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%. The Bloomberg Barclays U.S. Aggregate Bond Index and the Bloomberg Barclays U.S. Corporate High Yield Index returned 0.82% and 2.70%, respectively. 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 benefiting 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. In this global environment of high debt and high political risk, the prices of risk assets remain, to our minds, pretty full. If the world has too much debt and geopolitical risk is growing, you’d think that equities would be cheap relative to historical norms. But instead they’re expensive.
We see a similar pattern in the fixed income markets. Within the high yield market, leverage has increased, but spreads have gener-ally compressed, with the B/BB spread at 112 bp.2 This indicates to us that investors are reaching for yield—buying bonds and reaching lower in the credit spectrum and accepting less compensation for the incremental risk. We think that investors are not adequately differentiating for credit risk, and that, as a result, credit risk may be underpriced.
Duration risk may also be underpriced. Historically, duration has been secondary to credit as a risk factor in the high yield market, but today, there’s a distinct possibility that yields will increase and that a duration-induced drop in value will ensue. Nevertheless, we see few signs that the market is focusing on the management of duration.
Liquidity risk is yet another concern. Because of constraints introduced in the Dodd Frank Act and the Volcker Rule, banks and brokerage houses are no longer willing to maintain large inventories of corporate bonds. In the past—for a price—they served as shock absorbers in risk-off markets. In the absence of these players, the market seems to be mispricing liquidity risk. We think that liquidity was overpriced a year ago and that it is underpriced today. This is especially true in the high yield market.
Portfolio Review
Global Income Builder Class A shares (without sales charge)* returned 4.54% during the quarter, and the composite index regis-tered 4.13%. In a period of relatively high valuations in the equity market and widespread underpricing of risk in the fixed income market, opportunities were scarce, and our allocations to both stocks and bonds declined. As a result, our holdings of cash and cash equivalents increased in the quarter. In keeping with our fundamentals-based investment philosophy, these changes in asset alloca-tion reflected bottom-up judgments about individual securities rather than top-down projections of future asset-class performance.
Contributors
Weyerhaeuser Company (WY, Financial) and Hang Lung Properties Limited (HKSE:00010, Financial) were among the equities contributing to performance in the period. Bonds and loans that contributed included Government of Mexico 4.75% due 06/14/2018 and 6.5% due 06/10/2021; and Caelus Energy Alaska 03 LLC, Second Lien Term Loan (LIBOR floor 125 bps + 750 bps) due 04/15/2020.3 Contributions to performance from individual bonds and loans are generally substantially smaller than those from individual stocks. We hold bonds and loans because they help us meet the fund’s dual goals of income and capital appreciation while also potentially lending ballast to the port-folio. In this period, gold bullion, which the fund holds as a potential hedge against market disruptions, also helped performance.
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.4 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 Southeastern United States, 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.
Hang Lung Properties is a Hong Kong-based company that owns office buildings and grade-A shopping malls throughout China. During the first quarter, the stock advanced as Hang Lung’s business showed signs of recovery.
Mexico’s sovereign bonds recovered as the value of the Mexican peso rose from 20.68 to the dollar at the start of the quarter to 18.72 at the end. We believe that the Mexican government is taking steps to improve its fiscal situation.
Caelus Energy Alaska’s term loan rose in value because of a large oil discovery that the company made in Alaska’s North Slope.
Detractors
Stocks that detracted from performance in the first quarter included Cenovus Energy Inc., MITIE Group PLC and Xilinx, Inc. Bonds that declined in value included Vista Outdoor, Inc. 5.875% due 10/01/2023; Citgo Petroleum Corp. 6.25% due 08/15/2022; and New Gold Inc. 6.25% due 11/15/2022.5
Cenovus’ (CVE, Financial) stock declined both because of falling oil prices and because of 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.
MITIE Group (LSE:MTO, Financial) is a British company that provides facilities management services, such as catering and cleaning. The company has announced a series of earnings misses. It has replaced its management team, but the new leaders are constrained by old contracts that are still in place and substantial debt on the company’s balance sheet. We thought it prudent to take our losses and sell this position.
Xilinx is a US-based technology company that provides programmable logic devices. We are not aware of any negative news about Xilinx, and we would characterize its decline in the quarter as noise.
Vista Outdoor’s bonds declined in value during the first quarter. The company is a leading supplier of ammunition, and it also provides bicycle helmets and other sporting goods. In recent years, it acquired several 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 environment—felt less need to stock up on ammunition.
Citgo’s bonds detracted for two primary reasons: Oil refinery profits have declined, and Venezuela’s government—which is Citgo’s ultimate parent—faces serious economic and political strains. We remain comfortable holding these bonds because we believe they are very well covered by the value of domestic US assets.
New Gold is a Canadian company that owns gold mines in several locations around the world. During the quarter, the company reported delays and increased expenses related to its new Rainy River mine in Ontario. We believe New Gold’s bonds are well-funded through completion of this mine.
We appreciate your confidence and thank you for your support.
Sincerely
First Eagle Investment (Trades, Portfolio) Management, LLC
