Market Overview
Global equity markets ended a robust 2019 on a high note, with a strong fourth quarter rally adding to already impressive year-to-date gains. Performance over the last several months of the year was driven mainly by sectors of the market, such as tech-nology and health care, thought to have good long-term growth prospects. Investors—optimistic about increasingly accommo-dative central banks and signs of progress in the Sino-American trade war—rotated out of the more defensive positions that outperformed earlier in 2019 and into those likely to benefit most from ongoing economic expansion.
Notably, the equity market rally over the quarter and the year was unsupported by earnings growth. Profits for companies in the S&P 500 and MSCI EAFE indexes are expected to be flat to down when full-year 2019 numbers are released,1 meaning that returns during the year were driven entirely by multiple expan-sion. In hindsight it appears the market anticipated this looming earnings downturn back in fourth quarter 2018, when we saw a pronounced flight to quality as global equity indexes moved sharply lower while market volatility became more pronounced. Investors soon were coaxed back into risk assets by the surprise policy U-turn toward easing communicated by the Federal Reserve in January. This eventually was manifest in a series of fed funds rate hikes and the reintroduction of bond buying and was bolstered by a renewal of accommodative policies by other global central banks—all of which set the 2019 rally off and running.
In response to easier monetary policy and declining corporate profits, bond yields moved down around the world in 2019; the 10-year US Treasury, for example, finished the year roughly 75 basis points lower than where it began.2 Risk perception, implied volatility and credit spreads also declined during the year. This calm can be partially explained by easier monetary policy, as investors tend to feel more comfortable when financial conditions are loosening, but there likely were some more subtle causes as well. One is the ongoing mix shift in the economy from manufacturing to services. While the Institute for Supply Management’s manufacturing PMI declined steadily over the year and has been in contraction since August, the service sector—which accounts for about 80% of US GDP 3—has remained in expansion, albeit with somewhat volatile month-to-month readings. This pattern is also evident in other parts of the world.
The lower sovereign yields could also suggest that the bond market is anticipating a more sluggish global economy in the years ahead. Slower nominal economic growth could result from any number of headwinds currently facing the economy— lower workforce growth, lower productivity growth, higher debt levels, fiscal constraints, zombie banks, geopolitical risks, etc. Should such a scenario emerge, we may start to see some form of “locality risk” in which the global economy bifurcates into pockets of deflation and stagflation thanks to the fraught dynamic that has resulted from the interaction of monetary and fiscal policy in recent years.
For example, in the US and certain other developed market countries easy fiscal policy and relatively tight monetary policy have resulted in the unusual circumstance of large fiscal deficits accompanied by large trade 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, the expansion of these twin deficits leaves such economies particu-larly vulnerable to currency depreciation and inflation—or even stagflation—in the future. The corporate sector also has generally remained free -cash-flow positive in regions with large trade surpluses like the euro zone and Japan, where monetary policy has been very loose and fiscal policy relatively tight. With growth momentum remaining elusive, however, these economies face the ongoing threat of currency appreciation and, potentially, deflation should the global backdrop become less supportive.
We don’t seek to predict the future, but we are comfortable stating that there is no free lunch in economics; we believe 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 close to flat, we see few obvious places where risk is being appropriately priced. While it feels good to come off a year with 20%-plus equity market returns based on the MSCI EAFE Index,4 such a sharp rally in the absence of increased profits suggests to us that investors may want to temper their return expectations going forward.
We believe the prevailing environment is one of low returns with negative skew—a far less attractive investment world than we have occupied in the last decade. As fiduciaries, we will have to work very hard to identify what we believe to be companies with the resilience to thrive in this more challenging environ-ment as we also labor assiduously in an effort to avoid perma-nent impairment of capital.
Portfolio Review
Global Fund
Global Fund A Shares (without sales charge)* delivered a posi-tive return in the fourth quarter of 4.59%. All regions contrib-uted, with North America and developed Europe adding the most and developed Asia ex-Japan and emerging markets under-performing. On a sector basis, financials, materials, communi-cation services, consumer discretionary and health care led the way, while utilities, real estate and IT were relative laggards. The Global Fund underperformed the MSCI World Index in the period.
