Renewed easing by central banks worldwide was the defining move in financial markets during 2019, instigating a robust rally that left a number of major equity indexes at or near all-time highs by year-end even as renewed economic growth remained elusive. This policy shift was coincident with signs that the slow drain of liquidity from the system in recent years had begun to take its toll on both asset prices and the real economy, and fears that geopolitical issues—in particular the US tariff disputes with China and others—could further impair already flagging momentum. Notably, while investor sentiment seemed to improve during the course of the year, the market’s response to the renewed liquidity was not uniform. Instead, we saw large but barbelled gains suggestive of certain underlying tensions within the market, most notably between the “old” and “new” economies.
At First Eagle, we avoid taking sides in such battles, recognizing that quality busi-nesses can be found across industries and geographies. Instead, we focus on trying to identify those companies—old or new—most likely to demonstrate resilience over business cycles.
The Allure of the New
Risk markets ended 2018 on a sour note, as the aggregate impact of Federal Reserve rate hikes and the slow runoff of balance sheet assets appeared to bring the global financial structure to a choke point during the fourth quarter. Investors flocked to perceived “safe havens” like US Treasuries and defensive assets like gold in search of protection against downside risk. Global equity indexes moved sharply lower—and in some cases into correction territory—and market volatility became more pronounced. However, a surprise policy U-turn toward easing communicated by the Fed in January 2019—and bolstered by a renewal of accommodative policies by other global central banks—helped coax investors back into risk assets. Well worth noting is that the performance of major equity indexes like the S&P 500 and MSCI World last year was driven by multiple expansion, as corporate earnings growth in most markets was flat to down in the face of lackluster economic readings; such a sharp rally unaccompanied by increased profits suggests to us that investors may want to temper their return expectations going forward.
As bottom-up investors, we look to our portfolio as our primary source of informa-tion about macro trends; by examining the performance of our individual holdings over time, we can draw thematic connections across the investment universe. While 2019 was a strong year in general for risk assets, market dynamics suggested that investors expressed their stock preferences based not on individual merits but rather on a more thematic set of concerns.
Perhaps most notable among these themes was a pronounced distinction between old-economy and new-economy stocks, with investors for the most part taking a dimmer view of companies that “make stuff” in favor of those that “do stuff.” There was evident enthusiasm for businesses viewed to be on the right side of secular change in the economy, such as those involved with information technology and industrial automation as well as the many companies that exist in the services ecosystem. In contrast, investors expressed cynicism toward the prospects of old-line—but still significant—industries like autos, chemicals, tobacco and energy. This bias reminds us of a remark made by Alan Greenspan in the late-1990s. While over the years we’ve taken exception to some of the policies introduced by the former Fed chief and perpetuated by his successors, we have to give him credit for his observation that the literal weight of US GDP is “only modestly higher today than it was fifty or one hundred years ago” despite real GDP having expanded exponentially over the years, a phenomenon he attributes in large part to technological development:
Since the dawn of the industrial revolution, there has been an inexorable drive to leverage physical brawn and material resources into ever greater value added or output. …Almost all of the leverage of the physical to higher value added has reflected the substitution of ideas—new insights—for material bulk and brute human effort.1
Related to this old/new dichotomy is the increased importance investors appear to be assigning to environmental, social and governance (ESG) considerations; perhaps not coincidentally, it is the old-economy industries that are typically pigeonholed as lacking in these areas—especially environmental and social—and companies in businesses like tobacco, oil and gas, and mining generally lagged the broader market in 2019.
While we believe good ESG practices can contribute to a company’s ability to generate sustainable earnings over time, fiduciary responsibility demands a more nuanced and rigorous approach to evaluating the potential risks and opportunities these factors represent, especially for companies that at first glance may not appear to be model corporate citizens.
Coincident with elevated concerns over ESG issues has been the growth of assets under management in passive investment strategies and thus the outsized influence these managers can have on corporate stewardship. Though passive managers’ buy/ sell discretion is limited by their need to adhere to the composition of benchmarks, proxy voting can be a powerful bit of leverage for managers who choose to use it as such; shares held by the three largest index fund providers together represented about 25% of the total shares voted in 2018 director elections.2 However, with little incen-tive to invest in the resources necessary for effective corporate engagement and thou-sands of proxy statements to vote each year, how can we expect passive investment managers—who by definition do not engage in fundamental analysis of the stocks they own—to thoughtfully represent the interests of shareholders?
Monetary and Fiscal Policy Obscure Sluggish Trend Growth…
We believe central bank activity in 2019 illustrated an ongoing asymmetry in the monetary policy function. Even a whiff of economic fragility in fourth quarter 2018 inspired the Fed to abandon its tightening bias in favor of a range of expansionary actions, from rate cuts to bond buying, just as the impact of the 2017 – 18 tax cuts were beginning to fade. Other global central banks followed suit with stimulus measures of their own; this included the European Central Bank and Bank of Japan, whose benchmark rates have been set at or below zero for five years and 20 years, respectively. Though monetary and fiscal policy stimulus encouraged investors to bid up equities aggressively in 2019, we’ve yet to see indications that these measures have dislodged the global economy from the stall zone it settled into last year, under-scoring the many challenges that persist despite renewed accommodation.
