- Optimism over a return to normal economic activity globally sparked a rotation into value stocks. These trades typically last one to two quarters and we believe it will take an unlikely rise in inflation to sustain the current value run.
- 2020 was a year of monumental progress in renewable energy and the adoption of electrified transport, highlighting the importance of ESG analysis in guiding our portfolio construction and risk management process.
- Given the strong performance of growth stocks through the year, we took the opportunity to trim and sell more fully priced ideas and increase exposure to a recovering global economy.
Significant progress in the development of COVID-19 vaccines, resolution of the U.S. presidential election and continued Federal Reserve policy accommodation along with potential further fiscal support lifted international equity markets to strong gains to close a tumultuous 2020. The benchmark MSCI All Country World Ex-U.S. Index rose 17%, the developed market MSCI EAFE Index gained 16.1%, while the MSCI Emerging Markets Index was up 19.7%. Small caps outperformed larger stocks with the MSCI ACWI Ex-U.S. Small Cap Index adding 18.6%. After a long streak of growth style dominance, international value stocks and sectors outperformed growth stocks and the benchmark in the fourth quarter, with the MSCI ACWI Ex-U.S. Value rising 20.4% compared to 13.9% for the MSCI ACWI Ex-U.S. Growth (Exhibit 1).
Exhibit 1: MSCI Growth vs. Value Performance
Optimism about an economic recovery lifted cyclical shares, with the financials (+24.7%) and energy (+22.5%) sectors joining information technology (IT, +24.7%) as the top-performing sectors in the quarter. Materials (+20.0%) also outperformed the benchmark as manufacturing in some parts of the global economy, notably Asia, returned to pre-COVID-19 levels and excitement about a broadening global recovery led these underperformers for the period much higher. Defensive sectors like health care (+6.2%), consumer staples (+8.5%) and income-oriented real estate (+12.6%) lagged in the rotation into more economically sensitive areas.
These rotation trades normally last from two to five months, so we are likely at least halfway through the current value run. We have been examining what it would take to see an extended rotation into value and it’s closely tied to inflation. Higher inflation would lead to a rise in long-term interest rates, but we have yet to see any upswing in prices or market rates.
On a regional basis, Asia Ex-Japan, led by mining and cyclicals in Australia, along with emerging markets (EM) were the best performers. China, surprisingly, was a laggard in EM but strong performance from semiconductors and cyclicals oriented toward improving global trade helped Taiwan and South Korea. EM were helped by continuing U.S. dollar weakness and saw strong rebounds in key emerging currencies that had been fairly volatile and weak throughout the first three quarters of 2020. Europe Ex-U.K. and the U.K. shrugged off virus surges, a fresh set of COVID-19 restrictions and more Brexit drama to perform roughly in line with the benchmark, with performance led by the year’s underperformers in financials, mining and travel-related services. North America and Japan were slight laggards in a generally strong quarter across global markets.
The U.K. became the first country to roll out an approved COVID-19 vaccine in early December and markets have quickly discounted a brighter future. Assuming successful vaccine distribution, we believe the global economy should recover in the back half of 2021 and into 2022. However, early indications of successful rollouts are few at the time of this writing. International markets, especially those in service-oriented regions like Southern Europe that rely on personal contact to do business, should benefit more than the U.S. in a recovery as they have greater exposure to cyclical industries.
International stocks were also lifted by a relief rally when it became clear Joe Biden will be the next U.S. president. The leadership change should improve relations between the U.S. and the rest of the world. Biden is seen as more consistent and rational with his international policies negotiated diplomatically rather than by presidential decree. His first task will be repairing relationships with U.S. allies, Europe and Japan in particular, which should help trade with both regions. It will be very important to watch diplomatic agendas and the U.S. stance toward China. The Chinese are pragmatic in their policymaking and very interested in de-escalating the situation with the U.S. While they want to become independent from the West and de-escalation would buy them time to further these efforts, their stance on human rights, minority persecution and their moves in Hong Kong will mean that this administration may not necessarily perform a complete about-face in policy from the Trump administration.
