In the third quarter of 2017, the MSCI World Index rose 4.84% while in the United States the S&P 500 Index increased 4.48%. In Europe, the German DAX Index was up 4.09% and the French CAC 40 Index increased 4.28%. In Japan, the Nikkei 225 Index rose 2.34% over the period. Brent crude oil increased 20.08% to $57.54 a barrel, and the price of gold rose 3.11% to $1280.15 an ounce. The US dollar rose 0.11% against the yen and fell -3.29% against the euro.1
Markets continued to be dominated by risk-seeking behavior in the third quarter of 2017. Few investors seem to share our view that we are facing a period of elevated risks and subdued returns. Setting aside the geopolitical risks that we have discussed in the past, we are concerned about both secular and cyclical macroeconomic risks. The chief secular issues are slow productivity growth and high levels of debt across the globe. Among the cyclical factors, we would cite high levels of busi-ness and consumer confidence.
Secular Issues
Prior to the global financial crisis, Americans were accustomed to economic growth of about 3% a year. Since the crisis, average growth has been closer to 2%, with population growth and the reduction in unemployment rates accounting for approximately half of that figure. In other words, productivity growth—the other key ingredient in economic growth—has been sluggish. We suspect that productivity growth is suffering because of the forced growth engendered by years of easy fiscal and monetary policies.
This pattern can also be seen in China, which has made enormous fixed capital investments to construct cities and build out its manufacturing infrastructure. These projects have spurred economic growth, but some of them were, we believe, larger than necessary. Now, China will likely need to devote significant resources to maintaining its expanded asset base, and, as a result, it will have less capital available to invest in productivity-boosting initiatives. There is no free lunch. Over time, if a nation forces growth and tries to continue forcing growth, it imposes a higher and higher tax on produc-tivity. Over the long term, this creates a secular headwind for economic growth.
Low interest rates may be another secular headwind. Around the world, rates were lowered to protect people from the delete - rious effects of the global financial crisis, but the price for this protection may be a reduction in future asset returns. Because interest rates have gone from high to low, asset markets have re-rated from low P/Es to high P/Es and credit spreads have gone from high to low. As a consequence, the expected return on a market portfolio has fallen.
Low interest rates can be seen as a tax on savings. We grew up in a world where endowments, foundations and individuals believed that they could spend from their portfolios at rate of 5% a year and still preserve, and possibly grow, the real corpus of their wealth. But today, if long-term government bonds yield 2% and equities are priced for mid-single digit return, the return on the market portfolio may be in the low single digits and, perhaps, negligible in real terms. In this case, even modest amounts of spending may erode the real value of an individual’s savings. This raises the possibility, in the medium term, that people may need to save more. If consumers rebuild their savings and governments rebuild their balance sheets, demand in the economy may be less than robust, and there will likely be less capital available for productive investment.
We view today’s markets as ebullient, but, by virtue of the second-order consequences of the stimulus that was provided upfront, we think the medium-term future could be disappointing.
Cyclical Issues
On the cyclical side, consumer confidence is near its highest level in a decade. Unemployment has fallen from 10% to roughly 4%—the low end of its range over the last 50 years. This suggests that the improvement in consumer sentiment that comes from reducing unemployment may be peaking.
According to ISM surveys, business confidence is also high. Investors make money when confidence improves, and, while it could go higher in the short term, it has already come a long way.
In a period of high confidence, it is not surprising that risk perception is very low. The VIX Index implies US equity vola-tility of less than 10%, but we know that the actual long-term level is closer to 20%. Credit spreads, which are closely corre-lated with implied volatility, are tight. We believe P/E ratios are high and, as disciplined bottom-up investors, we have to search long and hard for new ideas. Easy monetary policy and the natural healing process of an economy coming out of a recession may be losing their force. The Fed has already been raising interest rates for a year, and it has begun to shrink its balance sheet. China faces problems of excess debt and excess capacity, and some expect it to restructure its economy following the close of its 19th Party Congress. Thus, there is reason to suspect that both the United States and China—two large sources of support for easier monetary conditions— appear poised to become less accommodative.
We cannot predict the markets, and we know that positive developments, such as corporate tax relief in the United States, can still occur. Nonetheless, we believe that much of the good news is behind us. Investors have experienced a strong bull market for stocks and seem confident that it will continue for the foreseeable future. In a world where asset prices are, in our view, inflated, we think it is important for investors to become more mindful of risk.
Global Fund
As the overall market continued its strong advance in the third quarter, the First Eagle Global Fund Class A (without sales charge)* returned 2.72% versus the MSCI World Index return of 4.84%.
Sectors contributing to quarterly performance included industrials, energy and information technology, and sectors detracting included consumer staples and consumer discre-tionary. Returns were positive from all regions except emerging markets, where South Korean stocks detracted.
