- During this period of elevated market volatility, the Strategy’s quality orientation toward companies with strong balance sheets and sustainable cash flows allowed us to significantly outperform the benchmark, especially in North America.
- We have taken advantage of attractive valuations to increase our U.S. exposure and add to positions in companies that should be beneficiaries of the shift to remote work environments.
- We believe our sell discipline and focus on valuing companies on long-term cash flows, where one year does not determine the intrinsic value, will pay off.
A coronavirus outbreak centered in China rapidly expanded into a global pandemic in the first quarter, sending global equities into a bear market and grounding economies across the world to a near halt. International equities were not spared in the selloff with the benchmark MSCI All Country World (ACWI) Index plunging 21.4% and the MSCI Emerging Market Index falling 23.6%. Growth stocks held up better than more value-oriented shares with the MSCI ACWI Growth Index down 15.7% for the quarter, compared to a loss of 27.1% for the MSCI ACWI Value Index (Exhibit 1).
On a regional basis, Japan (-16.8%) and North America (-20.1%) held up the best, followed by Europe Ex UK (-23.4%) and emerging markets (-23.8%) while Asia Ex Japan (-26.2%) and the UK (-27.3%) were the worst performers.
Exhibit 1: MSCI Growth vs Value Performance
On a sector basis, health care (-11.4%), information technology (IT, -13.7%), consumer staples (-13.9%) and communication services (‑16.2%) offered the most resilience. Energy (-43.9%) and financials (-31.7%), meanwhile, suffered the deepest losses.
Given very sizeable and relatively expeditious reactions around the world for stimulus both monetary and fiscal, markets recovered from extraordinarily high fear levels in mid-March to end with losses less severe than those of the Global Financial Crisis (GFC) in 2008. At quarter end, the Chinese economy was showing initial signs of life but regions in the U.S. and Europe continued to be among the hardest hit by the virus known as COVID-19.
Stimulus spending varied but for many countries was above amounts seen back in 2008, particularly in Europe and the UK (Exhibit 2). Unlike during the GFC, where the EU was slow to react with aggressive action, European policy makers have quickly thrown a lot at this crisis and in a coordinated manner to prevent stress in credit markets and to underpin confidence for both consumers and workers. It is unlikely that this will be all they do as it remains to be seen how large the crisis will be in Europe and how long it will last. Having learned hard lessons from the GFC, they will do whatever it takes to prevent this health crisis from becoming a liquidity crisis.
Exhibit 2: Key Fiscal Stimulus Announcements
A new €750 billion European Pandemic Emergency Purchase Program eases rules around quantity of government debt the European Central Bank can buy while the new EU budget will provide up to €8 billion in financing to incentivize banks to provide liquidity to small and mid cap companies. The policy response measures are meaningful and aimed at ameliorating the impact of mandatory lockdowns by targeting three areas: 1) preserving employment and a significant amount of current wages as businesses shut down; 2) easing cash shortages in the corporate sector, especially among small and medium-size businesses; and 3) facilitating credit flows from banks to companies. The total fiscal response so far is 2.6% of EU GDP and 3.2% of UK GDP, well above the cumulative 2.3% of GDP spent during the GFC. We expect they will do more on the fiscal side as countries like Germany have no debt, giving them plenty of room for deficit spending.
The U.S. policy response added unprecedented amounts of stimulus to mitigate the effects of the virus on financial markets and the real economy. The Federal Reserve undertook several extraordinary measures to help ensure liquidity, facilitate the flow of credit and mitigate the supply shock caused by the virus, including slashing short-term rates to near zero; introducing a $700 billion quantitative easing program; and signaling it would purchase unlimited amounts of government debt. On the fiscal side, Congress passed a $2 trillion package, the largest economic stimulus package in U.S. history. The package extends unemployment benefits, sends money directly to individuals and includes support for small and large businesses.
"We were opportunistic in making 14 new purchases while exiting 22 positions during the most volatile quarter we have seen since the Global Financial Crisis."
During this period of elevated market volatility, the quality orientation of the Strategy toward companies with strong balance sheets and sustainable cash flows has allowed us to outperform the benchmark by over 700 basis points. The North America portion of the portfolio (U.S. and Canada) had a return of -12% for the quarter compared to returns of -19.6% for the U.S. market as measured by the S&P 500 Index and -27.5% for Canada as measured by the MSCI Canada Index. As growth managers, we believe having an approach to buying different growth types (secular, structural and emerging) while also sizing those stocks and groups for their riskiness allows us to perform in a variety of market environments, including this one. While we understand these are unprecedented times, the focus on quality characteristics should allow the Strategy to hold up in current market conditions while also performing in an up market once we pass through this period.
Our initial portfolio actions following the virus outbreak were oriented toward demand in China. Having had a front row seat to the events in Asia in early January, we were concerned early on about the spread of the virus. Health care systems in Asia, especially China, are still developing and the concerns we had about how this would play out turned into a worst-case scenario in terms of spread and impact. With a population that was far more mobile in terms of both domestic and international travel than during the SARS epidemic, the outbreak, we realized, had the potential to be large. We also wondered what would happen if the virus spread to the U.S. and other developed and densely populated markets. With that in mind, there were areas where we felt stocks had been relatively fully priced and markets were still being far too complacent on developments in China. We trimmed names oriented toward travel retail and the Chinese consumer, including Alibaba, LVMH, Shiseido and Burberry.