In an extraordinary move during the quarter, the Chinese government forced the cancellation of the planned $30 billion Ant Group initial public offering that would have valued the company at $300 billion as Beijing began reining in e-commerce and fintech companies Alibaba and its subsidiary Ant. Alibaba, which owns a third of Ant, saw its shares rise strongly ahead of Ant’s planned November IPO. Alibaba shares dropped after Chinese regulators canceled the offering then fell again in late December when the government announced an antitrust probe into the company. We have been trimming Alibaba shares steadily through the year but decided that government intervention across its business had the potential to disrupt growth rates and profitability at least in the near term. We decided to close the position as we continue to evaluate Chinese government intervention and regulatory changes toward the company and others. Currently, we continue to hold Chinese Internet conglomerate Tencent, insurer Ping An and biotechnology firm Zai Lab and are monitoring developments to ensure these companies’ ability to generate revenue and earnings growth are not impaired by government interference.
Climate Focus Supports Renewable Energy
The pandemic has caused many of us to reflect on the current state of affairs and reminded us of the fragility of our personal welfare, economic systems and how impending climate change may further change our world. At the corporate level, climate issues are becoming central to investment conversations, as are societal issues, such as gender and race, and governance issues. 2020 was a monumental year for progress in renewable energy and the adoption of electrified transport. It will be remembered as the year the world started to reverse centuries of damage with the European Union announcing the Green Deal and leaders committing to cutting greenhouse gas (GHG) emissions to zero by 2050 and setting an ambitious short-term goal to cut GHG 55% by 2030. It is the centerpiece of the European Union recovery plan.
"Non-U.S. equities should benefit as cash still sitting on the sideline is put to work, notably in Europe and emerging markets."
Beyond trade, a Biden White House should also lead to greater U.S. support for global green initiatives. Several other large economies, including China, also came out with net-zero pledges. Many countries have adopted regulation to promote electric vehicles (EVs) and set end dates for the sale of gasoline-powered vehicles. California Governor Gavin Newsom issued an executive order banning the sale of new gas-powered vehicles after 2035, making California the first U.S. state to join the U.K., France, Canada and several other nations in putting an end date to sales of internal combustion engine cars.
We believe the unfolding energy transition will continue to accelerate. Companies exposed to the supply chains of solar technologies, wind power, the electric powertrain as well as batteries are well-positioned to benefit from increased demand as deflationary tailwinds, incentives and widespread public support drive the global adoption of these technologies. The ClearBridge International Growth ACWI ex US Strategy continues to be well-exposed to these positive long-term trends through several holdings such as EDP, SolarEdge and Nidec. The need for more power sources to support greater electrification of transportation, as well as falling costs for batteries and wind technology, also caused us to re-establish a position in Danish wind turbine producer Vestas Wind Systems during the fourth quarter.
Our integration of ESG as a part of our analytical work and investment process at the front end has enabled us to identify ideas to both invest in and, importantly, avoid. ESG as an investment focus is accelerating and remains the top recipient of active investment flows globally. We are well-placed to succeed in this environment and believe that our use of ESG as a tool will progress to a place where ClearBridge’s focus has long been established regardless of whether the portfolio is specifically oriented exclusively toward ESG or is more broad-based. PricewaterhouseCoopers believes ESG and sustainable investment will shift fund flows from 15% today to nearly 60% of European fund assets by 2025. Over two thirds of European institutional investors will no longer purchase funds without ESG and sustainability within their mandate. This will have broad implications for companies, in Europe and elsewhere, that are top performers in ESG and sustainability, as well as implications for those who do not take sustainability seriously.
Given the strong performance of growth stocks throughout the second and third quarters, we took the opportunity to trim and sell ideas that we felt were fully priced and increase exposure to a recovering global economy. This involved increasing our structural growth allocations, including repurchasing two previously held names: Swedish industrial manufacturer Atlas Copco and Canadian Pacific Railway. Atlas Copco has refocused its business away from mining over the last several years. Capital spending in many of its end markets are at depressed levels and should benefit from a post-COVID-19 recovery, while its low capital intensity and strong free cash flow generation can be redeployed into accretive acquisitions. Canadian Pacific has led the U.S. rails in implementing Precision Scheduled Railroading, driving down operating ratios and increasing margins. While some of its end markets have been weak in the past year with nearly no top-line growth, improved economic recovery in those areas, acquisitions and some new contracts could help volumes recover and operating ratios improve to the mid-low 50s by 2023, helping drive profitability to new highs.
