- Escalating trade risks led to a broad selloff for equities, with technology enduring the steepest losses.
- Stock-specific issues for several portfolio companies negatively impacted results but we remain confident in the long-term outlook for these names.
- The latest pullback represents another good buying opportunity within the current bull market.
Market Overview and Outlook
After touching new highs in April, the U.S. equity market stumbled in May as fresh trade tensions between the U.S. and China and the possibility of U.S. tariffs on imports from Mexico threatened global economic activity. The S&P 500 Index fell 6.36%, the Russell 2000 Index retreated 7.78% while the Russell 3000 Index declined by 6.47%. Growth and value stocks alike suffered losses, with the Russell 3000 Growth Index falling 6.40% and its value counterpart shedding 6.55%.
A breakdown in trade talks between the U.S. and China led to President Trump raising tariffs from 10% to 25% on $200 billion worth of goods, causing investors to flee risk assets. At the same time, the Trump administration also stepped up actions against Huawei, banning the Chinese telecom giant from doing business in the U.S. and effectively barring U.S. suppliers from selling to the company. Shares of several portfolio companies that are key suppliers to Huawei, including communications chipmaker Broadcom, were impacted during the month as the lost revenue from trade actions could delay an expected second-half recovery in several segments of information technology (IT) including semiconductors. Broadcom was also hurt by the announcement of an antitrust investigation by the Federal Trade Commission. Through a successful series of acquisitions over the last several years, Broadcom has become the market leader in several leading communications technologies used in wireless phones and cable boxes. Despite the near-term headwinds it faces, the company remains well positioned as wireless providers migrate to 5G.
The uncertain market environment created by tariffs could also hinder a recovery among hyperscale providers of cloud services. This overhang, as well as sluggish pricing trends for flash memory products, weighed on the stocks of Seagate Technology and Western Digital, which provide network storage for cloud companies.
"This market continues to climb a wall of worry, the current ones being related to trade, tariffs and increased regulation of mega cap technology."
Oil prices fell 16% amid rising U.S. crude oil inventories and worries that recent escalations in the U.S.-China trade dispute would slow economic growth and curb energy demand. In the latest report, U.S. crude stockpiles fell much less than expected, while U.S. production edged back up. A barrel of WTI crude fell from $63.91 at the end of April to $53.50 at the end of May. The portfolio’s overweight to energy proved a headwind in this environment.
In the health care sector, ongoing negative sentiment pressured pharmaceutical maker Allergan. Despite quarterly results that topped forecasts and higher guidance for the year, investors are concerned about weakness in several of the company’s key aesthetics products, including Botox. We remain convinced that Allergan maintains one of the most attractively priced businesses in the biopharmaceutical industry and that pipeline treatments nearing commercial approval are not being properly discounted by the market.
The most recent pullback is indicative of the rhythm of equities through the 10-plus year bull market. Despite the uptick in volatility, we don’t currently see excesses in valuations or sentiment. In fact, this market continues to climb a wall of worry, the current ones being related to trade, tariffs and increased regulatory scrutiny of the mega cap technology names. In the near- and medium-term, given the attractive public/private value gap in sectors like energy, media and health care, we expect to see a continued uptick in M&A and leveraged buyout activity. While each selloff has been met with outright negativity, we generally view this as indicative of a good long-term opportunity for high active share managers like ourselves.
The ClearBridge Aggressive Growth Strategy underperformed its Russell 3000 Growth Index benchmark in May. On an absolute basis, the Strategy had losses across the eight sectors in which it was invested (out of 11 sectors total). The primary detractors from performance were the IT and communication services sectors.
Relative to the benchmark, overall stock selection detracted from performance. In particular, stock selection in the IT and health care sectors and an overweight allocation to the energy sector hurt relative results the most. On the positive side, an overweight to health care and stock selection in the industrials sector aided performance.
On an individual stock basis, positions in L3 Technologies, UnitedHealth Group, Medtronic, Johnson Controls and Nuance Communications were the greatest contributors to absolute returns during the month. The largest detractors included Broadcom, Seagate Technology, Allergan, Comcast and Cree.
During May, we closed a position in Weatherford International in the energy sector after the company announced a restructuring of its business due to liquidity and financing constraints. New management led by CEO Mark McCollum had been pursuing a turnaround plan, selling non-core business units and other assets while working to reduce debt. Since the stock had traded down substantially, we believed this to be a high risk/reward situation. We stated previously that the probabilities of success through both improved operational execution and other restructuring options were not being properly discounted, but we underestimated the length and depth of the down cycle in the oil services business.