Risk management is core to our approach to managing the portfolio and we are constantly reassessing the credit and economic environment and analyzing whether something has changed in our theses for owning companies in the current crisis. We have been speaking with all of our companies frequently, trying to understand impacts to earnings and valuations, as well as re-evaluating ideas on our watch list of companies for potential entry points. This analysis, combined with a strict sell discipline that leads us to exit strong performers as they reach our price targets, provided opportunities to make 14 new purchases while exiting 22 positions during the most volatile quarter we have seen since the GFC.
"We will likely have an earnings period like none we have experienced before, with uncertainty around the end of the virus and the shock to consumer demand."
To make way for new names, we sold several winners including Tesla, the electric vehicle maker whose surging sales growth saw shares spike to $900 from our initial purchase several years ago at much lower levels. We also exited Swiss flavor and fragrance maker Givaudan as it reached our price target and British industrial gas producer Linde, another recent outperformer. Disney was eliminated, meanwhile, on concerns about the long-term impacts on its parks from less travel due to COVID-19.
We are positioned to take advantage of new ideas that we have evaluated as well as names we feel are sufficiently stress tested and at bear assumption levels. We will buy them when we, as a team, believe the risk is fully discounted. Much of our sale proceeds and available cash was directed into U.S. stocks to better balance their weighting in the portfolio. These included new purchases of cleaning & hygiene services provider Ecolab, renewable power producer NextEra Energy and cancer biopsy developer Guardant Health as well as adds to natural food company Hain Celestial, consumer products giant Procter & Gamble, heating/cooling systems maker Lennox and online pet food retailer Chewy.
We have generally avoided credit distressed companies and this has been even more critical as mandatory shutdowns of economic activity leave many companies with few options other than tapping financing to stay afloat. Our financials holdings illustrate our quality orientation. We continue to maintain a meaningful underweight position in banks broadly. Additionally, our holdings in Asian insurance (AIA) and capital markets (London Stock Exchange) have been key drivers of relative performance compared to the benchmark. We eliminated our premium valuation bank positions, HDFC Bank and KBC Group, whose premium is predicated on continued earnings growth, as well as U.S. regional bank Truist Financial and discount brokerage Charles Schwab where we were losing confidence in the thesis for owning each. In their place, we have taken advantage of attractive valuations to add positions in Hong Kong Exchanges & Clearing, which should be a beneficiary of heightened volatility and Brazilian financial services provider XP.
We have also been underweight areas of global equities that are capital intensive and currently being critically impaired, such as energy and materials and to a lesser extent, industrials. Our lack of exposure to industrial base metals and petrochemicals has helped significantly as we head into an environment where demand is likely to fall considerably.
We believe that a global recession is very much in the cards, but something far worse has been averted at the price of extreme monetary and fiscal expansion. The same cannot be said for earnings. As we enter the second quarter, dividends at nearly all European banks and many companies are being suspended, as they need to marshal their cash resources to endure for an indeterminable period. Cash raises of equity and bond issuance for solid credits are beginning. Share buybacks that were being undertaken are similarly suspended. Rents are not being paid to landlords while credit to consumers and small businesses is getting three-month extensions and much more. We will likely have an earnings period like none we have experienced before, with uncertainty around the end of the virus and the consumer demand shock for a period of time (Exhibit 3). We know developed markets are very consumer reliant, with approximately 70% of U.S. and 60%–65% of European GDP dependent on consumption. There will be very little in terms of near-term earnings; rather, the question is how deep will be the declines? If losses happen, for how long and do companies have the wherewithal to make it through to the other side of the health crisis and a hopeful rebound in consumer spending? 2020 is likely to be a write-off for corporate earnings, and this is already reflected in some areas of the market, but we think we are still at a fairly early stage in the market’s earnings reset.
Exhibit 3: Earnings Poised to Plummet Across the Globe
Our focus on valuing companies on long-term cash flows, where one year does not determine the intrinsic value, will pay off. Focusing simply on earnings misses the point. We are conferring with our companies to ensure their cash resources/debt lines will see them through. Our focus on quality businesses, including balance sheet strength, demonstrates why this matters, now more than any of the years post the GFC. The cut in dividend payments and buybacks means growth is now on more equal footing to other parts of the market, potentially making growth an even more attractive segment. And there will be companies that can prosper as a result of this pandemic and the changes in consumer behavior that result.
The ClearBridge Global Growth Strategy outperformed the benchmark MSCI ACWI for the first quarter. While the Strategy registered absolute losses across nine of the 10 sectors in which it was invested (out of 11 total), stock selection in each sector contributed positively to performance on a relative basis.
In particular, stock selection in the consumer discretionary sector and a lack of exposure to the energy sector were the primary drivers of relative results. Stock selection in the financials, health care, materials and real estate sectors, an overweight to IT as well as an underweight to financials were also significant contributors. Conversely, an underweight to the utilities sector was a detractor.
On a regional basis, stock selection in North America and Europe Ex UK had the most positive impacts.
On an individual stock basis, the largest contributors to absolute returns in the quarter included Tesla, Chewy, Nvidia, Teamviewer and Zai Lab. The greatest detractors from absolute returns included positions in StoneCo, Airbus, JPMorgan Chase, Ecolab and Burberry Group.
In addition to the transactions mentioned above, the largest positions we initiated included T-Mobile US and Tencent in the communication services sector, Tokyo Electron in the IT sector, Brambles in the industrials sector and MorphoSys in the health care sector. The largest additional positions closed included Verizon in the communication services sector, Teleperformance in the industrials sector, Albemarle in the materials sector and Intercontinental Exchange in the financials sector.