Market Overview
Equity market dynamics in third quarter 2021 suggested to us that investor confidence may have begun to wane even as widespread vaccine distribution prompted many jurisdictions to adapt their approach to managing the risk of Covid-19. While the MSCI World Index was flattish for the three-month period, September’s 4.2% decline—the first down month for the index since January—highlighted the challenges ahead for investors.1
After the stimulus-fueled rebound from the 2020 depths of the Covid-19 dislocations, the capital markets appear to have entered a more complicated phase, in our view, as a result of a variety of historical aberrations and growing imbalances. This is well illustrated by the coexistence of negative real interest rates and very low levels of risk premia like credit spreads. Under normal conditions, low or negative real interest rates are the result of some sort of macro distress, and credit spreads widen to reflect the perceived greater risk of default in such uncertain environ-ments. This was clearly evident upon the outbreak of Covid-19 in early 2020, as the nominal yield on the 10-year US Treasury hit modern-era lows, real rates turned negative for the first time since 2013, and credit spreads spiked to levels not seen since the global financial crisis.2
Today, while nominal Treasury yields have since about doubled off their 2020 trough, they remain far closer to the record low than the historical average,3 repressed by unabated central bank stimulus; combined with markedly higher inflation readings, this has kept real rates well into negative territory. Credit spreads have retightened, approaching the levels first seen when the central bank stepped into the primary and secondary bond markets last year.
Equity markets, meanwhile, appear priced with little room for error. Not only is the S&P 500 Index, in particular, trading at a high multiple of trailing earnings, these earnings are the product of a generational peak in profit margins.4 Mounting cost pressures—whether it’s from commodity prices or logistical bottlenecks or supply chain breakdowns or labor availability problems—suggest that these very high margins may be at risk even as economic growth persists.
Despite low interest rates and low risk premia, we have a hard time accepting that investment risk is low at this point. We’ve exited this recession with a much higher stock of debt to GDP than we entered with or than before the global financial crisis, and legislation winding its way through Congress would further add to that. Fiscal deficits have pulled back from 2020 but remain very high—the Congressional Budget Office forecasts a federal budget deficit of more than 13% in 20215—and the Federal Reserve has kept the stimulus flowing even as employ-ment conditions have improved markedly and recent inflation reports have come in at multi-decade highs. While Federal Reserve chair Powell and other board members have been consis-tent in their contention that the current pricing pressures are transitory, even the world’s most powerful policymakers cannot lay claim to a crystal ball. The Fed, in fact, has grown more hawkish in recent meetings, and there are suggestions it may begin to taper its monthly bond purchases before the end of 2021 and potentially hike the federal funds rate as early as next year. While the impact this would have on global markets remains to be seen, our experience over the past decade-plus suggests caution is warranted.
Geopolitical risks, meanwhile, are pronounced and can be traced most prominently to China. Chinese equities finished the third quarter down about 30% from their February peak,6 a decline prompted in part by concerns about increased regulation across both economic sectors and the day-to-day lives of the Chinese people. President Xi Jinping has publicly re-embraced the concept of “common prosperity” first put forth by Mao Zedong in the 1950s; he has reasserted the Chinese Communist Party’s primacy over, in particular, large companies and the oligarchs who lead them in an effort to narrow the country’s tremendous wealth gap. While such measures may improve China’s socioeco-nomic balance, a sweeping realignment of the power between the government and business risks upsetting a private sector that has been key to economic and job growth, with unknown potential impacts on the country’s—and the world’s—economic growth.
With a property market that accounts for 29% of China’s economic activity according to one study, Xi’s resolve may be tested by a potential turn in the country’s real estate cycle.7 We have long talked about the risk in China of malinvestment in real estate, and recent government efforts to curtail credit growth in the space—estimated at more than $5 trillion8—have resulted in liquidity issues among some of the country’s most heavily lever-aged developers. This includes Evergrande Group, China’s largest issuer of junk bonds, which in recent weeks has missed interest payments on two dollar-denominated issues and seen the pricing on its debt fall to distressed levels.9 A wave of defaults in this sector could have global implications.
We don’t know if these changes are fundamental or if China will reverse course and soften its regulatory rhetoric in order to forestall economic disruption, as it has sometimes done in the past. But China has now entered a risk category that we would describe as non-linear.
