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By Sean Bogda | Paul Ehrlichman| Safa Muhtaseb | Grace Su
Tight Commodity Markets Separate Wheat from Chaff
Market Overview
International markets continued to face headwinds during the third quarter, with the MSCI All Country World Ex U.S. Index declining 9.91% as slowing economic growth and hawkish monetary policy by central banks stoked investor fears of a possible global recession.
A resilient U.S. economy resulted in the Federal Reserve advocating an agenda of aggressive interest rate increases, raising rates by 75 basis points in July and September. This set the tone for monetary tightening for other global central banks, including the European Central Bank which followed suit with its own 75 basis point raise in September.
Add to that a brutal war in Ukraine that has sent energy prices skyrocketing during a particularly vulnerable moment for the global energy transition, and the result has been an economic environment eerily reminiscent of the 1970s, creating a “cost of living crisis,” particularly in Europe. Meanwhile, China continues to find itself subjected to headwinds as trouble in its real estate market and aggressive zero-COVID policy have weighed on the country’s economic prowess.
All 11 sectors of the MSCI All Country World Ex U.S. Index posted negative returns for the third quarter. Aggressive interest rate increases weighed on sectors such as communication services and information technology (IT), as higher discount rates worked to reduce the value of longer-term cash flows and compress valuation multiples.
The energy sector proved the best performing sector in the benchmark, as the geopolitical situation and sanctions on Russia have resulted in less supply of oil and gas in an already tight market. However, investors bracing for economic impact also sought out traditionally defensive sectors, with consumer staples following closely behind the energy sector’s performance.
Stock selection in materials proved a positive contributor to quarterly performance. The broader sector was pressured by lower prices for commodities, a decline in Chinese construction activity and companies pushing off capital investments due to increased economic uncertainty.
However, we believe this is exactly the kind of environment that separates the highest-quality companies from their peers and allows them to strengthen their competitive positioning. For example, Nutrien (NTR), a Canadian fertilizer company, was a top contributor during the quarter. While the war in Ukraine and economic sanctions on Russia have significantly reduced the output of two of the world’s largest agricultural producers, Nutrien has benefited from a strong global agricultural cycle and from farmers seeking to increase their output and capitalize on higher agricultural prices.
Likewise, Glencore (OTCPK:GLCNF), an Anglo-Swiss commodity trading and mining company, outperformed peers as volatility within financial markets helped propel positive performance within its commodity trading business that offset a relative lack of movement in copper prices during the quarter.
Despite the short-term challenges, we continue to have high conviction in both companies and the long-term prospects of the sector. Several years of underinvestment have significantly constrained the production capacity of crucial commodities, which we believe will result in higher material and stock prices as the trends of electrification and the global energy transition consume greater amounts of resources.
“Several years of underinvestment have significantly constrained the production capacity of crucial commodities.”
While the industrials sector also faced an increase in investor pessimism due to the prospect of a slowing global economy, the Strategy’s investment in several high-quality stocks helped buoy our performance in the sector over the benchmark. This included our top individual performing stock during the quarter, Jardine Cycle & Carriage (OTCPK:JCYCF), a Singapore-based conglomerate with many diverse lines of business, including automotive, financial services, heavy equipment and IT.
As the owner of the largest car manufacturer in Indonesia, the company benefited from a buoying of consumer spending and economic stability in the country thanks in large part to the increase in commodity prices, particularly nickel and palm oil. Japan Airlines (OTCPK:JAPSY) also caught an updraft. The company provides air transportation and related services for passengers and cargo, as the country’s easing of COVID-19 restrictions was seen as a positive for the company, which has suffered from a lack of consumer travel over the last two years.
Health care proved to be the most challenging sector to navigate during the quarter, as several companies were subjected to elevated risk aversion due to possible litigation implications. Two of our top five largest individual detractors for the period were in the health care sector: Sanofi (SNY) and Bayer (OTCPK:BAYZF). Sanofi, a French pharmaceutical and health care company, saw its share price fall after it was named as a co-defendant in a class action lawsuit alleging that Sanofi and other sellers of the heartburn medication Zantac failed to warn of the drug’s risk of containing a possible carcinogen.
We believe the market’s reaction to the news is overblown but continue to monitor the situation. Bayer, a German multinational pharmaceutical and biotechnology company, suffered a legal setback when the U.S. Supreme Court declined to review an appeal to overturn a lower jurisdiction ruling against it. We believe this liability has already been priced into the company’s share price, which still represents a significant discount to its peers despite a strong and growing pipeline.
