- Our pro-cyclical positioning proved beneficial, with strength in industrials names leading to outperformance. We continue to favor these as well as materials and energy companies in a reflationary global environment.
- The Strategy also saw strong contributions from our emerging market holdings, which are heavily skewed toward technology (IT), health care, and industrial stocks.
- We believe investors focused on current data points are missing or misreading a number of key trends and developments supportive of value stocks, such as policy shifts and the capacity for significant interest rate increases.
The second quarter marked the fifth consecutive quarter of equity gains off the March 2020 lows, though leadership and breadth appeared less decisive than recent quarters. While global economies continued to recover, COVID-19’s resurgence due to the Delta variant threw numerous countries across Europe and Asia into renewed lockdowns, putting a damper on the reopening trade. Commentary from June’s FOMC meeting further exacerbated the growth scare, as it appeared the Fed would begin tightening sooner than the market had anticipated. As a result, June saw a strong reversal back toward stagnation era winners, and the overall quarter reverted back to growth stock leadership.
The MSCI EAFE index returned 5.2% for the quarter, led by Europe (+7.9%) where returns were particularly strong in Denmark, Finland, Austria, France and Switzerland. Concerns around new variants and associated lockdowns caused a correction in more cyclically dependent countries, such as Germany, Italy, Spain, and Norway. An increase in COVID-19 cases in previously spared Asian countries also contributed to poor overall performance in the region, with Japan (-0.3%) and Asia Ex-Japan (+4.8) underperforming the benchmark. China and Hong Kong were further impacted by concerns around policy tightening and regulatory crackdowns on leading technology firms. In emerging markets (EM), overall returns of the MSCI Emerging Markets Index (+5.1%) matched those of developed markets, with notable gains in Latin America.
Developed markets small cap shares mostly underperformed their larger peers in the quarter, with the benchmark MSCI EAFE Small Cap Index returning 4.3%, with geographic trends similar to the broader markets. The notable area of outperformance in the period was in emerging markets, where the MSCI Emerging Markets Small Cap Index rallied 11.25%, with particular strength in Taiwan, South Korea and China. The small cap indices in these countries are heavily skewed toward information technology (IT), health care, and industrial stocks, and have thus benefited from the recent rotation back toward growth sectors.
"We also took advantage of fears surrounding the Delta variant to add several new consumer names."
Owing in large part to this strength in EM, the ClearBridge International Small Cap Strategy posted another solid quarter of outperformance versus the benchmark. Significant gains in our EM health care names played a big factor, with companies such as Shanghai Haohai Biological (biomedical materials), Value Added Technology (dental imaging) and i-Sens (blood glucose metering) all showing strong momentum. While each stock has its own company-specific factors, the common driver was the restart of many elective healthcare procedures and sales efforts that had been paused during the pandemic.
The other major contributor to performance was the portfolio’s industrials exposure. In particular, dry bulk shippers D/S Norden, Golden Ocean Group, and Star Bulk Carriers were all among the quarter’s top performers. Shipping companies began the year with analysts calling for significant profit declines over the next two years. New capacity additions have remained near record lows while demand for commodities has rebounded significantly, leading to daily rates remaining elevated. This is allowing the companies to lock in attractive earnings and free cash flows, and enabling large dividend payouts. Profit expectations have nearly doubled for this year and next, with the potential for the cycle to extend well into 2023.
On the flip side, energy and materials were the largest detractors for the quarter. Energy losses were most notable in our holding of Norwegian gas shipper Avance Gas. The company announced an equity offering in April to finance the purchase of two new shipping vessels for 2023 delivery. While the placement was dilutive, we were encouraged to see shipping magnate and largest shareholder John Fredriksen increased his stake during the fundraising, signaling a strong vote of confidence for the move. We continue to find Avance attractive at its current discount-to-NAV in combination with its strong dividend yield.
Shares of Australian contract miners Perenti Global and NRW Holdings also posted disappointing results which pressured the shares. Continued COVID-19 driven quarantines and border closures exacerbated an already tight labor situation in Western Australia, resulting in significant wage and margin pressure for both companies. While pandemic restrictions will eventually ease, the skills shortage in the region appears more structural than we had anticipated, and thus we eventually chose to exit both positions.
Don’t Overlook the Big Picture
During the quarter, most investors were focused on the “great inflation debate,” counting COVID variants, and looking for evidence that the recovery had peaked. We believe this maniacal focus on current data points is leading to missing or misreading a number of key trends and developments.
From a broad, macro standpoint the landscape is profoundly changing. What is popularly known as “the Fed put” has shifted from protecting and inflating the value of financial assets to directly stimulating the real economy. Central banks are committed to increasing real goods prices and wages and generating strong nominal GDP growth. This is aligned with massive fiscal stimulus that aims to boost activity as a means of reducing inequality and addressing urgent environmental needs. Given these policies and the requirement to debase away a large public debt burden, the current debate about whether inflation is transient or sustained is moot. Any sign that inflation or growth is faltering will be met with aggressive easing. In short, the new Fed put means markets are more likely to experience overheating worries than growth scares.
