- Markets love resolution and COVID-19 vaccine successes enabled investors to look past current economic weakness to a day when mobility will be restored.
- We began shifting the portfolio to a modestly more cyclical stance six months ago. Despite four months of leadership from economic recovery stocks, selected opportunities remain.
- Companies held by ClearBridge across sectors are playing a significant role in the vaccine rollout, striking a delicate balance between supporting stakeholders and delivering to shareholders.
Market Overview: Opportunities Remain Despite High Valuations
After a lackluster October driven by concerns over a resurgence in COVID-19 infections and a contentious U.S. presidential election, equity markets powered ahead in November and December to post a robust 12% fourth-quarter return.
Markets love resolution and COVID-19 vaccine successes enabled investors to look past current economic weakness to a day when mobility will be restored. Meanwhile, investors celebrated a federal government closely balanced between the parties - creating an environment where only incremental legislation will be passed. Importantly, liquidity remains ample, as evidenced by a second fiscal stimulus in the form of December’s $900 billion pandemic relief bill and continued unprecedented monetary support from the Federal Reserve.
The best-performing sectors during the fourth quarter of 2020 were the cyclical energy, materials and industrials sectors, along with financials and the economically sensitive areas of communications services. The defensive consumer staples and health care sectors lagged. Consumer cyclicals lagged due to weak performance from the largest stocks in the sector. The fourth quarter saw a continuation of the trend that started in September where economic recovery stocks led companies with COVID-19-resilient business models. Small cap and high-beta stocks outperformed large cap and defensive stocks.
After more than a decade of undershooting its 2% inflation target, the Federal Reserve changed its regime in 2020 and is now looking to overshoot by keeping monetary policy stimulative and interest rates very low even as the economy begins to recover. Over $4 trillion was pumped into the U.S. economy as part of the stimulus packages. In 2020 the U.S. M3 money supply grew over 25%. Much of the strength in financial assets last year was surely caused by the funds injected into the economy. Commodities such as steel and aluminum saw powerful price increases in the second half of 2020 despite capacity utilization in the 70 percent ranges, far below the low 90% level normally necessary to induce inflation. Because wages are 70% of the U.S. economy, the high level of unemployment will prevent runaway inflation. But we believe inflation will become an increasing focus of investors over the next several years.
"Much of the strength in financial assets last year was surely caused by the funds injected into the economy."
Although we remain optimistic on the equity market in 2021 as the economy recovers from the COVID-19 pandemic, we are increasingly concerned about market excesses. Our concern goes beyond simply looking at the S&P 500 Index’s 22x P/E multiple as “1999-like” to the amount of capital chasing returns. For example, blank check companies known as SPACs (special purpose acquisition companies) exploded in 2020, growing fivefold and raising a record $70 billion; Bitcoin went parabolic between September and year end, rising 200%; and anything tied to electric vehicles or renewable energy seemingly knows no ceiling, whether it’s the oft-cited 740% rise in Tesla in 2020 or open˗ended returns in solar power solutions or fuel-cell-focused stocks. Investor fear of missing out on the next open-ended growth opportunity crushed considerations regarding valuation or business model durability.
Despite the high valuation of the stock market we do see attractive areas to invest in. The U.S. has underspent on roads and bridges for decades. A Democratic Congress is likely to enact a significant infrastructure bill. Housing appears to be entering a powerful cycle and might even experience a Goldilocks environment. COVID-19 ignited migration from the cities to the suburbs. And there is significant pent-up demand after more than a decade of underproducing population growth. The Federal Reserve will keep interest rates lower for longer, helping affordability. Bank stocks will benefit from a steeper yield curve but a low absolute level of rates likely caps upside.
We began shifting the portfolio to a modestly more cyclical stance six months ago. Despite four months of leadership from economic recovery stocks, selected opportunities remain. European steel stocks will benefit from green initiatives to limit imports from countries with lax environmental controls. Enormous amounts of new ethylene and propylene capacity in China will hurt commodity chemicals earnings but help specialty chemicals margins. Large pharmaceutical stocks are inexpensive, but the risk of price controls under an all˗Democratic government likely limits upside. Big cap tech is very expensive, has difficult comparisons from COVID˗19˗boosted results and faces regulatory and anti˗trust threats. That said, it also has terrific growth prospects. It probably will not dominate stock market performance in 2021 the way that it has the past six years. We will keep significant positions in companies we see as long-term winners. The best way to participate is probably to identify emerging winners rather than owning only the largest companies.
We remain risk-averse investors who believe diversification and a balanced approach to stock selection, industry allocation and factor exposure is prudent. However, as discussed above, we are constructive on the outlook for economic growth and believe businesses levered to improved economic activity have better risk/reward than the mega cap secular growth companies, on average. As a result, we have methodically and prudently tilted our portfolio slightly more toward investments that reflect this view. This is done within the context of our rigorous focus on high-quality stocks and downside protection.
The ClearBridge Appreciation ESG Strategy had a positive return during the fourth quarter of 2020, underperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in 10 of 11 sectors in which it was invested during the quarter. The main contributors to the Strategy’s performance were the information technology (IT), communication services, financials and industrials sectors. The real estate sector was the sole detractor.
In relative terms, the Strategy underperformed its benchmark due to stock selection and sector allocation. In particular, stock selection in the IT, real estate, materials and consumer discretionary sectors and an underweight to the energy sector detracted the most from relative performance. Conversely, stock selection in the communication services sector proved beneficial.