The supposition that central banks have the ability to engineer nominal financial stability has led investors to become more and more comfortable with large midcycle fiscal deficits and with interest rates that lag the rate of nominal GDP growth. Unfortu-nately, the interaction of monetary and fiscal policy in recent years has created a fraught dynamic that further complicates the path forward for policy makers and carries with it the potential for significant negative macroeconomic consequences. In the US and certain other developed market countries, including the UK, easy fiscal policy and relatively tight monetary policy has resulted in the unusual circumstance in which large current account deficits are accompanied by large fiscal deficits. While pro-cyclical spending and tax cuts may have supported positive free cash flows in the face of slowing near-term corporate earnings growth, expanding twin deficits leave economies particu-larly vulnerable to currency depreciation and inflation—or even stagflation—in the future. The corporate sector also has remained free cash flow positive in regions with large current account surpluses like the euro zone and Japan, where monetary policy has been very loose and fiscal policy relatively tight. With growth momentum remaining elusive in these economies, however, they face the ongoing threat of currency apprecia-tion and potentially deflation should the global backdrop become less supportive.
In fact, with developed market economic growth trending around 2% in the post-crisis era and China slowing to a more sustainable pace,3 the world may just need to accept slower trend growth in general—and reprice assets accordingly. There’s a similar argu-ment to be made that inflation, too, is likely to remain low for longer, given ongoing structural developments. This seems to be what the bond market is telling us, at least, given a flat yield curve and readings from various forward-looking indicators.
But as we learned in the late 1960s—another period of large fiscal and current account deficits and low unemployment—it’s easy for the central bank to fall behind the curve, especially if the currency weakens or it experiences an exogenous shock in a key commodity like oil. Such a scenario seems all the more possible in light of the limited traditional policy options that remain viable and the Fed’s intention to let inflation run a little hot as an offset to the many years of sub-target price increases. Further, any signs that the Fed may be losing the thread could shake the markets’ faith in both central banks and the fiat currency they control, which is a key component of the effectiveness of policy actions. We’ve seen this play out in dramatic fashion in recent years in coun-tries with weaker institutions, like Argentina and Turkey.
…And Persistent Macro Risks
While investors no doubt are pleased with the sharp rally in asset prices during 2019, secular forces—including increasingly automated manufacturing processes, aging demo-graphics in key economies and the threat of climate change—remain complicated and will need to be addressed by investors and policymakers over the years. Further, more immediate risks to the economy persist, as evinced through a contracting manufac-turing sector in a number of major economies alongside a slowing services sector. While the combatants in the US/China trade war announced a “phase one” agreement that would cut certain existing tariffs and postpone threatened ones, many deep-seated issues between the world’s two largest economies remain unresolved. And though this pause in trade tensions should ease some of the downside pressure on China, its contribution to global growth has continued to shrink as its pace of economic expansion has slowed to levels not seen since the early 1990s. Global debt, for its part, continues to trend higher.
Geopolitical concerns figured prominently during 2019, and tensions are likely to remain high as the new multipolar world order continues to define itself. Hong Kong—battered by sometimes violent clashes between protesters and the police for much of the second half of the year—was among the poorest-performing developed markets during 2019, with property developers bearing the brunt. Latin America also remained unsteady, as weak economies and stark inequality have fueled populist movements and social unrest across the region. Another 2019 underperformer was the UK, as ongoing uncertainty around Brexit continued to hamper corporate invest-ment, though a landslide victory by the Conservative party in December’s general election powered a relief rally into year-end as the country’s immediate future came into better focus.
In some ways the 2016 Brexit referendum was the canary in the coalmine for the anti-establishment feelings burgeoning worldwide. Since UK voters decided by a slim margin to leave the European Union more than three years ago, we’ve seen the rise of a variety of populist and sometimes autocratic movements, across the ideological spectrum and the globe. The recent victory by the Tories under the leadership of Prime Minister Boris Johnson—in what was seen by many as an de facto second referendum on Brexit after three-plus years of negotiations following the first failed to produce an agreement acceptable to both Brussels and UK parliamentarians—is expected to result in the country’s withdrawal from the EU on January 31, ushering in a new stage of negotiations on the future state of play in the region. And it could again serve as a bellwether of political events to come, with particular resonance in the US, where the impeachment of President Trump will continue to play out over the early part of 2020 before increasingly polarized voters head to the polls in November.