Leading contributors to the Fund’s performance in the fourth quarter included Schlumberger, British American Tobacco, gold bullion, Lloyds Banking Group, and KDDI corporation.
After struggling for much of 2019 given falling oil prices and idiosyncratic company issues, oil field services company Schlumberger (SLB, Financial) finished the year with a flourish. While Schlumberger, like British American Tobacco, had been a target for tax-loss harvesting, these selling pressures appeared to ease in the latter months of the year. Moreover, there was an uptick in oil prices toward year-end, as well as a pronounced effort by Schlumberg-er’s new CEO to better position the business to succeed across various oil-price environments.
Although British American Tobacco’s (BTI, Financial) earnings were growing, its shares were priced for rapid fade heading into the fourth quarter, in part because of tax-loss selling. During the quarter, the company benefited from news that the US Food and Drug Administration was planning to regulate e-cigarettes, which it did at the start of the new year. Regulation provides the company with some additional clarity about its operating environment moving forward. We consider British American Tobacco a well-run company, and we think that it should be able to better navigate the complexities new regulation represents.
Historically, the price of gold bullion has inversely tracked real interest rates with considerable regularity, and the transition to a lower interest rate environment in 2019 was constructive for bullion throughout the year. In addition, the supply/demand balance has become more favorable for gold: The supply outlook is very constrained, while wider recognition of gold’s potential as a hedge has resulted in stronger demand for the precious metal.
Shares of Lloyds Banking Group (LYG, Financial), a large British financial insti-tution, advanced after the UK’s general election in December reduced uncertainty about Brexit. In our view, the company’s business is relatively stable and did not change much during the fourth quarter, but the evolution toward a possible resolution on Brexit reduced the discount on this stock.
Shares of KDDI (TSE:9433, Financial), a Japanese telecom, had declined in recent years following the introduction of a fourth competitor in Japan’s mobile-phone market. However, the new entrant, Rakuten, has been slower than anticipated in building out its network. Moreover, KDDI reached an agreement to partner with Rakuten in roaming, so it stands to benefit from Rakuten’s potential growth. In addition, declining sovereign rates made KDDI’s shares more attractive as a bond proxy, a purpose for which some investors use KDDI given its relatively steady cash flow and the yen’s standing as a defensive currency. The rollout of 5G network infrastructure in Japan represents a risk, as it could challenge the pricing power of KDDI and other Japanese telecoms.
The leading detractors in the fourth quarter were Oracle Corpo-ration, Colgate Palmolive Company, Danone SA, Teradata Corporation and Sompo Holdings, Inc.
Oracle’s (ORCL, Financial) stock was down modestly in the fourth quarter following a decent run earlier in the year. The company has made significant progress in transitioning from upfront sales to a multi-year subscription model and to Cloud software. Its customers tend to be very large organizations that take time to adopt these changes. Oracle has leading market share in several key areas: cloud-based enterprise resource planning, high-end relational databases, and autonomous databases using artificial intelligence. We believe that Oracle will be able to compete effectively and complete a successful transition.
Colgate-Palmolive (CL, Financial) is a stable business that has been generating free-cash-flow yield of approximately 5% and distributing it to shareholders; it has grown organically at about 4% a year.5 One possible negative last year was the acquisition of a specialty skin cream company for which Colgate paid a relatively full multiple. However, Colgate was once again aligning with a science-based product that has strong advocacy from medical professionals (dermatologists in the case of the skin care acquisition), as it had done previously with dentists in its toothpaste business and veterinarians in its pet-food products. Another possible negative is that Colgate—with its large market share in India, Brazil and Mexico—is exposed to some weak currencies. In past periods, however, the company has often been able to recapture through pricing some of what it has lost on foreign exchange.