Among individual stocks, the top five contributors for the quarter were Orbital ATK, Inc.; Keyence Corporation; gold bullion; SMC Corporation; and Microsoft Corporation.
Orbital ATK, a US-based producer of components for missiles and satellites, agreed to be acquired by Northrop Grumman at a premium to its then-current trading price.
Keyence, which makes electronic sensors, and SMC, which provides pneumatic equipment, are Japanese industrial compa-nies that benefitted from strong demand in their end-markets. We trimmed both positions because of their price appreciation.
Gold bullion also contributed to the Fund’s return. We hold gold as a potential hedge against disruptive market events, and we know that gold often trades off in a strong equity market. Nonetheless, both gold and equities climbed in this period, possibly because the supply of newly mined gold has been constrained by low critical investment and a fall-off in new gold discoveries. Gold also benefitted from the perception of increased geopolitical risk in North Korea.
As Microsoft once again gained share with its cloud-computing platform, investors appeared to recognize the company’s potential to continue to generate cash flow.
The top five detractors in the quarter were Omnicom Group, Inc.; Carrefour SA; KIA Motors Corporation; Shimano Inc.; and Oracle Corporation.
Shares of US-based advertising company Omnicom lost value as reduced advertising budgets at consumer staples companies and the ongoing shift of advertising from traditional media to the Internet weighed on advertising industry stocks.
Carrefour, the French-based supermarket and hypermarket chain, obtained a price we consider attractive for the IPO of its Brazilian operation, but its core French business faced continued competitive assault from different retail formats, including the Internet.
Shares of Kia Motors came under pressure as threats from North Korea weighed on the South Korean stock market. Kia was also affected by a Chinese boycott of South Korean products.
Shimano, a Japanese manufacturer of high-end bicycle compo-nents and fishing tackle, has been in the Fund’s portfolio for many years. The valuation had gotten very high, and we had been selling the stock, but during the quarter the price returned to more rational levels.
Overseas Fund
The First Eagle Overseas Fund Class A shares (without sales charge)* returned 2.41% versus the MSCI EAFE Index return of 5.40%.
Leading contributors in the second quarter included Keyence Corporation’ SMC Corporation’ Potash Corporation of Saskatch-ewan, Berkeley Group Holdings plc, and gold bullion.
Keyence, SMC and gold bullion are discussed above in the Global Fund’s portfolio review.
During the quarter, Potash Corporation (POT, Financial) of Saskatchewan held merger talks with Agrium Inc., another Canadian fertilizer company. If the merger goes through, we believe the combined company will likely be able to reduce costs.
Shares of Berkeley Group Holdings plc (LSE:BKG, Financial), a British real estate company focusing on London, had been discounted following Brexit, but they drifted higher in the third quarter on signs that the UK real estate market remained healthy and that Berkeley Group was continuing to execute on its business plan.
The top five detractors were KIA Motors Corporation; Carre-four SA; Shimano, Inc.; Mitsubishi Estate Company, Ltd.; and KT&G Corporation. KIA Motors, Carrefour and Shimano are discussed above in the Global Fund’s portfolio review.
Mitsubishi Estate Company Limited controls about one-third of the real estate in central Tokyo’s Marunouchi District. The stock fell on fears that a competing supply of new buildings outside this district could affect the company’s rental rates. Even if this occurs in the near term, we remain confident that Mitsubishi Estate Company is a business with long-duration assets in a hard-to-replicate location.
KT&G, which is in the tobacco and ginseng businesses, has also been perceived as a laggard in the development of e-cigarettes, but it has announced that a product will soon be launched.
We continue to view KT&G’s valuation as attractive relative to global tobacco companies.
U.S. Value Fund
The First Eagle U.S. Value Fund Class A Shares (without sales charge)* returned 3.15% versus the S&P 500 Index return of 4.48%.
Leading contributors were Orbital ATK, Inc.; gold bullion; Microsoft Corporation; Teradata Corporation; and American Express Company. Orbital, gold bullion and Microsoft are discussed above in the Global Fund’s portfolio review.
Leading detractors were Omnicom Group, Inc.; Alleghany Corporation; Flowserve Corporation; Oracle Corporation; and H&R Block, Inc. Omnicon is discussed above in the Global Fund’s portfolio review.
Alleghany (Y, Financial) is a property and casualty insurance company that had exposure to hurricane damage during the third quarter through TransRe, its reinsurance subsidiary. We believe that TransRe will pay claims and take some losses, but that the overall impact on Alleghany will be modest.
Oracle (ORCL, Financial), which specializes in enterprise software and database management, made further progress in its transition from front-end sales to cloud-based subscriptions. We thought the growth rate it reported during the quarter was impressive, but the market evidently expected more.
We appreciate your confidence and thank you for your support.
First Eagle Investment (Trades, Portfolio) Management, LLC
