First Eagle Global Income Builder Fund's 2nd-Quarter Commentary

Discussion of markets and holdings

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Jul 31, 2020
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Market Overview

The old adage “don’t fight the Fed” has surely been proven right over many short periods of time—second quarter 2020 among them. The powerful rebound in both stocks and bonds that began in late March extended through the second quarter, even as the Covid-19 pandemic continued to ravage the globe. Driven by a massive influx of liquidity from the Fed and other global policymakers, investors piled into growth-related equities, including shares of new-economy companies that appeared to be speculative plays on uncertain future potential, as well as passive corporate bond ETFs that provide indiscriminate exposure to debt issuers.

We think the key issue investors need to consider is where we stand in the fight against Covid-19. Though financial markets are acting as if the pandemic’s impact has reached an inflection point, epidemiological data would suggest otherwise. Confirmed cases have exceeded 12 million worldwide and deaths more than 500,000, and these numbers continue to grow.1 Emerging and low-income countries now appear to be the epicenter of the disease, though developed countries—the United States chief among them—are by no means out of the woods. Cases are accelerating in Arizona, California, Florida, Georgia, Texas and elsewhere, and a number of states are slowing or reversing plans to reopen their economies. While we can’t know the future trajectory of the virus, we believe there is a long road ahead to herd immunity or a vaccine—possibly in the 2022 time frame.

In June, the National Bureau of Economic Research made offi-cial what most observers had intuited: The US economy entered recession in February, as the Covid-19 outbreak began to inten-sify on these shores. From a global perspective, pandemic-related shocks to supply and demand are expected to result in a reces-sion of historic proportions. The World Bank is forecasting that more than 90% of the world’s economies will be in recession in 2020, which would represent the most broad-based contraction of the past 150 years. The World Bank also expects the current recession to be the deepest in per-capita terms since the Great Depression.

The performance of financial markets in the second quarter seemed to reflect expectations of a V-shaped economic recovery: i.e., a sharp decline followed by an equally sharp rebound. Though there have been some promising signs in recent data as economies worldwide have begun to reopen, we do not share the markets’ confidence. The emergence of Covid-19 has produced the greatest blow to demand in a generation, and permanent economic scarring seems likely. Even if the public health elements of the crisis are contained, the headwinds are significant. After peaking at 14.7% in April, the US unemploy-ment rate fell to 11.1% in June, still well above the high of 10% in the global financial crisis.2 Though the credit cycle has only just turned over, we have already seen bankruptcies by such well-known brands as Hertz, Neiman Marcus and Brooks Brothers. With restaurants, airlines and lodging companies operating at partial capacity for an undetermined length of time, we don’t know how large the hit to output ultimately will be. The recovery may wane as fiscal stimulus moderates and the marginal benefit of additional monetary stimulus declines. These are the types of factors that can turn a V into something less clearly legible.

Perhaps learning a lesson from their hesitant reaction to the global financial crisis in the late 2000s, central banks worldwide have responded rapidly and forcefully to the dislocations of 2020. Policy rates were slashed, massive levels of quantitative easing were pushed out, and programs to ensure market liquidity were introduced. With policy rates at the lower boundary in most advanced economies, central banks have been notably aggressive with their asset purchases, and the combined balance sheets of the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England now amount to approximately $20 trillion, up about $5 trillion since the beginning of the year.3 The expansion has come primarily from increased purchases of government securities, as well as from special lending programs and purchases of risk assets. This has not been a mere easing of policy; it’s been a step function. M2 money supply in the United States, for example, expanded 23% over the 12 months ended May 2020, driven by a 16% increase from February to May.4 Already-planned quantitative easing suggests that double-digit money supply growth is likely to persist into 2021 or later.

The Fed’s plan for the fixed income markets includes multi-billion-dollar backstops for the primary and secondary bond markets, a program of secondary market purchases of invest-ment-grade and fallen-angel debt, and a Main Street Lending Program to support small and medium-sized businesses. In our view, the underlying reason for the Fed’s intervention in the fixed-income markets was recognition that the structure of the US bond market had been “broken” by regulatory measures introduced after the global financial crisis. Banks and brokerages had traditionally served as market makers, providing a counter-cyclical bid when fixed income investors wanted to sell and prices were gapping lower. However, regulatory measures introduced to prevent a recurrence of the global financial crisis inadvertently put an end to this practice. From a risk-capital point of view, the new regulations made it much more costly for banks to hold bonds on their balance sheets, so they largely withdrew from playing this market-stabilizing role. As the Covid-19 pandemic unfolded, investors sold risk assets at an accelerating pace, and in the absence of market support from banks and brokerages, price action turned violent. The Fed recognized that it alone could restore order to the fixed income markets.