Meanwhile, the policy measures we’ve seen in recent years may be pushing the economy into unknown territory. “Unknown” is the key word here; the economy is a complex system, and our ability to foretell its future is limited. One observation we are comfortable with, however, is that there is no free lunch in economics; we expect there ultimately will be second-order costs to the policies that fueled markets in 2019. With credit spreads tight, risk perception low, stock multiples high and yield curves flat, we see few obvious places where risk is being appropriately priced into markets. Continued softness in economic growth and corporate earnings could weigh on markets that appear priced for perfection after 2019’s rally. On the other hand, robust labor conditions in many economies suggest an acceleration in economic activity could inspire inflation levels higher than those currently anticipated by the markets—as well as wage pressures and margin erosion—and quickly create an envi-ronment less comfortable for financial assets.
To us, all of this says that now is not a time for investors to throw caution to the wind, despite impressive 2019 market gains. It also underscores a key precept of First Eagle’s investment philosophy: to seek resilience in portfolios from the bottom up.
Avoiding Top-Down Narratives from the Bottom Up
We believe that investors in general spend too much time trying to divine the macroeconomic trends that will drive near-term market returns, and the growth of index funds and ETFs in recent years has made it easier for investors to express their thematic expectations. In our view, however, passive investment approaches detach investors from the fundamental value of the companies to which they’ve entrusted their money, while also distorting the capital allocation function of markets. We’d hazard to guess that a close analysis of the individual stocks that comprise many of these passive vehicles would give their investors pause.
Of course, even the most ardent value investor would have no compunction about owning a company that appears well positioned to benefit from structural changes in the economy—assuming such a company has solid fundamentals and can be had at an attractive price. The problem lies in overpaying for the “next big thing” that invariably fails to meet expectations.
Flashes of thematic growth often fall victim to their own success, however, as investor enthusiasm for certain segments of the economy or certain regions of the world attracts significant capital, which may result in excess capacity, pressure on corpo-rate profits and margins, and, eventually, disappointment for investors. In the late 1980s, for example, Japanese assets skyrocketed as many believed that the country’s economy was poised to take over the world; these investors were deeply disappointed as a market crash plunged the nation into a deflationary lost generation from which it has yet to fully recover. Similarly, the dot-com era of the late 1990s, advances in financial engineering in 2007 and the post-crisis rise of BRICS in the mid-2010s all held great thematic allure for investors.
Like most value- oriented investors, First Eagle seeks to avoid the hazards of such top-down narratives in favor of a bottom-up approach predicated on identifying quality companies that can be bought with what we believe to be a “margin of safety”4 in price. Some observers associate value investing strictly with old-economy stocks.
This may have been accurate within the industry at one time, but it is not true at First Eagle today. We seek resilience in our portfolios by identifying individual companies, representing both old-economy industries and new, that we believe have the poten-tial for persistent earnings power over time by virtue of possessing a scarce asset—a tangible or intangible factor that we believe provides them with an operational advan-tage and is highly difficult to replicate, such as a well-located physical resource or an advantaged market position. Further, we aim for balance in our portfolio construc-tion, combining a curated selection of equities with holdings in gold as a potential hedge and in cash and cash equivalents in an effort to capitalize on what appears to be attractive investment opportunities when they become available. Historically, this approach has positioned us to protect against the permanent impairment of capital across various business cycles and market regimes.
Fade risk is real for all companies, though 2019 market dynamics suggest that it can seem more tangible in those businesses tarnished with the “old-economy” epithet. We’d go so far as to say that there are many subsegments of the old economy where the market has not been punitive enough—say large non-US banks, or marginal players in commodity markets, or retailers and media companies unresponsive to the seismic changes underway in their industries. However, there also are old-economy companies with what we view as scarce assets that should afford them some measure of persistency even if the economy’s emphasis, in aggregate, is shifting. While the next big thing will always have a certain allure to investors, the tried and true should not be forgotten.
We want to close by thanking you for your continuing support. We look forward to serving as prudent stewards of your capital in the years ahead.
Sincerely,
Matthew McLennan T. Kimball Brooker, Jr.
Head of the Global Value Team Deputy Head of the Global Value Team
Portfolio Manager Portfolio Manager
Global, Overseas, U.S. Value Global, Overseas, U.S. Value and
and Gold Strategies Global Income Builder Strategies
1. Alan Greenspan, “Technology and Trade,” (remarks before the Dallas Ambassadors Forum, Dallas, Texas, April 16, 1999).
2. Lucian Bebchuk and Scott Hirst, “The Specter of the Giant Three,” Boston University Law Review 99, no. 3 (2019): 721–741.
3. Source: International Monetary Fund.
4. The Global Value team defines “margin of safety” as the difference between a company’s purchase price and our estimate of its intrinsic value.
The opinions expressed are not necessarily those of the firm and are subject to change based on market and other conditions. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or invest-ment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any security.