Danone (XPAR:BN, Financial) is a French food-products company with three key business lines: essential dairy and plant-based products (such as yogurt and soy milk), specialized nutrition (including infant formula and protein drinks) and waters. The stock rallied for much of the year, but investors trimmed positions in the fourth quarter following lowered guidance for full-year 2019 sales.
Teradata (TDC), a US-based enterprise data warehouse and analytics company, is transitioning its business from upfront license sales to a subscription-based model. As we have learned from other investments in software companies, revenue trends are generally sluggish in the first years of this transition but can improve as the annuity-like subscription revenues ultimately mount. Last year was challenging for Teradata’s cash flow as clients transi-tioned (and revenues dropped) faster than expected. We believe that Teradata will be able to complete the transition to the subscription model and generate potentially better free cash flow in the future.
Sompo (TSE:8630, Financial) is a major property-casualty insurer in Japan. The end-2019 typhoon season caused widespread damage, which darkened investors’ view of property-casualty insurers, but we are impressed by the company’s efforts to enhance profitability. In our view, Sompo has exhibited strong capital management over time, showing good discipline in the prices it has paid for international acquisitions, providing a healthy dividend and buying back stock.
Overseas Fund
Overseas Fund A Shares (without sales charge)* delivered a positive return in the fourth quarter of 3.84%. All regions contributed, with developed Europe, Japan and North America adding the most. On a sector basis, communication services, consumer discretionary, industrials and information technology led the way, while energy and real estate detracted slightly. The Overseas Fund underperformed the MSCI EAFE Index in the period.
Leading contributors to the Fund’s performance in the third quarter included British American Tobacco, Lloyds Banking Group, KDDI Corporation, gold bullion, and Taiwan Semicon-ductor Manufacturing Company.
The leading detractors in the second quarter were KT&G Corporation, Compania Cervecerias Unidas SA Sponsored ADR, Sompo Holdings, Danone SA and TechnipFMC.
U.S. Value Fund
U.S. Value Fund A Shares (without sales charge)* delivered a positive return in the fourth quarter of 4.09%. On a sector basis, financials, energy, materials, industrials and health care led the way, while information technology and utilities detracted slightly. The U.S. Value Fund underperformed the S&P 500 Index in the period.
The top contributors were Schlumberger NV, gold bullion, Weyerhaeuser Company, Tiffany & Co., and Anthem, Inc.
Detractors included Teradata, Colgate-Palmolive Company, Oracle Corporation, TechnipFMC Plc, and C.H. Robinson Worldwide, Inc.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
- Source: Factset.
- Source: US Department of Treasury.
- Source: US Bureau of Economic Analysis
Source: Bloomberg.
*Performance for Class A shares without the effect of sales charges and assumes all distributions have been reinvested, and if a sales charge was included values would be lower.
5. Source: Company reports.
*Performance for Class A shares without the effect of sales charges and assumes all distributions have been reinvested, and if a sales charge was included values would be lower.
*Performance for Class A shares without the effect of sales charges and assumes all distributions have been reinvested, and if a sales charge was included values would be lower.
The performance data quoted herein represent past performance and do not guarantee future results. Market volatility can dramatically impact a Fund’s short-term performance. Current performance may be lower or higher than figures shown. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance data through the most recent month-end are available at www.feim.com or by calling 800.334.2143. The average annual returns for Class A Shares “with sales
charge” of First Eagle Global, Overseas and U.S. Value Funds give effect to the deduction of the maximum sales charge of 5.00%.
- The annual expense ratio is based on expenses incurred by the Fund, as stated in the most recent prospectus.
- These are the actual Fund operating expenses prior to the application of fee waivers and/or expense reimbursements.
The Adviser has contractually agreed to waive its management fee at an annual rate in the amount of 0.05% of the average daily value of the Fund’s net assets for the period through February 29, 2020. This waiver has the effect of reducing the management fee shown in the table for the term of the waiver from 0.75% to 0.70%.
The commentary represents the opinion of the Global Value Team portfolio managers as of December 31, 2019, and is subject to change based on market and other conditions. The opinions expressed are not necessarily those of the entire firm. 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 investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. 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 fund or security.
