Market Overview
In the first quarter of 2017, the MSCI World Index rose 6.38%, while in the United States the S&P 500 Index increased 6.07%. In Europe, the German DAX Index was up 8.03% and the French CAC 40 Index rose 6.83%. In Japan, the Nikkei 225 Index rose 3.55% over the period. Brent crude oil fell -5.02% to $52.83 a barrel, and the price of gold rose 8.46% to $1,251.20 an ounce. The US dollar weakened -4.67% against the yen and fell -1.40% against the euro.1
Judging from the strong market trends of the first quarter, investors were generally enthusiastic about the outlook for global econo - mies and markets. Our own view is more guarded. At a global level, debt remains high, and there has been no major deleveraging relative to GDP. We have been repeatedly reminded that debt is easier to create than to destroy.
In the first quarter, our concerns focused on China and the United States, the world’s two largest economies. China’s economy has benefited from economic stimulus measures introduced early in 2016, but during the first quarter their impact appeared to be dwin-dling. Our medium-term concerns in China center on the dramatic growth in credit over the last decade. While Chinese banks have reported only modest increases in provisions for nonperforming loans, this picture may be incomplete because many loans can be transitioned into wealth management products from China’s shadow banks, whose reporting is opaque. In China, aggregate fixed capital investment remains very high relative to GDP. Looking out beyond the immediate horizon, we have questions about the level of debt in China.
In the United States, very short-term trends were positive: Business momentum was strong, profits were up, and household and corporate confidence were high. Nevertheless, we thought the outlook in the United States had become a bit more uncertain. Some of the initial enthusiasm underlying the Trump rally has become muted, as investors have begun to question whether the promise of fiscal stimulus from tax reform and infrastructure spending will indeed be fulfilled.
In March, the Federal Reserve took another step in its plan to raise interest rates in modest increments, and the forward curve suggests that rates will be at 2% within two years. While this rate is certainly not high by historical standards, the overall level of debt in the United States is elevated relative to history, which means that the economy could be more sensitive to a pickup in rates than it has been in the past. Furthermore, some commentary from the Fed suggests that it may decide to shrink its balance sheet. In our view, quantitative easing (QE) provided meaningful support to financial assets. While the market is now counting on a boost from growth-oriented government policies, if this stimulus does not emerge, the unwinding of QE could be challenging for markets to digest in future years. We do not predict this outcome, but we believe that, at the margin, the outlook for the United States has become somewhat cloudier.
In contrast to China and the United States, Europe was in something of a sweet spot in the first quarter. As in the United States, the political pendulum in Europe had been swinging toward populism, but in the Dutch elections that took place in March, the more extreme populist candidate did not prevail. At the same time, confidence seemed to be slowly returning to the European economies, with fixed investment increasing and unemployment drifting lower from high levels. While Europe has been benefitting from a weak currency and somewhat of a cyclical recovery, it still has structural issues to contend with, including bank recapitaliza-tions, a series of critical national elections against a backdrop of rising populism, Brexit negotiations and a need to better define its security and fiscal union.
Looking beyond the economic trends, we continue to be troubled by geopolitical concerns. We are living in an environment where global risks are substantially higher than they were a generation ago when the Berlin Wall fell. We have clearly entered a world that’s multi-polar in nature, which makes for complex and unpredictable dynamics.
Portfolio Review
Global Fund
In a pattern that has become familiar in strong market environments, the Global Fund lagged the broader market but delivered sound absolute returns in the first quarter of 2017. The First Eagle Global Fund Class A (without sales charge)* returned 5.42% versus the MSCI World Index return of 6.38%. Results were positive in all regions, with North America, developed Europe and Japan leading the way. In sector terms, industrials, materials and information technology made the largest contributors, and energy was the sole detractor.
The leading contributor was gold bullion, which advanced strongly in the first quarter. Other contributors included businesses that would be expected to thrive in a window of better economic sentiment, such as Fanuc (robots) and SMC (pneumatic controls)— Japanese companies serving the factory automation market.
Oracle (ORCL, Financial) contributed, as well. We have spoken for some time about the company’s transition from selling traditional licenses to selling cloud-based software products. In the early stages, this transition diluted revenues because the company’s upfront license fees shrank before the stream of annual payments that would replace them had an opportunity to grow. The company’s most recent quarterly earnings report showed improving revenue growth as Oracle began to benefit from the layered annual payments it receives from its cloud-based business.