"The vaccine technology could also be valuable for other infectious diseases as well as oncology."
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in JPMorgan Chase, Apple, Walt Disney, Honeywell and Pinterest. The greatest detractors from absolute returns were positions in Salesforce.com, Air Products and Chemicals, American Tower, Home Depot and Amgen.
During the quarter we initiated new positions in Eli Lilly in the health care sector and Union Pacific in the industrials sector. We closed positions in Devon Energy in the energy sector, AbbVie and CVS Health in the health care sector, Ciena in the IT sector, SBA Communications in the real estate sector and Unilever in the consumer staples sector. We also received and retained shares in Viatris, formed from the merger of Mylan and portfolio holding Pfizer’s Upjohn business.
ESG Highlights: Public Companies Taking Lead in Vaccine Rollout
The COVID-19 pandemic has forced companies large and small to adapt in order to safely serve customers, care for employees and in some cases, just stay afloat. Businesses have also been central to another key development, as the online maps millions used to check the spread of the virus in the spring of 2020 now show the rollout of vaccines. Innovation and adaptation by public companies spanning several industries are bringing vaccines to a world in need through a real-time mobilization for which there is no easy comparison.
Companies held by ClearBridge across sectors are playing a significant role in the vaccine rollout, striking a delicate balance between supporting stakeholders and delivering to shareholders. In some cases, the ability to effectively distribute the vaccines has been made possible by improved business models. For others facilitating vaccinations is simply the right thing to do, as solving the pandemic is the best way for all companies, as well as their employees and customers, to thrive.
Vaccines a Reminder of Innovation in Health Care
The swiftness of development and the efficacy of the two initial vaccines, by Pfizer/BioNTech and Moderna, reflect how the health care industry’s drive to innovate treatments and cures has made meaningful advances not only for rare and genetic diseases, but also for infectious diseases. BioNTech and Moderna effectively developed a brand-new platform from first infection to market in under a year, an achievement that stands out among vaccine efforts in other pandemics (Exhibit 1). Going forward, the technology could also be valuable for other infectious diseases as well as oncology.
Exhibit 1: COVID-19 Vaccines Represent Remarkable Achievement
More broadly, the vaccines, as well as the life-saving advances in treatment for symptoms of the virus, serve as a poignant reminder that the health care industry has the capability and the responsibility to use its resources to improve the welfare of society at large.
While governments have rightly supported the development of vaccines, companies with the financial resources have also taken substantial economic risk on their own. Pfizer, for example, has invested several billion dollars in its partnership with BioNTech, including manufacturing its vaccine before being certain it would work.
Distribution is a Logistical Challenge
Vaccine mobilization also requires a vast and efficiently operating delivery network. Logistics companies such as FedEx and long˗time ClearBridge holding United Parcel Service (UPS) have been working very closely with health care companies and health agencies on coordinating the distribution of vaccines. Shipping vaccines entails GPS tracking, special labels and first-loaded status on planes and trucks, as well as ensuring precise temperature conditions. While parcel delivery capacity has been extremely tight in 2020 with significant shifts by consumers towards online shopping, FedEx and UPS have prioritized the national health effort by reserving meaningful capacity for distribution of the vaccine. UPS has gone so far as to publicly state it prioritized vaccine distribution ahead of holiday shipments, a typically critical set of volume for the company.
UPS is also focused on serving small and medium-size businesses (SMB), which have been especially challenged by the pandemic in 2020. These efforts include increasing speed of delivery service, which helps make SMBs more competitive, creating 1,500 more UPS Access Point locations - partnerships with independent retailers such as hardware and grocery stores that drive traffic for smaller businesses and expand service to underserved areas - and adding visibility and tracking solutions designed for SMBs.
Health care equipment companies are also stepping up to ensure a successful vaccine rollout. ClearBridge holding Becton Dickinson, for example, has estimated the opportunity for needles for vaccination to be $100-$150 million, although at below˗corporate-average margins. The company is working with the U.S. government, as well as investing on its own, to expand domestic needle manufacturing capacity so that there is additional capacity in the U.S. for both business growth and future surges.
Testing Has Also Been a Triumph
COVID-19 testing has been a crucial component in controlling the virus. Becton Dickinson has also been a large supplier of COVID-19 diagnostic tests, both PCR and rapid antigen tests. Diagnostics firms such as ClearBridge holdings Danaher, Thermo Scientific and Hologic have also demonstrated their value by putting the right instruments and equipment in place in labs, as testing was key especially in early stages of the pandemic. Investments in testing equipment, instruments and consumables (such as the reagents used to perform tests) may also yield longer-term benefits even after COVID-19 has been contained, increasing preparedness for other threats down the road. Although the magnitude and benefits of this for diagnostics firms is unclear, it is likely there will be a higher baseline testing level for infectious diseases going forward, a tailwind for diagnostics companies and a positive for the public.
All Will Benefit
As the vaccine rollout develops, we are optimistic for a reduction in infection and death rates, but also reductions in unemployment as pandemic-related restrictions can be rolled back. The breadth of the dimensions involved for vaccine distribution, reopenings and implementation oversight will mean it will take some time. But the effect of public companies prioritizing stakeholders by helping the vaccines reach all corners of the country will be a tangible improvement in societal well-being, and even those who are not owners of these equities will greatly benefit.