The Federal Reserve’s about-face on monetary policy was the most important factor driving markets higher in first quarter 2019. The Fed had steadily raised rates throughout 2018 and in December signaled that it was likely to do the same in 2019. The statement following its January meeting suggested a more dovish stance, however, with the central bank indicating that it would be patient with future adjustments to the federal funds rate and flexible in reducing its bond holdings. We think the Fed’s rather abrupt change in attitude speaks to broader issues within the financial system.
As we have written in the past, the growth of debt over the last decade has brought forward demand in the economy and gener-ally benefited corporate profit margins; in the future, however, debt instead may become a headwind for nominal growth around the world. Furthermore, when the level of debt is high relative to borrowers’ capacity to repay it—i.e., the cash flows available to businesses and consumers and the latent taxing capacity of governments—debt that comes due cannot be amor-tized from cash flows; it needs to be rolled over. We believe this renders markets more vulnerable to bouts of risk aversion. We saw an example of this in December 2018 when the window for high yield issuance closed for a period of time. Simultaneously, the prices of certain European bank stocks dropped to new lows—even lower than they had fallen in 2008.
The Fed evidently became concerned that the tightening it had already implemented might dampen credit growth and economic growth, which already were decelerating as the fiscal stimulus from the 2018 tax cuts cycled off. The Fed responded by calling a halt in the tightening schedule it had announced. We were struck by the fact that, against a backdrop of high global debt, the financial system reached a choke point at a relatively low level of interest rates. It is now an open question whether the global financial architecture can withstand what we used to think of as normal interest rates.
As we have seen for some time, when the rise of populism and other geopolitical complexities are superimposed on over-indebted economies, central banks may respond with experi-mental policies (e.g., quantitative easing and negative interest rates). Since the global financial crisis, inflation has been largely below 2%,1 and some academics have argued that this could cause people to expect a lower rate of inflation in the future. They have advanced the theory that the Fed should experiment with allowing the economy to run a little hot so that inflation is greater than 2% for a period of time. This may not be a wise course of action. The last time easy fiscal conditions coincided with the Fed falling behind the inflation curve was the late 1960s/early 1970s. The decade that followed was not a good time for financial assets in the United States, but it was gener-ally a good time for gold. We are not predicting a carbon copy of that environment, but it does illustrate the role that gold has played during such challenging periods.
The pause in Fed tightening was accompanied by an easing of conditions in China. Some stimulus has also been introduced in Europe: Germany recently, and Italy earlier in 2018. All of these actions gave world stock markets some near-term optimism and helped spawn recoveries from the lows of the December quarter. As measured by the CBOE VIX Index, risk perception that was starting to rise in December evaporated quickly, and implied volatility dropped to around 14%. COMEX copper prices rallied by 12%, Brent crude oil prices by 27% and stock markets generally advanced strongly—particularly the NASDAQ.2
We would emphasize, however, that this not a time to be complacent about markets. While we have no idea what is going to happen in the next six or 12 months, we are mindful of the fact that while gold was predictably a little soft in the face of the first quarter’s equity rebound, it wasn’t that soft. Secondly, the yield curve inverted, which has been something of an indi-cator—although not a perfect one—of tougher economic times and increased market volatility ahead. That may not neces-sarily mean a crisis, but the fixed income markets are telling us through the Treasury curve that they expect more volatility. In our view, credit spreads and stock prices generally do not reflect this possibility. At this moment we think it is prudent to be prudent.
Portfolio Review
The Global Fund delivered a positive return in the first quarter but underperformed the MSCI World Index. The First Eagle Global Fund Class A shares (without sales charge)* returned 9.88% versus the 12.48% return of the MSCI World Index. On a sector basis, information technology, financials and consumer staples contributed the most to the fund’s fourth quarter perfor-mance, and transportation and paper & forest products had no effect on the portfolio’s performance. On a regional basis, returns were positive in all regions, with North America and developed Europe leading the way.
As share prices generally advanced, we trimmed positions in a number of portfolio holdings that approached our estimates of their intrinsic value. As a result, we were net sellers during this period, and our cash and cash equivalents position rebuilt
The top contributors to performance in the fourth quarter were Oracle Corporation; British American Tobacco p.l.c.; Philip Morris International Inc.; ExxonMobil Corporation and Schlumberger NV.
In addition to being lifted by the market tide, Oracle shares also were boosted by the company’s stock-buyback program, its introduction of new product, and reports of favorable reactions from satisfied customers.
The two tobacco stocks—British American Tobacco and Philip Morris—had been extremely weak at the end of the fourth quarter but recovered strongly in the first quarter despite no major changes in their business results.
Oilfield- services company Schlumberger benefited from a sharp recovery in the price of oil during the first quarter, as did Exxon Mobil.
The largest detractors from first quarter results were KDDI Corporation; Jardine Matheson Holdings Limited; HOSHIZAKI Corporation; Vista Outdoor Inc.; and BT Group.
Telecoms, including Japan’s KDDI and Britain’s BT, generally did not fare well in the prevailing market environment of the first quarter, as investors slighted sectors and names perceived to be stodgy or defensive.
Jardine Matheson (LSE:JAR, Financial) likely declined for a similar reason. Shares in this Hong Kong-based holding company had served as ballast in portfolios in the fourth quarter of 2018, and they lost ground as investors turned their attention to higher-growth names.
HOSHIZAKI (TSE:6465, Financial), a position we initiated in the first quarter, is a Japanese company that is a world leader in ice-making machines for restaurants and other commercial establishments. Despite an irregularity at one of its subsidiary locations that impacted sentiment in Japan, we felt comfortable with the company and its long heritage.
Vista Outdoor (VSTO, Financial) is a US-based producer of equipment for outdoor sports, including firearms, motorcycle helmets and water bottles. Given weakness in some of its end markets, the company was in the process of recapitalizing its balance sheet by selling several businesses.
Overseas Fund
The First Eagle Overseas Fund Class A shares (without sales charge)* returned 7.86%, underperforming the MSCI EAFE Index which returned 9.98%. Sectors contributing most positively to quarterly performance included consumer staples, industrials and financials, while paper & forest products and utilities had a neutral effect and communication services detracted. On a regional basis, developed Europe and North America contributed the most.
The top contributors for the quarter were British American Tobacco p.l.c.; Nestlé S.A.; FANUC Corporation; TechnipFM plc; and Lloyds Banking Group plc. The largest detractors for the quarter were HOSHIZAKI Corporation; SK Kaken Co., Ltd.; Telefónica Deutschland Holding AG; KDDI Corporation and Jardine Matheson Holdings Limited.
U.S. Value Fund
The First Eagle U.S. Value Fund Class A shares (without sales charge)* returned 10.45% versus the 13.65% return of the S&P 500 Index. Sectors contributing positively to quarterly performance included information technology, financials and energy with transportation having a neutral effect and holding companies detracting.
The top contributors were Oracle Corporation; Schlumberger NV; Weyerhauser Company; Philip Morris International Inc.; and Exxon Mobil Corporation. The top detractors were Wells Fargo & Company; H&R Block, Inc.; Berkshire Hathaway Inc. Class A; Alleghany Corporation and Vista Corporation.
We appreciate your confidence and thank you for your support. First Eagle Investment (Trades, Portfolio) Management, LLC
1. Source: Bloomberg.
2. Source: Bloomberg.
The commentary represents the opinion of the Global Value Team portfolio managers as of March 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.
