- Investors embraced relative certainty on trade, lower for longer interest rates and an expanding money base to push U.S. equity markets higher in the fourth quarter.
- In a risk-on quarter, higher-beta technology names were top contributors, while those with less economic sensitivity generally underperformed.
- Taking a life cycle approach to the beverage container’s challenges brings home how there are several entry points for action that can reduce environmental impact.
The season of giving was prosperous for U.S. equity markets. In the final quarter of 2019 investors were treated with resolution — at least partially — to many key concerns: the U.S. and China reached a phase one trade agreement; the Fed cut interest rates by another 25 basis points and resumed expansionary monetary policy to address malfunctioning repo funding markets (but don’t call it quantitative easing); and the UK inched toward a Brexit resolution.
The result was a steady grind higher for equities resulting in a robust 9.07% return for the S&P 500 Index. Volatility was noticeably absent: there were only five trading days with >1% swings in the market, the least in over a year.
The quarter’s impressive return can be almost exclusively explained by an expansion of the market multiple as investors embraced relative certainty, lower for longer interest rates and an expanding money base. S&P 500 earnings estimates for 2020 and 2021 were revised lower by 2.24% and 1.72%, respectively, over the past 90 days as the market rallied. As a result, the 12-month forward P/E multiple expanded from 16.8x to 18.3x during the quarter (Exhibit 1). The expanding market multiple is noteworthy because the current S&P 500 P/E multiple is within an earshot of the peak post-crisis multiple (18.4x in December 2017) and 1.5 standard deviations above the 15.1x average forward multiple. In our view, markets will be more dependent on a rebound in earnings to drive the next leg of market returns.
Exhibit 1: S&P 500 Index 12-Month Forward P/E Multiple
Not surprisingly, as key investor concerns diminished, consumer and business confidence measures improved steadily. The University of Michigan’s consumer confidence survey increased from 93.2 in September to 99.3 by year-end, while the NFIB Small Business Optimism index also improved from 101.8 in September to 104.7 in the most recent reading (end of November). The bottom line is investor mindsight shifted from “when” a recession will begin to “if” a recession is within a forecastable horizon. Given the market rally on expanding multiples, investors clearly concluded the longest U.S. economic expansion on record (10.5 years and running) has legs as we enter 2020. Supporting this concept, the New York Fed’s Probability of a Recession model, which looks ahead 12 months, declined from 34.8% in September to 23.6% at last reading in December. This measure never surpassed 12% during the 2009–2018 timeframe so concern remains elevated, just less so than at mid-year. This data is consistent with ClearBridge’s Recession Risk Dashboard, which turned to a more cautious “yellow” signal in June, indicating a more mixed economic picture but not an imminent recession.
"The fourth quarter’s leadership change is another sign investors are betting on continued U.S. economic expansion in 2020."
Increased confidence played out in the form of a bullish change in market leadership. Information technology (IT) regained leadership from defensive sectors — REITs and utilities — which led the market during a choppy third quarter. Of note, health care recouped some 2019 year-to-date underperformance as the specter of a Warren or Sanders Democratic nomination diminished. The 2020 Presidential election, meanwhile, remains a focal point for U.S. equity investors. In sum, the fourth quarter’s leadership change is another sign investors placed bets for a continuation of U.S. economic expansion in 2020.
The Appreciation ESG Strategy maintains a conservative approach to investing and focuses on both upside participation and downside protection. We tend to focus on high-quality earnings compounders with quality balance sheets and durable competitive advantages. These are not the types of stocks short-term investors gravitate to in a renewed risk-on or expanding multiple environment. For example, Travelers was a leading detractor: the company had idiosyncratic issues that catalyzed underperformance, and it is also a business with less sensitivity to a changing economic landscape. Meanwhile, higher-beta stocks Apple, Microsoft, Facebook and Adobe were four of the top six contributors.