Prudence Is Paramount
Given the risks we have discussed, we believe this is clearly a time for prudent investing. At First Eagle, our commitment to prudent investing resides in part in our allocation to gold and gold-related equities as a potential hedge for our portfolios against disruptive events. Gold in many ways serves as an indi-cator of risk perception; the limited risk premia evident in equity and fixed income markets can also be seen in the weakness in the gold price this year. Despite the headwinds that gold has faced, we remain confident in its value as a potential hedge. In fact, we believe gold currently appears to be a value version of itself given its price relative to other investment options such as real interest rates, bitcoin and risk assets like growth equities.
From the portfolio’s bottom up, we are trying to selectively identify pockets of long-term opportunity for resilient wealth creation in the face of markets priced for very high expectations. This may include companies that we believe could benefit from a fuller return to pre-Covid norms in areas like travel and hospi-tality, energy, retail, real estate and a number of others. It may also include high-quality names that could benefit from secular changes in their industries, whether it’s cloud computing or lasers or trucking.
Portfolio Review
Global Fund A Shares (without sales charge*) posted a return of -1.93% in third quarter 2021. Japan was the sole contributor from a regional standpoint, while Developed Europe and emerging markets were notably weak. Information technology and financials were the top contributors among economic sectors; consumer staples, industrials and materials were among the largest detractors from performance. The Global Fund underper-formed the MSCI World Index in the period.
Leading contributors in the First Eagle Global Fund this quarter included Oracle Corporation, Shimano Inc., Teradata Corpora-tion, Sompo Holdings, Inc. and HCA Healthcare Inc.
Oracle (ORCL, Financial) continues to make progress reinventing itself for the cloud-computing environment. Impressively, it has affected this turnaround primarily through organic research & development and smaller, well-priced acquisitions rather than expensive, head-line-grabbing mergers. Results in recent quarters have suggested Oracle’s subscription-based model is gaining traction, and we believe the company will be a strong competitor in the huge addressable public cloud market. With a high level of insider ownership and a strong balance sheet, Oracle has been a strong cash flow generator and has historically returned excess cash to shareholders in the form of dividends and share buybacks.
A Japanese manufacturer primarily of bicycle components, Shimano (TSE:7309, Financial) in the third quarter continued to benefit from pandemic-related demand for bicycles across the market, from professional to recreational. While it remains to be seen whether the Covid bump has legs, we’ve been impressed by the company’s recent efforts to adapt to the growing and likely durable popularity of e-bikes.
A longstanding participant in the data warehousing space, Teradata (TDC, Financial) has been transitioning its focus from on-premises database management and analytics to the rapidly growing cloud-computing market. The company has delivered a series of impressive quarterly results, and markets appear to be taking notice of what we see as a sticky, high-margin, high-cash-gener-ating business.
Japanese financial holding company Sompo (TSE:8630, Financial) has been offering insurance policies in the country for more than 130 years. It’s primary business line of domestic property and casualty insur-ance is complemented by a domestic life insurance company and subsidiaries offering insurance products overseas. Amid the backdrop of a solid but low-growth Japanese insurance market, Sompo in recent years has made a number of overseas invest-ments, to mixed results. More recently, however, the company has been forthcoming about its ex-Japan strategy and the renewed discipline it intends to apply in mergers and acquisi-tions; that combined with a relatively strong Japanese stock market in the third quarter helped boost a stock that in our view has appeared quite cheap for some time.
HCA Healthcare (HCA, Financial) owns and operates 185 hospitals and approxi-mately 2,000 sites of care in the US and UK. Admissions to its facilities, depressed during the worst of the Covid-19 outbreak in 2020, have begun to rebound. HCA reported a nearly 20% year-over-year increase in admissions during the second quarter and a 14% increase in revenue, and forecast that volume would continue to improve throughout the year. We maintain our posi-tive opinion of the company’s management team, believing them to be effective stewards of both the balance sheet and HCA’s business operations.
The leading detractors in the quarter were Compagnie Financière Richemont SA, Alibaba Group Holding Ltd. Sponsored ADR, Jardine Matheson Holdings Limited, Ambev SA Sponsored ADR and Newmont Corporation.
Richemont (XSWX:CFR, Financial), which counts Cartier and Van Cleef & Arpels among its maisons, has a very large exposure to the Chinese luxury market, which has been hurt by curbs on international travel. In addition, recent rhetoric from the Chinese Communist Party has suggested a renewed focus on the “common prosperity” of its population and raised concerns among equity investors about the potential impact this could have on the spending habits of wealthy Chinese, many of whom likely recall the personal uncertainty that surrounded the country’s anti-corruption campaign launched in 2018. Though the degree to which China’s redistribution efforts will impact the revenues of luxury retailers like Richemont remains unclear, a broadening of economic growth could increase disposable income within the country’s middle- and upper-middle -class cohorts, aspirational buyers that typically serve as drivers of luxury sales volumes.