The Fed met its objective quickly—and, as it turned out, rela-tively inexpensively. In a typical selloff there are not just months but entire quarters when spreads widen, liquidity is scant and investors have opportunities to profit from countercyclical bids. In this case, the window was open for perhaps two or three weeks before the market recovered sharply, to the detriment of the prudent investor. Apparently convinced that the Fed would do what it takes to keep the market functioning properly, many investors sought corporate bond exposure indiscriminately, piling into passive ETFs and driving spreads back closer to pre-pandemic levels.

The Fed’s bond-buying programs also encouraged issuers to tap into the debt markets. Primary issuance of both investment grade and high yield corporate debt hit record levels in the second quarter

The “Fed put” has become increasingly massive each time it has been employed. In response to Covid-19 the Fed has rolled out all the facilities it implemented in response to the global financial crisis, as well as new programs to support the corporate bond market, the municipal market, small and medium-sized enter-prises and, most recently, nonprofits. Government and corporate debt levels are going to be much higher after this crisis, making the Fed’s dual mandates of stable prices and full employment vulnerable to any dysfunction in the bond markets. We think this increases the likelihood that the Fed will serve as a buyer in size to maintain functioning markets, if necessary.

Nevertheless, while more fiscal support appears likely in the near term, governments cannot carry the private sector indefinitely. Already-high sovereign debt levels have continued to climb as these programs are implemented, expanding deficits in the face of falling nominal GDP. Economic recovery eventually will help narrow these deficits somewhat, as revenues rebound and auto - matic stabilizers decline. However, the debt incurred to rescue economies will persist.

Finding Value in Today’s Markets

While current policy has proved to be an analgesic for econo-mies and markets suffering from the impact of Covid-19, it is hard to believe that the imbalances built up over a 10 -year-plus expansion could be corrected within a single quarter. It seems more likely that only time can heal these wounds. The price of the S&P 500 troughed in March at around 15 times trailing peak earnings—well above its usual level in a recession—and at quarter’s end the index was trading at nearly 22 times trailing peak earnings.5

The current equity market rally has been notable for its lack of breadth; the proportion of stocks in the MSCI World Index outperforming the index as a whole stood at 37% at the end of the second quarter, a low not seen since before the bursting of the dot-com bubble.6 Perhaps not coincidentally, a new breed of technology stocks is leading the charge this time around, both well-established (the so-called FANG stocks) and less so. In the latter category, we would include Square (which traded at about 175 times trailing 12-month earnings at quarter’s end), Zoom (which traded at about 1,500 times trailing 12 -month earnings) and Shopify (which had no trailing 12-month earnings).7 IPOs were also hot in industries as diverse as biotech and insurance, as well as in special purpose acquisition companies (SPACs).

Clearly, there have been outsized returns to be gained in these market darlings, assuming an investor knows when to buy and to sell ahead of the thousands of competitors trying to do the same. Moreover, as the prices of these stocks continue to climb faster than any improvement in fundamentals, arithmetic suggests that their expected future returns will be lower unless they can capture market share at an extraordinary rate or further expand their already-high multiples. This is not a game in which we’re interested in testing our luck.

Although the corporate credit markets recouped much of the steep loss suffered in the first quarter of the year, we continue to believe that we’re in the early stages of the end of the credit cycle. The corollary is that we believe the second quarter of 2020 represented a false dawn. Leverage remains elevated, especially for this point in the credit cycle. Typically, we see leverage like this toward the end of a recession not at the beginning. The default rate for high yield bonds continues to climb, and both Moody’s and S&P expect it to reach the double digits as we exit 2020. The upgrade-to-downgrade ratio continues to stay low. There has been a record amount of fallen angel activity—$185 billion—which is more than we saw in 2008 and 2009, and the year is only half over.

