- U.S. investors are abandoning the notion of open-ended central bank intervention with U.S. interest rates permanently pegged at zero.
- We began shifting the portfolio to a modestly more cyclical stance in mid-2020, methodically tilting to underweight technology stocks while allocating incremental capital to the more cyclical areas of materials and financials, which we believe positions us well for the remainder of 2021.
- In a hot housing market, many companies held across ClearBridge portfolios are helping make the homes of the future — back deck included — more environmentally responsible spaces.
After stumbling out of the gate, the S&P 500 Index added 6.2% in the first quarter, increasing more than 5% for the fourth consecutive quarter. But, make no mistake, underneath the surface the quarter was anything but uneventful.
Like the mindset of a freshly COVID-19 vaccinated adult, the psychology of the U.S. equity market shifted markedly in the first quarter. As we exit the abyss of seemingly endless days homebound in sweatpants, U.S. investors are similarly abandoning the notion of open-ended central bank intervention with U.S. interest rates permanently pegged at zero.
Mass vaccinations and improved mobility are only part of the evolving investment landscape. In January we inaugurated a new president whose policies on taxation, stimulus, climate change and government expenditures represent a material shift from those of his predecessor. Investors also dealt with two high-profile potential black swan events with Melvin Capital/GME and Archegos Capital; an unprecedented assault on Capitol Hill; and the continued epidemic of race-based hate crimes. Indeed, fiduciaries have more to consider today than ever before, extending well beyond beating a benchmark. Today’s institutional investors must consider how our capital allocations impact society and the environment.
"There remains significant labor force slack, which we believe will act as an impediment to labor cost inflation."
Investor repositioning toward economic recovery beneficiaries continued in the quarter. Both energy
and financials — which lagged significantly at COVID-19’s outset — posted a second consecutive quarter of outperformance, at a magnitude not seen since exiting the global financial crisis (GFC) in 2009. Energy’s first-quarter relative performance was its best since at least 1999 and the sector has now posted two consecutive quarters of 15%+ relative outperformance, a feat accomplished by any sector only one other time since 1999 (the real estate sector did it in 2009, exiting the GFC). Financials also posted two consecutive quarters of nearly 10% relative outperformance, results not seen by the sector since exiting the GFC in mid-2009.
On the flip side, after seven consecutive quarters of relative outperformance (all of 2019 and three quarters of 2020), information technology (IT) lagged for a second-straight quarter. Of note, IT has not underperformed the S&P 500 for three consecutive quarters since the second quarter of 2013.
On a similar theme, consumer discretionary stocks have now lagged for two quarters, weighed down by the large and technology-centric Tesla and Amazon.com. Finally, consumer staples were the S&P 500’s largest laggard as investors repositioned for recovery and away from household product stocks.
At the heart of evolving sector leadership is the debate about the future path of inflation and interest
rates. No doubt, goods inflation is here and real (Exhibit 1). Commodity prices — both hard and soft — are up materially, which will inevitably be passed to consumers. As an example, with oil at about $60/barrel we’re paying nearly $3/gallon at the pump, up 50% year over year. Lumber prices are up nearly 300% year over year, which is a direct passthrough to homebuyers from homebuilders. Although not as stark, soft commodities such as sugar, corn and soybeans have all rallied significantly, implying higher prices at the grocery store. When considering a consumer that has never been more liquid on unprecedented stimulus-driven savings (Exhibit 2); additional stimulus en route to consumer bank accounts; and supply chains of all kind stressed with lean inventories and extended lead times, we expect goods inflation will remain with us for the majority of 2021.
Exhibit 1: Goods Inflation Does Not Mean Services Inflation
Exhibit 2: Consumer Balance Sheets are Flush
Is goods inflation a sustainable driver of higher inflation that would force the Fed to raise rates? We don’t believe so. For the Fed to consider raising rates we believe the linchpin is labor costs and services inflation. The service sector accounts for 80% of the U.S. employment base. Today service inflation is moderating.
With unemployment hovering around 6%, underemployment still double digits and an estimated 10.5 million more jobs necessary to return to pre-COVID-19 levels, there remains significant labor force slack, which we believe will act as an impediment to labor cost inflation (Exhibit 3). That said, with input cost inflation real and no way to prove the labor cost argument until we are well into a “normal” economic environment, we believe it is prudent to maintain a balanced approach. Although our daily lives seem poised to return to “normal” in 2021, the investment landscape looks anything but normal.