The company’s agricultural division is exceptionally well run and represents an opportunity for the company to spin off its consumer health division at a material premium to continue focusing on its best-in-class agriculture product lines.
Portfolio Positioning
While we remain highly confident in our portfolio holdings as we navigate such a tumultuous market, we are vigilant for opportunities to refine our positioning and improve the risk/reward profile of the portfolio. We continuously monitor our existing holdings for any developments that change our investment theses and maintain an extensive backlog of high-quality companies with strong balance sheets and compelling long-term growth potential that we can draw on to respond to these evolving catalysts. As a result, we initiated one new position and exited three holdings during the period.
We added Woodside Energy Group (WDS), Australia’s largest independent dedicated oil and natural gas exploration company. We believe there is a structural mismatch between the current supply and demand due to decades of underinvestment, and this is being actively reflected in skyrocketing energy prices in Europe and low global inventories. Woodside represents a compelling opportunity within this context due to high-quality assets within the Pacific basin, positioning it well to cater to fast-growing Asian economies.
It also adds further regional diversification to the portfolio. The company’s leadership has allowed it to develop long-term commitments within a favorable regulatory environment. Finally, the company has been involved in investing and exploring renewable energy options for long-term success. We believe Woodside’s high return on capital employed is sustainable and indicative of attractive long-term value creation opportunities.
We exited our position in Marston’s (OTCPK:MARZF), a British pub and restaurant operator. The company saw its share price decline in tandem with the broader consumer discretionary sector in the first half of 2022 as inflation sparked a shift in consumer spending patterns and a retreat to more defensive sectors.
Additionally, the company faced headwinds due to the inflationary impacts of rising input costs in food, alcoholic beverages, energy and rising wages in the face of weaker demand. These proved to increase the company’s near-term economic uncertainty and, given the compelling valuations and growth prospects of our other long-term U.K. stocks, we elected to exit the position.
We also exited our position in KION (OTCPK:KIGRY), a German manufacturer of materials handling equipment including intralogistics, warehouse automation equipment and industrial trucks. Demand for KION’s products has weakened due to oversupply, and the company has been locked into contracts while inflation has increased the costs of labor and materials. The company’s recently lowered guidance helped illustrate these challenges and we elected to exit the position and redeploy capital elsewhere.
Outlook
The future continues to look choppy as investors fret over interest rate and inflationary expectations in light of a potential economic recession. Having already experienced the multiple compressions indicative of the first stage of a market drawdown, we will likely see further turbulence as companies cut earnings outlooks in the name of conservative guidance.
However, while we understand that we may see some pain in our more cyclical sectors with lowered expectations, we remain confident in both our portfolio holdings and in our overall positioning. We believe our recent performance underscores the strength of taking a long-term perspective and investing in high-quality companies with strong balance sheets and attractive growth catalysts. We will continue to rely on our process and philosophy as a roadmap for long-term success.
Portfolio Highlights
The ClearBridge International Value Strategy outperformed its MSCI All Country World Ex-U.S. Index benchmark during the third quarter. On an absolute basis, the Strategy had losses across nine of the 10 sectors in which it was invested (out of 11 sectors total). The financials, health care, consumer discretionary and industrials sectors were the main detractors, while the real estate sector was the sole positive contributor.
On a relative basis, overall sector allocation and stock selection effects contributed to performance. Specifically, stock selection in the materials, real estate and industrials sectors, an underweight allocation to the communication services sector and an overweight to the energy sector aided performance. Conversely, stock selection in the health care and communication services sectors weighed on returns.
On a regional basis, stock selection in Asia Ex Japan, Japan and North America and an underweight allocation to emerging markets contributed to performance. Stock selection in emerging markets weighed on performance.
On an individual stock basis, Jardine Cycle & Carriage, Daito Trust Construction (OTC:DIFTY), Glencore, Nutrien and BAWAG (OTCPK:BWAGF) were the leading contributors to absolute returns during the quarter. The largest detractors were KION, Bayer, Sanofi, Vistry (OTCPK:BVHMF) and Standard Chartered (OTCPK:SCBFF).
During the quarter, in addition to the transactions mentioned above, the Strategy exited its position in Fresenius Medical Care (FMS).
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Past performance is no guarantee of future results. Copyright © 2022 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Morgan Stanley Capital International. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance is preliminary and subject to change. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent. Further distribution is prohibited. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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