- As the U.S.-China trade war weighed on economic activity and depressed corporate investment, the Fed pivoted to become more accommodative.
- Amid a volatile backdrop, our portfolio of high-quality dividend growers performed relatively well.
- Low rates continue to be supportive of asset values and we think the economy could still provide reasonable, if uninspiring, growth.
Market Overview and Outlook
While the S&P 500 Index was up 1.7% in the third quarter, beneath the surface things were far choppier. Interest rates and trade, the two factors discussed in our previous quarterly letter, remain front and center.
The trade war with China persists and the market continues to react to each new tweet. To date, these reactions have been much ado about nothing. The stalemate endures and it is unclear if progress is being made. There are whispers of a pending partial agreement, but after so many ups and downs we will not hold our breath.
As the trade war weighs on economic activity and depresses corporate investment, the Fed has pivoted to become more accommodative, cutting rates twice in the quarter. Interest rates in the U.S. are back near all-time lows and interest rates globally have hit new lows. Investors have generally cheered this trend and pushed the market up 20%+ year to date.
During August, however, the stock market dropped despite plunging rates. Declining rates became viewed as a symptom of economic malaise rather than a catalyst to brighter days ahead. Investors feared the U.S. was following Europe and Japan into a moribund state of low growth and near zero (or negative) interest rates. Volatility surged and stocks declined.
Markets stabilized in September as U.S. economic data came in better than feared and interest rates recovered somewhat. Time will tell how the trade war will end and what trajectory the economy will follow. It is possible that August’s jitters were ill-founded, but it is also possible they presage something more worrisome. Either way, interest rates now seem likely to remain in a lower range for a longer period than we modeled previously.
Amid this uncertain backdrop, our portfolio of high-quality dividend growers performed relatively well. The market was led by rate-sensitive sectors such as utilities, real estate and consumer staples. While our holdings in these sectors outperformed on a relative basis, our picks in sectors such as industrials and consumer discretionary — not often viewed as bond proxies — stood out even more. In industrials the portfolio was led by United Parcel Service (UPS). The company is in the middle of a multi-billion-dollar transformation initiative that will increase efficiencies and better position UPS to profit from the ongoing shift to B-2-C. This transformation has been characterized by fits and starts, but the company believes this quarter marked the turning point. Home Depot, a standout in consumer discretionary, continues to deliver robust financial performance and is a good example of the portfolio’s emphasis on companies operating in attractive market structures (Home Depot’s is effectively a duopoly) and generating both high returns on invested capital and large, recurrent cash flows. It has also grown its dividend an annualized 22% over the past five years.
Political rhetoric about changes to Medicare and scrutiny of prescription drug prices soured sentiment on the health care sector and made for a tough quarter for UnitedHealth and Pfizer, although the portfolio’s significant underweight to the sector and relative outperformance from Zoetis and Merck helped mitigate the pressure.
“A new corporate structure for some alternative asset managers should be a long-term tailwind for their share prices.”
During the quarter we built a position in Apollo Global Management, an alternative asset manager that, like existing holding Blackstone, has operations in private equity, real estate, infrastructure and credit. Both are well-positioned to benefit from the low-rate environment as institutions, under pressure to meet their financial obligations, reduce allocations to traditional asset classes like investment grade fixed income and shift into alternatives. Both also enjoy robust growth in assets under management, attractive fee streams and are not subject to redemption. They are also underowned. Historically these companies were structured as publicly traded partnerships, which prevented many investors from owning their shares. During the quarter, however, these companies converted to C-corporations, the standard corporate structure of most public companies. We believe that as new investors migrate into these stocks, they have the potential to provide a long-term tailwind to their share prices.
As we head into year end, we find ourselves looking both backward and forward. After a terrible fourth quarter of 2018, the stock market bounced back nicely in early 2019 and to date has delivered gratifying returns. Low rates continue to be supportive of asset values and we think the economy could still provide reasonable, if uninspiring, growth. It seems, however, that the oft-repeated litany of concerns (trade, political polarization, geo-political uncertainties, etc.), is getting longer rather than shorter (impeachment?) and we question whether the market’s resiliency will endure. Amid such uncertainty, we continue to believe that a portfolio of high-quality dividend growers is a relatively good place to be.
The ClearBridge Dividend Strategy outperformed its S&P 500 Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in nine of the 11 sectors in which it was invested for the quarter. The main contributors to Strategy performance were the consumer staples, information technology (IT) and financials sectors. The energy and health care sectors, meanwhile, detracted from absolute results.
On a relative basis, stock selection added to performance for the quarter. In particular, stock selection in the industrials, consumer discretionary and IT sectors contributed positively to relative returns. An underweight to the health care sector and an overweight to the consumer staples sector also proved beneficial. Conversely, stock selection in the health care sector detracted from relative performance, as did an overweight to the energy sector.
On an individual stock basis, the largest contributors were Home Depot, Blackstone Group, Apple, Procter & Gamble and UPS. Positions in Williams Companies, Pfizer, Schlumberger, UnitedHealth and Johnson & Johnson were the main detractors from absolute returns in the quarter.
During the quarter, we initiated positions in Apollo Global Management and Wells Fargo in the financials sector and Edison International in the utilities sector. We closed positions in Brookfield Infrastructure Partners in the utilities sector, Schlumberger in the energy sector and BlackRock in the financials sector.