns across cycles.
The ClearBridge Large Cap Value Strategy underperformed its Russell 1000 Value Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in nine of the 11 sectors in which it was invested for the quarter. The largest contributions came from the industrials, financials and materials sectors. The health care and energy sectors were the sole detractors from Strategy performance.
On a relative basis, sector allocation detracted from performance, while overall stock selection contributed positively. In particular, underweights to the consumer staples, utilities and real estate sectors dampened relative returns. Stock selection in the health care and information technology (IT) sectors also weighed on relative performance. Conversely, the Strategy’s stock selection in the industrials and materials sectors proved beneficial.
On an individual stock basis, the largest contributors were UPS, Martin Marietta Materials, JPMorgan Chase, American Tower and Home Depot. Positions in Anthem, Pfizer, DISH Network, UnitedHealth Group and Fox were the greatest detractors from absolute returns in the quarter.