While the Fed has certainly given the markets confidence, it cannot be everything to everybody. We believe there will be days in the coming quarters when prices will gap lower and the Fed will be judicious in the amount of firepower it uses to support the markets. Under these conditions we think opportunities will come from a market that is still dysfunctional from a liquidity perspective. Credit metrics have deteriorated, cash flow has been declining and bankruptcies are going up—all signs of mounting stress. We think spreads will widen as investors respond to greater credit risk. We also think there will be opportunities in longer-duration fallen-angel paper.

As we have always tried to do in the bond markets, we intend to take only those risks for which we are properly compensated. Because we still believe there is liquidity risk, we plan to empha-size larger and shorter-term issues. Because we don’t think we are being adequately compensated to take credit risk, we want to stay up in quality. We are also looking to stay in companies with balance sheets resilient enough to meet whatever cash flow short-falls they may encounter; they may have capacity under their committed credit facilities and/or assets they could potentially monetize to raise liquidity if needed.

In short, we believe now is a time for patience and fortitude across financial markets. In the equity markets, rather than staking everything on change agents that might shape the future, we prefer to humbly accept that the future is unknowable and seek to own businesses with scarce, durable assets that we believe have the potential to generate persistent earnings power over time—and acquire these businesses at prices consistent with our strict valuation discipline. We further seek companies supported by prudent management teams and robust capital structures, and we believe such companies generally will be more poised to deliver shareholder value over the long term—with less speed, perhaps, than growth stocks, but also, in our view, with greater likelihood.

Portfolio Review

Global Income Builder Fund A Shares (without sales charge*) posted a return of 10.33% in second quarter 2020, underper-forming the composite index in the period. As of June 30, 2020, the Fund’s allocation to equities was 57.26% (39.19% interna-tional stocks and 18.07% US stocks). The Fund’s 27.81% bond allocation included 16.52% in investment grade issues.

The leading equity contributors to performance in the second quarter were gold bullion, Exxon Mobil Corporation and Fanuc Corporation. The top three fixed income contributors were BI-LO, LLC term loan, due 5/31/24; Citgo Petroleum Corp. 6.25%, due 8/15/22; and IHO Verwaltungs GmbH 4.75%, due 9/15/26.

Gold’s recovery from its brief mid-March swoon continued in the second quarter, sending the price of the metal to a new seven-year high in nominal US dollar terms; meanwhile, nominal gold prices established all-time highs in all the other currencies we track. With the extraordinary policy accommodation introduced to combat the impacts of Covid-19 unlikely to be unwound anytime soon, we expect the quality of man-made money to continue to deteriorate. If so, it would highlight gold’s historical role as a long-duration potential hedge against the myriad risks facing investment portfolios.

With oil prices stabilizing somewhat after a disastrous first quarter, players in the oil patch like Exxon Mobil (XOM, Financial) were able to claw back some early-year losses. While Covid-19’s impacts on demand likely will continue to challenge the energy industry in the quarters ahead, we believe that a best-in-class name like Exxon, given its significant, long-duration reserves and attractive position on the oil-cost curve, is better equipped than most to withstand lower prices.

Signs of economic recovery during the second quarter, particu-larly in China, helped drive the shares of Fanuc (TSE:6954, Financial), which had struggled alongside its industrial client base during the first quarter as factories worldwide began to shut down in response to Covid-19. Post-crisis changes to supply chains may favor companies like Fanuc, a global leader in computerized numerical control devices and robots, as manufacturers seek to automate their local capabilities. In the meantime, substantial net cash on its balance sheet and limited leverage appear likely to enable Fanuc to weather additional economic uncertainty.

BI-LO, which owns and operates supermarkets in the south-eastern portion of the US, has, in our view, performed well since emerging from bankruptcy as Southeastern Grocers—shrinking its store base, increasing its EBITDA margins and hitting its earnings guidance. Southeastern recently announced that it would no longer operate stores under the BI-LO banner and had agreed to sell 62 of its stores (including 46 BI-LO and 16 Harvey’s Supermarkets) to Food Lion; the company is exploring strategic options for its remaining BI-LO outlets. Given expec-tations for continued improvements in the company’s credit metrics, Moody’s upgraded the rating on this bond a notch.

