Market Overview
In the first quarter of 2016, the MSCI World Index declined −0.35% while in the United States the S&P 500 Index increased 1.35%. In Europe, the German DAX was down −3.07% and the French CAC 40 index decreased −0.80%. In Japan, the Nikkei 225 index fell −5.76% over the period. Crude oil rose 3.51% to $38.34 a barrel, and the price of gold rose 16.40% to $1,234.20 an ounce. The US dollar weakened −7.03% against the yen and weakened −4.90% against the euro.
The first quarter of 2016 was a tale of two very different market environments: a correction in the first half followed by a fairly strong rally in the second. For years now, we have been concerned about the policy experiments introduced by central banks in response to the Global Financial Crisis—the quantitative easing and, more recently, negative interest rates—that have raised overall debt in the world economy to levels we consider unsustainable. In the first half of the past quarter, we saw some signs that a neces-sary process of deleveraging had finally commenced. European bank stocks collapsed, and some were trading below their 2008 lows. Defensive currencies, such as the Japanese yen, started to do well. And gold and gold-mining stocks strengthened.
What happened next? In the middle of the first quarter, central banks responded to the negative price action in stock markets with more of the same experimentation. The European Central Bank moved bank interest rates further into negative territory; the Japa-nese initiated negative interest rates; the Chinese committed themselves to double-digit money-supply growth for the next five-year plan; and the Fed put its process of policy tightening on hold.
Central banks initiated zero interest rates as a cyclical response to the Global Financial Crisis, but they are still engaging in this policy—in fact, accelerating it—nearly eight years after the crisis. In the second half of the past quarter, equity markets responded favorably to the fresh injections of liquidity, but world economies did not get any closer to the structural adjustments they require. The central bankers of the world seem to be committed to trying to fight debt with more debt. And if central banks have to do this in a non-recessionary state of the world, what are they going to do when the next recession arrives? What will be the next level of experimentation?
In a time when questions like this loom over the markets, we see opportunities in four areas:
- Individual stock selection—Rather than trying to find high-growth companies, we look for persistent businesses that we believe have scope for sustainable free-cash-flow generation and conservative valuations relative to EBIT or replacement value.
- Cash1—Although the real return on cash is repressed, if we can deploy our cash in periods of market crisis, we may be able to earn a real return on these assets through the cycle.
- Currencies—The strength of the dollar may create diversification opportunities for some of our cash. A handful of economies where we believe debt levels are not excessive may be able to support real interest rates on their sovereign debt, combined with what we consider a “margin of safety” in the valuation of their currencies.
- Gold—Since the breakdown of the Bretton Woods agreement, gold has produced an attractive real return—albeit with large cycles. The supply of gold has been relatively constant per capita during this period, and as the nominal economy has inflated, so too has the equilibrium price of gold. Although we do not attempt to predict the price of gold, we are cognizant of the fact that the supply of gold has become constrained: Limited gold discoveries have been made in recent years, ore grades are declining at many existing mines, and many large gold miners are facing declines in production. One disadvantage of gold has always been that it does not yield anything, but today, neither does much of the world’s sovereign debt. In the current environment of geopo-litical uncertainty, excessive sovereign debt and possible further policy experimentation, we consider gold a valuable potential hedge against extreme market outcomes.
Portfolio Review
First Eagle Global Fund
During the first quarter, the Global Fund Class A shares (w/out sales charge) returned 3.48% versus -0.35% for the MSCI World Index.
Our gold holdings, including both bullion and shares of mining companies Barrick Gold and Newcrest Mining, made the largest contribution to the quarterly return. Gold rallied strongly as the stock market slid in the first part of the quarter.
Oracle and Weyerhaeuser also contributed during the quarter. Oracle (ORCL, Financial) has been transitioning to cloud-based delivery of its software licenses. Up -front revenues declined in the early stages of this transition, but recurring revenues may potentially make up for this shortfall. In the first quarter, we believe the market started to believe that this will, indeed, occur. The company has become one of the largest players in cloud software, and it is performing well relative to its competitors.
Early in the first quarter, Weyerhaeuser (WY, Financial) merged with Plum Creek Timber, another of our large timberland holdings. Commodity-related stocks were weak at that time, and Plum Creek’s depressed share price made it a detractor from the fund’s return. However, the combined company (which kept the Weyerhaeuser name) rebounded strongly as commodity-related stocks recovered in the second half of the quarter, and it was one of our five leading contributors for the period. Over the longer term, due to urban encroachment of forests, we view timber as a supply-constrained commodity.
A number of financial stocks—Sompo Japan Nipponkoa, American Express and Bank of New York Mellon—detracted from the quarterly return, as the financial repercussions of central bank policies affected them in a variety of ways. Like other insurance companies, Sompo normally derives a substantial share of its income from its fixed income portfolio, but with the Japanese govern-ment moving interest rates into negative territory, it became harder for Sompo to earn a solid return on its reserves. Investor senti-ment turned negative on the stock.
American Express (AXP, Financial) illustrates the negative supply consequences of easy monetary policy. Zero -percent interest rates have generally compressed banks’ net interest margins, but not in the consumer credit card business, where margins have remained wide. This has become an especially bright spot in the financial sector, and banks have committed more capital to credit cards. As a result, American Express has faced a period of heightened competition, which has put pressure on its stock. We believe American Express has remained a very well-entrenched franchise, and in a world where many banks are earning single-digit return on equity (ROE), American Express has earned a 25% ROE.2 Its balance sheet is solid by comparison, and it has been able to buy back stock rather than needing to issue stock. We have remained committed to American Express, but we acknowledge that its environment has become somewhat more challenging.
Bank of New York Mellon (BK, Financial) has been struggling with the effects of central bank policy. The fact that the Fed has not tightened interest rates further and the possibility of negative interest rates are hurting the valuations of banks, which normally earn interest on deposits. Interest rates that have stayed low for a long time have increased investors’ worries that these headwinds to Bank of New York Mellon will persist—both for its deposit float and for the fee waivers in its money market asset management businesses.
Another detractor was Berkeley Group Holdings plc (LSE:BKG, Financial), a British property-development company whose shares we first purchased in the wake of the Global Financial Crisis. The stock has approached our sense of its intrinsic value, and we trimmed the position. We believe that the first-quarter weakness in Berkeley’s shares reflected the company’s more elevated valuation, as well as recent softness in the high-end London real estate market.
First Eagle Overseas Fund
The Overseas Fund Class A shares (w/out sales charge) returned 3.05% for the quarter versus -3.01% for the MSCI EAFE Index.
The top five contributors to performance for the quarter were gold bullion, Newcrest Mining, Agnico Eagle Mines, Barrick Gold and Goldcorp. The largest detractors were Sompo Japan Nipponkoa Holdings, Fanuc Corporation, Berkeley Group Holdings, SMC Corporation and Hoya Corporation.
First Eagle U.S. Value Fund
The U.S. Value Class A Shares (w/out sales charge) returned 4.36% for the quarter versus 1.35% for the S&P 500 Index. The top five contributors to performance for the quarter were gold bullion, Oracle Corporation, Weyerhauser Company, Omnicom Group and Comcast Corporation. The largest detractors were Plum Creek Timber Company, American Express, Bank of New York Mellon, BB&T Corporation and Intel Corporation.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