On an individual stock basis, the single largest contributor to our return was Apple. However, our 4%+ portfolio weight in Apple remains roughly 40 basis points below market weight, despite being the second-largest position in our portfolio. As such, Apple’s 1,700 basis point outperformance versus the IT sector weighed against our relative performance. Meanwhile, UnitedHealth Group was our third-largest contributor to performance and our best relative performing stock. The position is a roughly 130 basis point active weight that outperformed the health care sector by over 2,100 basis points during the quarter.
During the quarter we initiated a position in Arista Networks as we viewed soft demand for its networking switches from cloud providers to be temporary. We anticipate a ramp up in demand in the second half of 2020 and believe risk/reward supports initiating a position today. We funded this purchase by trimming Cisco Systems as we view the growth outlook for Arista Networks relative to risk/reward increasingly compelling relative to networking hardware peers.
Although we have subdued expectations for the U.S. economic outlook, we believe actions taken in recent months will support a low-growth economic expansion through at least the first half of 2020. Lower interest rates support a benign credit outlook (though we remain concerned about total leverage and interest coverage should rates rise). An expanding monetary base should keep liquidity ample while trade placidity could provide a much-needed boost to corporate capex. Finally, employment trends remain encouraging with the unemployment rate at 50-year lows, total payroll growth steady and initial claims near cycle lows. Considering consumer spending accounts for three quarters of U.S. GDP, steady employment data should buoy consumer spending.
While we believe the U.S. is in the late stages of its current economic expansion (the longest economic expansion on record at 10+ years), we also believe actions in the fourth quarter likely support further modest growth in early 2020. We continue to focus on investing in high-quality, large cap companies with quality balance sheets and stable free cash flow. We believe this to be especially important given late-cycle dynamics and elevated political risk as we look to the November 2020 election.
The ClearBridge Appreciation ESG Strategy had a positive return during the fourth quarter of 2019, underperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in all 11 sectors in which it was invested during the quarter. The primary contributors to the Strategy’s performance were the information technology (IT), health care and financials sectors. The real estate and utilities sectors were the main laggards.
In relative terms, the Strategy underperformed its benchmark due to stock selection and sector allocation. In particular, stock selection in the IT and communication services sectors detracted the most from relative performance. Conversely, an underweight to the consumer discretionary sector boosted relative returns.
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Apple, Microsoft, UnitedHealth Group, JPMorgan Chase and Facebook. The greatest detractors from absolute returns were positions in Home Depot, Travelers, Cisco Systems, International Business Machines and Vulcan Materials.
As a follow-up to our 2018 commentary on plastic waste, given growing beverage consumption and declining recycling rates, we take a closer look at beverages, in particular plastic bottles and other container options. Americans are increasingly choosing water beverages (both still and sparkling) over soda, and most water for purchase is still bottled in plastic containers. The beverage container touches many industries, upstream and downstream, pre- and post-consumer, presenting logistical and environmental challenges at each step. Taking a life cycle approach to the beverage container’s challenges, however, brings home how there are several entry points for action that can reduce environmental impact.
Plastic Upstream to Downstream
From a production and logistics standpoint, plastic bottles can make a lot of sense: they are durable and versatile, enable long shelf life, are easily molded and are light, which makes them easy to transport and lowers the carbon footprint from transportation costs. A polyethylene terephthalate (PET) bottle costs roughly half as much as a standard 12 ounce can (which costs $0.09–$0.10)1 and produces 77% less greenhouse gases than a glass bottle (which are heavier to transport and can break during shipping).2
This convenience comes with some major challenges, however, the biggest being recycling, as increased use results in high levels of plastic waste. Globally, only 12% of plastic waste is recycled. Sixty percent of plastic waste stays in the environment, entering urban areas, rivers and landfills around the world (Exhibit 2) — an alarming level given that it takes 450 years for a PET bottle to decompose. Another 28% of plastic waste is incinerated, resulting in significant greenhouse gas emissions.3 In the U.S., the 29% recycling rate for PET bottles is higher than the global rate, but still dismal.4
Exhibit 2: Top Ten River Sources of Plastic Waste in Oceans
The increased use of single-use plastics is another major challenge. A third of all plastic produced is for single use, but because these single-use items have a short shelf life they generate 42% of waste.5 Bottled water consumption helps illustrate the single-use challenge. We consume 100 billion gallons of bottled water globally each year. The U.S. consumes 14 billion gallons, of which 70% comes in single-serve bottles (the average American opens six water bottles per week).6 Consumption in the emerging markets tends to skew more toward bulk retail and is often a result of limited access to clean water as opposed to convenience. More single-serve plastic use means a higher plastic consumption intensity per gallon of bottled water consumed, increasing the scope of waste generation.