We sold our position in Novartis in favor of adding Alcon, a Swiss maker of medical devices for eye care, and Cellnex, a Spanish operator of cell phone towers. Alcon has major positive product cycles in both of its core businesses - cataract surgery and contact lenses - that will accelerate revenue and earnings. It also has a significant opportunity to expand margins by investing in new manufacturing and leveraging its commercial investment. As the largest independent tower company in Europe, Cellnex is poised to capture a large portion of tower sales likely to result from divestment by telecom companies. This should significantly increase Cellnex’s asset base, bolstering a defensive business model with high recurring revenue and predictable cash flows from long-term contracts.
We added more cyclicality to the portfolio by increasing our exposure to industrials while continuing to underweight traditional financials such as banks. Those funds have instead been redeployed into the fintech area, which we consider financials but which the market classifies as IT. We currently have a more neutral health care weight, having sold Novo Nordisk, which trades at a premium to large cap pharma peers, but continue to look for new ideas in this space. Performance has been strong in our health care names, led by Chinese pharmaceutical Zai Lab, a company bringing best-in-class treatments through local trials and registrations to the nascent Chinese pharmaceutical market.
Since the lows of the first quarter, technology and related communications and Internet stocks have done well, as have the Asian countries that implemented the earliest lockdowns and are further along in their recovery. We are well-exposed in the portfolio to the secular growth trends of cloud computing, artificial intelligence, renewables and electric vehicles. Europe, Japan and most emerging markets have not rebounded as vigorously and are more cyclical in nature; this is where we see the most attractive opportunities in the near term.
Non-U.S. equities should also benefit as the high levels of cash still sitting on the sideline are put to work. Asia and Japan have seen inflows already, but Europe and the rest of emerging markets have not. Valuations remain compelling, even after the bounce we’ve seen over the last three quarters. Central banks learned their lessons from the financial crisis and will keep interest rates low and monetary policy accommodative. This is all positive for equity markets and even Japan, which has been out of favor for decades, is undergoing secular changes under a new prime minister, including a drive for greater digitalization.
One thing we have all learned from recent events: predicting human behavior, economic performance and having a strong top-down view around which to orient portfolios does not work. Our focus on understanding companies and their near-term and long-term growth potential, adjusting and re-adjusting our view of growth as it develops and evaluating new growth areas is where we will put our efforts.
Our proprietary model helps identify, from the thousands of companies out in the marketplace, interesting ideas with good growth and attractive valuations. From there we have to dig in and do the fundamental work of validating growth characteristics, valuations, cash flows and, of course, ESG characteristics. 2020 was a humbling year with many gains and great personal losses and sacrifices. We hope that 2021 will not deliver so much of the negatives of last year and we will remain vigilant and focused on delivering returns in line with our multidimensional growth approach and valuation discipline.
The ClearBridge International Growth ACWI ex US Strategy underperformed the benchmark MSCI ACWI ex U.S. Index for the fourth quarter. The Strategy delivered gains across eight of the nine sectors in which it was invested (out of 11 total), with the IT and industrials sectors the leading contributors.
On a relative basis, overall stock selection detracted from performance. In particular, stock selection in the consumer discretionary, financials and materials sectors and an underweight to financials hurt results. On the positive side, an overweight to IT as well as stock selection in the IT, health care and utilities sectors were the primary contributors to performance.
On a regional basis, stock selection in the U.K. and North America and an underweight to EM hampered results, while stock selection in Japan and EM proved beneficial.
On an individual stock basis, the largest contributors to absolute returns in the quarter included Samsung Electronics, Stoneco, Taiwan Semiconductor, Tokyo Electron and EDP-Energias de Portugal. The greatest detractors from absolute returns included positions in Alibaba, Barrick Gold, Morphosys, Ocado Group and Arco Platform.
In addition to the transactions mentioned above, we initiated a position in Burning Rock Biotech in the health care sector and closed positions in Umicore in the materials sector and Deutsche Boerse in the financials sector.