The Chinese stock market was down sharply in the third quarter as investors grew increasingly concerned about the country’s slowing economy and Beijing’s newly aggressive regulatory posture. Tech stocks, in particular, have suffered, and e-commerce giant Alibaba (BABA, Financial) was no exception. Though risks may continue to pressure the company’s shares, we believe Alibaba is a strong business with an entrenched market position and attrac-tive valuation.
Hong Kong-headquartered holding company Jardine Matheson Holdings (LSE:JAR, Financial) controls a diversified collection of business franchises predominantly across Greater China and Southeast Asia. The company’s stock price lagged in the third quarter as renewed Covid-related restrictions in markets like Indonesia and Thailand impacted sales volumes there. Further, the debt crisis at Chinese property developer Evergrande may have dented investor enthu-siasm for companies exposed to Asian real estate; in 2020, 38% of Jardine’s earnings were attributable to the property segment. Jardines has taken advantage of price weakness to buy back stock, and given its solid balance sheet and attractive franchises, we continue to believe it offers attractive value.
The global flareup of the Delta variant of Covid-19 has weighed on the stocks tied to socialization and entertainment, including Brazilian brewer Ambev (ABEV, Financial). Further, inflationary pressures—spawned by the commodity rally, drought and a weaker currency—have challenged Brazil’s nascent economic recovery and pushed input costs higher for many companies. Amid this difficult backdrop, Ambev (a subsidiary of Anheuser-Busch InBev) has reaped the benefits of its conservative management and strong balance sheet, aggressively bolstering its already-dominant market share in many South and Central American markets. We believe the company is poised to benefit from favor-able demographics and attractive consumption trends once the Brazilian economy gets back on track.
The largest gold miner in the world, Newmont (NEM, Financial) shares lost ground in what was a volatile and ultimately down quarter for the price of gold. The Colorado -based company has continued to execute well in what has been a challenging environment. The company recently reaffirmed its full-year 2021 production guidance, but indicated that it was likely to come in at the mid to low point of the range provided as a result of disruptions from Covid-19 as well as severe weather events. It also noted that inflation pressures were likely to push its costs higher in 2021. None of this changes our opinion of the stock, which has historically offered steady production anchored in good jurisdictions, a good pipeline of organic projects, a strong balance sheet and proven management.
First Eagle Overseas Fund
Overseas Fund A Shares (without sales charge*) posted a return of -2.93% in third quarter 2021. Japan was the sole contributor from a regional standpoint, while returns in emerging markets and Developed Europe were notably weak. Financials and energy were the top contributors among economic sectors; consumer staples, consumer discretionary and industrials were among the largest detractors from performance. The Overseas Fund under-performed the MSCI EAFE Index in the period.
Leading contributors to the Fund’s performance this quarter included Sompo Holdings, Inc., Shimano Inc., Keyence Corpo-ration, Royal Dutch Shell Plc Class A and Nutrien Ltd.
Detractors included Ambev SA Sponsored ADR, Compagnie Financière Richemont SA, Jardine Matheson Holdings Limited, Alibaba Group Holding Ltd. Sponsored ADR and Haw Par Corporation Limited.
First Eagle U.S. Value Fund
US Value Fund A Shares (without sales charge*) posted a return of -1.02% in third quarter 2021. Information technology and financials were the top contributors among economic sectors; industrials, energy and materials were among the largest detrac-tors from performance. The US Value Fund underperformed the S&P 500 Index in the period.
Leading contributors to the Fund’s performance this quarter included Oracle Corporation, HCA Healthcare Inc., Teradata Corporation, Alphabet Inc. Class A and Salesforce.com, Inc.
Detractors included IPG Photonics Corporation, Colgate-Palmo-live Company, Newmont Corporation, NOV Inc. and Exxon Mobil Corporation.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management
- Source: FactSet; data as of September 30, 2021.
- Source: Federal Reserve Bank of St. Louis; data as of October 12, 2021.
- Source: Bloomberg; data as of September 30, 2021.
- Source: FactSet; data as of September 30, 2021.
- Source: Congressional Budget Office; data as of July 1, 2021.
This commentary represents the opinion of the First Eagle Global Value Team portfolio managers as of September 30, 2021 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.