Weyerhaeuser (WY, Financial) was also among the top contributors. We think the gain in Weyerhaeuser’s stock was driven by stronger housing numbers. Before the global financial crisis, the United States had nearly two million housing starts a year. That number fell below 700,000 in 2009, but it has now recovered to over 1.2 million.2 Weyerhaeuser has often said that when housing starts reach 1.2 or 1.3 million, timber prices may begin to advance. Timber pricing has remained weak in the Southeast, and this could represent a source of latent earning power for Weyerhaeuser. In the meantime, a dividend yield of more than 4% has kept us comfortable holding this stock.
Among the quarter’s detractors, Vista Outdoor’s stock experienced the largest percentage decline. Vista is a leading supplier of ammunition, and it also provides bicycle helmets and other sporting goods. In recent years, it acquired a number of sporting equipment companies, and during the quarter, disappointing sales at these businesses forced Vista to take write-offs. In addition, bullet sales declined sharply following the US presidential election, as gun owners—less worried about a harsher regulatory environ-ment—felt less need to stock up on ammunition.
Several of our energy holdings—Cenovus Energy, TechnipFMC and Schlumberger—also detracted in a period of lower oil prices. In the case of Cenovus, there were other factors, as well—notably, the company’s agreement to buy a material package of assets from ConocoPhillips. Cenovus knew the assets well, because it already operated there in partnership with ConocoPhillips, and we think the price it paid was fair. But to complete the deal, Cenovus had to issue stock at a depressed valuation.
Shares of oil-field services companies TechnipFMC and Schlumberger weakened because of the decline in the oil price. Schlumberger dominates many niches in this industry, and it spends more on research and development than its next three largest competi-tors combined. Even at the bottom of the energy industry’s worst cycle since the Second World War, it was still distributing cash flow to shareholders. We added to our position in Schlumberger during the quarter.
Shares of Mitsubishi Estate Company, a Japanese real estate company with holdings in central Tokyo, retraced during the quarter due to strengthening in the yen and softening of reflation-sensitive names in Japan.
Overseas Fund
The First Eagle Overseas Fund Class A shares (w/out sales charge)* returned 6.39% versus the MSCI EAFE Index return of 7.25%.
Leading contributors in the first quarter included Fanuc Corporation, gold bullion, Grupo Televisa, SMC Corporation and Hang Lung Properties.
Shares of Mexican media giant Grupo Televisa (TV, Financial) gained both because of appreciation in the peso, which helped Televisa’s stock price in dollar terms, and because of an increase in advertising prices that the company instituted about one year ago. At first, higher prices had a negative impact on volumes, but the company’s TV advertising business has since returned to revenue growth. In addition, Televisa is reaching the end of a period of heavy capital spending on its cable network, and we believe it is in a position to potentially start generating greater free cash flow.
Leading detractors in the quarter were Cenovus Energy, Mitsubishi Estate, Shimano Inc., Imperial Oil and Emin Leydier. This includes a number of Canadian energy stocks that declined in a period of lower oil prices. In the case of Cenovus Energy, there were other factors, as well – notable, the company’s agreement to buy a material package of assets from ConocoPhillips.
Cenovus knew the assets well because it already operated them in partnership with ConocoPhillips. We think the price it paid was fair, but to complete the deal, Cenovus had to issue stock at a depressed valuation.
Imperial Oil, another oil-sands company based in Alberta, is majority owned by Exxon. It has a history of returning capital to shareholders, and if the oil price recovers, it has the potential to have considerable free cash flow with which to do so.
Shares of Mitsubishi Estate Company, a Japanese real estate company with holdings in central Tokyo, retraced during the quarter due to strengthening in the yen and softening of reflation-sensitive stocks in Japan.
Shimano is a Japanese producer of bicycle components and fishing tackle that exports much of its production overseas. Strength in the yen, plus a relatively high valuation, accounted for the decline in Shimano’s share price.
U.S. Value Fund
The First Eagle U.S. Value Fund Class A shares (w/out sales charge)* returned 3.96% versus the S&P 500 Index return of 6.07%.
Leading contributors in the quarter were gold bullion, Oracle, Weyerhaeuser, Comcast and Microsoft.
Leading detractors were Vista Outdoor, TechnipFMC, BB&T Corporation, Synchrony Financial and Schlumberger.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
1. Bloomberg.
2. Source: US Census Bureau.