In contrast, current bond rates indicate monetary and fiscal policies will fail with the global economy returning to stagnation. Sluggish loan growth and low monetary velocity are cited as signs that inflation and the recovery are faltering, which is also confirmed by a flattening yield curve. But this conclusion ignores significant differences compared to the 2009 global financial crisis (GFC) experience. During the GFC recession, non-financial company deposits fell by $255 billion. In the COVID downturn, firms’ deposit balances rose by over $1 trillion. Europe embarked on a program of reducing leverage in the banking system and fiscal austerity after the GFC bust but is now rapidly increasing fiscal stimulus. China’s expansionary policies between 2009 and 2011 aided global growth but also encouraged a massive supply response from the energy, industrial and basic material producers. Now, commodity companies are limiting capital spending and capacity expansion in favor of improving cash returns to shareholders.
Another idea obscured by the investor focus on durability of current price gains is that interest rates
could rise significantly without an increase in inflation. Real interest rates are back to the lowest levels since the 1970s at around negative 2%. The longer-term average is roughly positive 2%. Therefore, if nominal economic growth remains healthy due to abundant global liquidity, the tendency will be for real rates to normalize and the yield curve to steepen even if inflation remains well contained. Additionally, interest rates could rise even in the face of moderating growth in the money supply if velocity begins to improve. As the global economy more fully reopens over the next year, fiscal spending begins, record low inventories are rebuilt, capital spending improves, and consumers utilize some of their record savings it would not be surprising to see money multiply.
Positioning and Outlook
Investor skepticism towards the durability of growth and inflation means that this generational shift in the investment landscape from the March 2020 lows is far from being reflected in current valuations and performance. As a result, we used the correction in reflation beneficiaries in June as an opportunity to add to high conviction holdings and upgrade quality and potential growth in the portfolio.
At the sector level, we continue to maintain a significant overweight in pro-cyclical sectors, adding selectively in industrials, materials and energy. We also took advantage of fears surrounding the Delta variant to add several new consumer names to the portfolio, including Eastern European spirits distributor Stock Spirits Group. Stock is the third largest European spirits distributor and a dominant player in both of its main markets, Poland and Czech Republic. Competitive pressures from prior years seem to have stabilized, particularly in Poland, which has now evolved into a stable oligopoly structure. Longer term, top line growth should be supported by continued premiumization and product innovation. With a solid balance sheet and valuation (14x P/E) less than half of industry peers, we believe there is significant room for Stock to re-rate as COVID-19 headwinds ease.
From a geographic standpoint, we made few changes outside of some pruning of materials names which led to a reallocation from Asia to the U.K. Overall, we continue to see the best combination of value and earnings growth in Europe and the U.K. Our screening process has also begun to identify a greater number of undervalued companies in Asia and EM which could present interesting opportunities for us in the coming quarters. Lastly, Japan remains our biggest underweight and has been a laggard market due to the country’s poor handling of vaccine distribution. However, the situation has changed in recent months and vaccination rates appear to be accelerating. Given that Japan is now on pace to catch up with Europe’s vaccination rates by the end of September, there may be opportunity to add quality reopening plays at still attractive valuations.
In conclusion, investors remain hesitant to recalibrate asset allocation around the new central bank policies and support for fiscal objectives. Our belief is that the old Fed put has shifted to a new global mandate to move inflation to the next stage and into the real economy, and we have positioned our portfolio accordingly. Companies are already benefiting from this transition as firms with operating leverage tied to the real economy are posting the best performance and earnings growth. The U.S. market leadership appears likely to finally give up some ground to the global laggards as economic growth becomes broader and more inclusive.
The ClearBridge International Small Cap Strategy outperformed its MSCI EAFE Small Cap Index benchmark during the second quarter. On an absolute basis, the Strategy had gains across seven of the 11 sectors in which it was invested (out of 11 sectors total). The industrials sector was the primary contributor to returns during the quarter.
On a relative basis, overall stock selection contributed to performance. Specifically, stock selection in the industrials, health care, financials and IT sectors, an overweight to industrials and an underweight to consumer staples drove returns. Conversely, sector allocation was a headwind to relative performance with an overweight to energy, an underweight to real estate and stock selection in materials detracting from results.
On a regional basis, stock selection in emerging markets and the U.K. and an underweight to Japan drove performance while stock selection in Asia Ex-Japan and an overweight to EM hurt results.
On an individual stock basis, D/S Norden, Golden Ocean Group, Star Bulk Carriers, Shanghai Haohai Biological Technology and MaireTecnimont were the leading contributors to absolute returns. The largest individual detractors were Avance Gas, Perenti Global, NRW Holdings, Marston’s and Sundrug.
During the second quarter, in addition to the names mentioned above, we initiated positions in RHI Magnesia and Juno Minerals in the materials sector, Serica Energy in the energy sector as well as Wickes Group in the consumer discretionary sector. We also closed positions in Shanghai Haohai Biological Technology in the health care sector as well as Centerra Gold and Americas Gold and Silver in the materials sector.