Exhibit 3: Jobs Market Contains Considerable Slack
While powerful near-term economic growth and the likelihood of a long economic expansion ahead of us make us comfortable with intermediate-term stock market returns, we believe the path to future market gains will encounter increased volatility and greater risk of a 10%+ market correction. With the reopening economic expansion upon us, we are concerned that it seems nobody is talking about the possibility of a correction (Exhibit 4). The specter of higher inflation is a headwind to near-record valuation multiples, especially for the heady multiples of hyper-growth and thematic stocks (clean energy/renewables, electric vehicles). In addition, the market excesses discussed in our last letter are still brewing and we’re mindful of the black swan flybys of the first quarter. We began shifting the portfolio to a modestly more cyclical stance in mid-2020, consciously and methodically tilting our portfolio to underweight technology stocks while allocating incremental capital to the more cyclical areas of materials and financials, which we believe positions us well for the remainder of 2021.
Exhibit 4: Valuation Multiples Near Records
Despite these concerns we still see attractive areas to invest in. The U.S. has underspent on rails and bridges for decades and a Democratic Congress is likely to have success passing a significant
infrastructure bill. We continue to believe housing is at the start of a powerful cycle ignited by migration from the cities to the suburbs plus pent-up demand from over a decade of below-trend household formation. We also believe the rotation out of growth has left some idiosyncratic opportunities for stocks with bright fundamentals and more reasonable valuations.
The outbreak of COVID-19 in the U.S. introduced short-term volatility and amplified pre-existing market conditions, benefiting companies perceived to have open-ended growth opportunities while cyclicals and rate-sensitive stocks lagged. For risk-averse, valuation-conscious investors who believe a diversified portfolio will outperform through the cycle, avaluation-agnostic market with a narrow set of winners — like the one that existed up until the fourth quarter — tends to be a challenge for us. But the portfolio looks well positioned for the conditions that appear to be playing out in 2021.
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 that seek to protect investor downside. We believe the Appreciation ESG Strategy’s conservative approach to investing and portfolio of high-quality earnings compounders with quality balance sheets and durable competitive advantages is well-positioned for a powerful economic recovery but an expensive stock market.
The ClearBridge Appreciation ESG Strategy had a positive return during the first quarter of 2021, 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 financials, communication services, industrials and consumer discretionary sectors. The consumer staples 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 consumer staples, industrials, materials and IT sectors and an underweight to the energy sector detracted the most from relative performance. Conversely, stock selection in the consumer discretionary sector proved beneficial.
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in JPMorgan Chase, Alphabet, Microsoft, Home Depot, and Bank of America. The greatest detractors from absolute returns were positions in Apple, Costco, Amazon.com, Adobe and Merck.
During the quarter we initiated a new position in Chubb in the financials sector and closed positions in Viatris in the health care sector and AT&T in the communication services sector.
We are in the midst of a booming real estate market: prices for many houses are growing the fastest in over a decade thanks to millennial household formation which was increasing before the pandemic, a pandemic-driven acceleration of the exodus from urban centers and a healthier banking system after the global financial crisis. New home sales are elevated even given the winter’s typical seasonal lull (Exhibit 5). Despite a recent pickup in long-term bond rates, 30-year fixed mortgage rates are near historic lows, suggesting the growth could continue. Stimulus money and lifestyle changes engendered by people spending substantially more time at home during the pandemic have also meant more home remodeling.
Exhibit 5: New Privately-Owned Houses Sold
As many people move into new single-family houses or apartment homes, or refresh the existing housing supply, now is a good time to reflect on how green the building and renovation processes can be, as the residential sector contributes a meaningful amount to national carbon emissions (Exhibit 6). A wide range of ClearBridge portfolio companies are working to improve the sustainability profile of tomorrow’s homes, which should help reduce costs over the long term as well. Homebuilders, residential REITs, roofers and insulators, smart home enablers and others across ClearBridge portfolios, are helping make the homes of the future — back deck included — more environmentally responsible spaces.
Exhibit 6: End-Use Sector Emissions of CO2 from Fossil Fuel Combustion (2019)
Homebuilders are beginning to take steps toward building more environmentally friendly homes and
disclosing the impact of their own operations. In many cases, the price sensitivity of new home buyers discourages the incorporation of green building in new homes. Homebuilder Lennar, for example, included solar panels in every home it built in California for several years prior to the California Energy Commission making solar standard as part of new construction, although this has not been without consumer pushback.
ClearBridge holding Century Communities, which makes single and attached homes, recognizes homebuilders can be a laggard industry in sustainability disclosures. The company finds that consumers in the past have not been willing to pay a price premium for green features on homes and apartments, even though they say they want them. This has led the industry to generally build to the lowest common regulatory standard, as additional green building practices were dilutive to returns.
Driven by top-down recognition of the strategic importance of green building as well as by demographic changes in home buyers (younger buyers value green features more than older buyers do), Century Communities is taking steps to be a leader in green building by publishing its first ESG report. Disclosing the company’s Scope 1, 2 and 3 carbon emissions for the first time, the report represents a strategic commitment to increased disclosure and better sustainability practices with the ultimate goal of Century Communities becoming an ESG leader in the homebuilding space. We applaud this step toward clear, tangible results.