Citgo bounced back from a tough first quarter, along with much of the energy complex. Also supporting the bonds in the second quarter was the announcement of plans to issue $750 million in new senior secured notes this summer, the proceeds of which will be used to repay an outstanding term loan and serve other general corporate purposes. While Citgo is owned by PDVSA, Venezuela’s national oil company, these bonds are backed by assets in the United States, and US sanctions prohibit Citgo from paying any dividends to PDVSA.

IHO Verwaltungs, a German holding company, controls auto parts manufacturer Schaeffler. The auto sector in general was hurt by the Covid-19 outbreak in the first quarter, but IHO Verwaltungs’ bonds, which are reasonably high in quality and possess good liquidity, rebounded in a second quarter marked by investor preference for higher-quality issues.

Equities that detracted most from second quarter performance included Jardine Matheson Holdings Limited, Wells Fargo & Company and Hiscox Ltd. Fixed income detractors included Iron Mountain Incorporated 5.25%, due 7/15/30; American Axle Manufacturing, Inc. 6.625%, due 10/15/22; and Meredith Corporation 6.875%, due 2/1/26.

Hong Kong-headquartered holding company Jardine Matheson (LSE:JAR, Financial) controls a diversified collection of business franchises predomi-nantly across Greater China and Southeast Asia. Significant headwinds in certain parts of Jardine’s empire continued to hurt the company in the second quarter despite the global equity market rebound. The company is heavily exposed to Hong Kong real estate, which has been under pressure from China’s ongoing efforts to exert greater control over the territory and the anti-government protests that have come in response. Further, demand impacts from the Covid-19 pandemic continue to hobble its Indonesia-based Astra business as well as its Mandarin Oriental hotel chain. We view the company as having a solid balance sheet and attractive franchises, and we continue to believe the stock offers attractive value.

Wells Fargo (WFC, Financial) and many other US banks struggled in the second quarter, weighed down by a combination of very low interest rates and an uncertain loan-loss environment as the economic disruption from Covid-19 continued to play out. Wells was particularly battered given widespread expectations that it would be forced to cut its dividend as a result of the Federal Reserve’s recently instituted cap on dividend payouts. While the path forward for Wells and other banks remains unclear, we are comfortable with the capital held by Wells Fargo and its likely ability to withstand very adverse scenarios.

Hiscox (LSE:HSX, Financial), an international commercial insurer domiciled in Bermuda and listed on the London Stock Exchange, has found itself in the midst of a battle that also involves many other insurers worldwide. The issue is whether insurance companies that have written business-interruption coverage are required to pay claims for disruptions emanating from the Covid-19 outbreak. Litigation costs are mounting as these disputes make their way through the courts, and an adverse decision could have a negative financial impact on insurers like Hiscox. Regardless, we believe the reserves Hiscox has set aside against these claims appear to be sufficient.

Iron Mountain (IRM, Financial) is a leader in the North America storage and information management market. With a large base of recurring storage rental revenues, Iron Mountain is a fairly stable busi-ness, in our view. Though the company’s bond traded slightly lower on the quarter, it had only a minor impact on portfolio performance.

Detroit-based American Axle & Manufacturing (AXL, Financial) builds auto-mobile driveline and drivetrain components and systems. The company recently announced a new debt issue, the proceeds of which it plans to use to redeem the 2022 notes.

Meredith (MDP, Financial), an Iowa-based media conglomerate, issued new senior secured notes during the quarter that subordinated the unsecured notes we own, negatively impacting their value. Separately, Moody’s downgraded Meredith on expectations for ongoing negative impacts from the Covid-19 pandemic on media and entertainment companies.

We appreciate your confidence and thank you for your support.

Sincerely,

First Eagle Investment (Trades, Portfolio) Management, LLC

  1. Source: Johns Hopkins University.
  2. Source: Bloomberg.
  3. Source: Federal Reserve, European Central Bank, Bank of Japan, Bank of England.
  4. Source: Federal Reserve.

  5. Source: FactSet

  6. Source: FactSet.

  7. Source: FactSet.

The performance data quoted herein represent past performance and do not guarantee future results. Market volatility can dramatically im-pact the 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 Income Builder Fund give effect to the deduction of the maximum sales charge of 5.00%.