What are the Solutions?
While there are several solutions available to the individual consumer — use less plastic, and use less often; if you use, reuse (consider having your own bottle); finally, recycle — there are several ways businesses can improve the situation up and down the beverage container supply chain. For plastic bottles in particular, we can use alternate substrates, use more recyclable content, use less plastic packaging or improve recycling itself, either by increasing consumer awareness or investing in technology to better recycle content.
Using Alternate Substrates
One much-discussed option to reduce the amount of plastic water or beverage bottles produced is to switch some uses to aluminum cans, which have much higher recycling rates (75% globally) than plastic bottles. This shift is being made possible in part by ClearBridge portfolio companies Ball Corporation, the largest manufacturer of recyclable aluminum beverage cans in North America, and Crown Holdings, a global leader in the production of steel and aluminum cans for food and beverage products. These companies are helping meet the demand for aluminum beverage packaging, which, with aluminum becoming both a consumer and recycling package preference over plastic bottles, we expect to increase dramatically.
In a November 2019 call with Ball CEO and investor relations on its business and sustainability we discussed how the environmental challenge posed by packaging is a key driver for growth for the business. We see Ball as an innovator within the aluminum can industry. Ball will be the first company to build a fully dedicated aluminum cup company — partnering with vendors to introduce recyclable aluminum cups to be used in stadiums and event venues across the U.S. They are also pioneering the development of new aluminum products such as resealable aluminum containers that will help increase penetration in the bottled water segment.
"Using more recycled plastic could start a virtuous cycle of raising plastic’s waste value, encouraging more recycling."
While aluminum is more carbon intensive to manufacture and it releases greenhouse gases in its production process, it is infinitely recyclable, which indicates the overall life cycle impact would be less than that of plastic. Several large beverage makers, such as ClearBridge portfolio companies Coca-Cola, PepsiCo and Nestle, have begun to make the shift from plastic to aluminum with some of their water brands.
Investing in Technology to Increase Recyclable Content
Still, to the extent that plastic will continue to be used, there are ways to improve its use. Some beverage companies are working to improve the recyclability of plastic. PepsiCo, for example, announced in June 2019 that its LIFEWTR brand will be packaged in 100% recycled PET or rPET. Using more recycled plastic could start a virtuous cycle of raising plastic’s waste value, encouraging more recycling.
In addition, several companies across the plastic packaging value chain, ClearBridge portfolio company Unilever among them, have formed a new group aiming to accelerate the commercialization of BP Infinia, a technology for recycling certain types of PET plastic waste, such as highly colored and opaque plastic bottles or food trays, until now difficult to recycle. The technology is designed to turn these types of PET plastic waste into higher-quality PET packaging that can be recycled repeatedly without losing quality. In October 2019, BP announced plans to construct a $25 million pilot plant in the U.S. to prove the technology before progressing to full-scale commercialization. Higher recycling rates would reduce both virgin production and waste ending up in landfills and oceans or incinerated.
At a recent event with Coca-Cola C-suite members and head of sustainability, we discussed how plastic packaging remains a large sustainability focus area. Coca-Cola and several other large staples companies have invested in Circulate Capital, a firm that finances and invests in companies and infrastructure that prevent plastic from entering our oceans. Key technological focus areas include chemical recycling and increasing the capability to use post-recycled plastic content in new packaging. One of the big outstanding non-technological barriers is that in China and India regulators do not allow post-recycled plastic to be used for food and beverage purposes; Coca-Cola continues to work with industry players and NGOs to try and amend those regulations.