While homebuilders face some structural challenges in improving green building (with some exceptions), residential REITs, which take on longer-term responsibilities in owning and operating the properties, are in this way more incentivized to make sustainability gains.
ClearBridge holding American Homes 4 Rent builds, acquires and leases more than 52,000 single-family rental homes across 22 states. The company designs homes with resource-efficient fixtures and appliances. To help residents conserve water, it installs high-efficiency toilets and plumbing fixtures in all development properties and in renovations of existing homes. In arid states such as Arizona and Nevada, it installs smart, water-efficient irrigation features in its landscape design.
There’s More Than Just Bricks in the Wall
Roofer and insulator Owens Corning, also a ClearBridge holding, is helping make the building sector more sustainable. The company operates across 33 countries and has positive environmental impact primarily through its insulation business. In the EU, for example, buildings are responsible for 40% of energy consumption and 36% of GHG emissions. New buildings consume only half of the energy of those built over 20 years ago, according to the company. But as 85% of the buildings in the EU are older than 20 years, and 85%–95% of them are expected to still be standing in 2050, there is need for a massive renovation. Roughly 35 million buildings in the EU will need to be renovated by 2030, according to the company.
Properly insulated homes lower energy intensity and thus the overall carbon footprint of a home. According to Owens Corning, insulation intensity of new homes is on the rise, driven in part by state and municipal rules requiring certain levels of insulation, but also by consumer preference for reducing energy consumption and being greener in the home. The company is helping meet this demand with insulation products that are lighter weight yet deliver stronger performance than higher-weight/higher-density products. The insight that greater density does not necessarily mean better performance has allowed the company to reduce shipping weight and fuel.
Owens Corning’s roofing business also features shingles that use a highly reflective granule technology to reflect the sun, keep roofs cooler and lower air conditioning energy demand. Its composites business alsocounts wind turbines as a major end use, another positive for sustainability
As part of its 2030 Sustainability Goals, Owens Corning is also looking to grow a circular economy model in which virgin raw materials, waste, energy and emissions are minimized through intelligent design, renewable and recycled input and energy-efficient production.
Smart thermostat maker and ClearBridge holding Resideo Technologies is also helping homes become more sustainable through behind-the-wall innovation. Resideo makes behind-the-wall components and front-facing controls for homes whose purpose is to drive water and energy conservation or improve air quality. Resideo’s smart thermostats help provide the right temperature using the lowest energy consumption; its components and controls for boilers, furnaces and heat pumps help energy conservation; and its leak and freeze detectors aid in water conservation. Currently, of Resideo’s 150 million home installed base, only 6 million are conservation-advantaged “connected homes.” The company’s goal is to grow this mix, while also launching predictive tools for its professional installer customer (a plumber might get an alert once a pipe starts leaking, rather than waiting for the call once a basement is flooded) and working closer with utilities to make the grid smarter and more efficient. Resideo’s smart thermostat, meanwhile, is built into homebuilder Lennar’s new line of Connected Homes.
Home Expansion Offering Green Opportunities
Just as the new home market has been hopping amid low interest rates and the greater need for space, the market for home improvement has also been robust for similar reasons. Decks have been perfect places for safe social gatherings during the pandemic, and ClearBridge portfolio holding Trex has been meeting demand with its composite decking made from recycled wood fibers and plastic waste.
Trex’s high-performance decking portfolio is made using more than 95% recycled content. Trex uses locally sourced reclaimed wood that would otherwise end up in landfills and so avoids cutting down trees to make its products. The recycled plastic film it uses comes from a variety of sources, including industrial shrink wrap, agricultural plastic sheeting and household plastic such as grocery and shopping bags. With the average 500-square foot composite Trex deck containing 140,000 recycled plastic bags, Trex is one of the largest plastic bag recyclers in the U.S. The company has also innovated ways of recycling dirtier plastics more likely to end up in landfills.
Trex has seen already strong demand get stronger during the pandemic; the company was sold out during much of 2020 and began expanding capacity across the U.S. to meet heightened demand. With lumber prices soaring amid the strong housing market, Trex’s composite decks are increasingly gaining share, especially in price-sensitive areas of the market, which bodes well for both the environment and shareholders.
Sustainability Is Growing in Prominence in the Building Sector
We are encouraged by the increasing number of companies working to build the home of tomorrow more sustainably, which will typically provide an improved return on investment. In addition, the sustainably built home covers expansive geographies and diverse demographics. This is particularly important in the context of climate change, as homes that use water and energy efficiently can also prove more resilient amid volatile energy and water availability and prices. As the EPA notes, homes that maintain habitable conditions in extreme heat, power outages and strong storms are crucial to protecting their inhabitants. If they can be built using sustainable resources by companies actively looking to reduce carbon emissions, all the better.