We also discussed how using returnable glass packaging is a competitive advantage in certain markets, and how this system allows the cost of the packaging to be amortized over 10+ uses, which gives the consumer a >30% discount versus a single-serve offering. Recycling infrastructure, however, remains crucial. A lack of glass recycling capability in the U.S., for example, limits the glass-packaged beverages Coca-Cola can sell in the U.S. market.
Challenges to Improving Recycling Practices
Whether we’re using plastic or aluminum, recycling practices likewise show considerable room for improvement. Recycling rates in the U.S. have been flat at 35% since 2012, with the latest data available being 2017.7 Recycling for PET and high-density polyethylene (HDPE) liquid containers is 29%, down from 31% in 2012.8 Aluminum can recycling has also declined to 49% from 56% in 2014.9 Overall plastic recycling rates are holding steady at 8%–9%.10
Adding to the stress on the recycling system, China, hitherto the largest importer of waste plastics, accounting for 26% of the global market, imposed significantly higher contamination standards, in effect banning the import of several types of waste, including plastics, in early 2018. Municipalities, deprived of Chinese demand for their waste, have seen prices of recycling commodities fall precipitously, in effect raising the cost of recycling.
In a December 2019 engagement with ClearBridge portfolio holding Waste Management, an integrated waste services company, we discussed how contamination — non-recyclable material or garbage that ends up in the recycling system — has increased as more people have begun recycling. The company estimates contamination rates at 25%, up from 10% in recent years. Since the ban, Waste Management and other U.S. recyclers have improved contamination in their recycling basket, although this has raised costs for municipalities even as the commodity value of recycling has collapsed, in some cases threatening recycling programs. Processing costs today are as much as $75–$85/ton, which compares to average landfilling costs of $55/ton. Higher costs have made it difficult for some municipalities to recycle.
Another waste disposal option is waste to energy. ClearBridge portfolio company Covanta, for example, operates energy-from-waste facilities that convert over 21 million tons of waste into power for over one million homes and recycles roughly 400,000 tons of metal every year.
On a recent onsite visit with Covanta at one of its garbage collection sites, we discussed emissions comparisons for energy-from-waste versus landfilling and learned about the energy-from-waste process, from the intake of waste to energy generation. Energy-from-waste takes non-hazardous waste that would otherwise go to landfills, combusts it in boilers, then recovers the heat to generate steam to use in power generation. After the combustion takes place, Covanta recovers metals from the remaining ash and re-sells them. This recycling prevents the carbon-intensive production of new metal products and saves more than 1.2 million tons of greenhouse gases each year, the equivalent of removing 113,000 cars from the road for a year, according to Covanta.
"Higher costs have made it difficult for some municipalities to recycle."
There are, of course, trade-offs with the energy-from-waste process as well, as combustion does release CO2 into the atmosphere, albeit less than would be generated by the waste going to a landfill over a very long time.
The ultimate driver of improving recycling rates and lowering the cost of recycling may start in the home and office. If consumers were to increasingly recycle properly, the resultant higher recycling rates would lower costs in a virtuous cycle. Downstream industries using more recycled commodities outside the U.S. as feedstock would also help by boosting the value of recycled commodities and therefore lowering the cost of recycling to the consumer.
Exhibit 3: Total Plastic Containers and Packaging Municipal Solid Waste by Weight
The practices of recycling and, to a lesser extent, combustion with energy recovery have grown in the past 30 years (especially outside the U.S.), helping slow the amount of waste entering landfills (Exhibit 3). To help continue this trend, ClearBridge takes a life cycle approach to the challenges surrounding the beverage container. This approach offers several entry points for driving change, and as active investors we seek this change through working with companies producing beverages, those producing their containers and those working to improve recycling practices. All are part of an international effort that is gaining strength.