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Fierce Fed Calls for Defensible Franchises
Market Overview and Outlook
A quickly changing interest rate environment, growing fears of a recession and geopolitical uncertainty made for a volatile second quarter of 2022. The Russell 1000 Value Index declined 12.21%, outperforming its growth counterpart by over 800 basis points. Every sector of the value benchmark had negative returns: energy and more defensive health care, consumer staples and utilities sectors were down single digits, while economically sensitive sectors such as materials, financials and industrials were down double digits. While leading broader markets in recent years, information technology (IT) performed the worst within the value benchmark, down about 19%.
A resurgence in inflation forced the Fed’s hand in 2022, leading to progressively higher federal-funds rate hikes: 25 basis points in March, 50 basis points in May, and 75 basis points in June, the latter being the most aggressive hike since 1994. Starting in June, the Fed also began reducing the size of its $9 trillion balance sheet, i.e., conducting quantitative tightening (QT) by initially letting $47.5 billion in Treasurys and mortgage-backed securities mature per month, and increasing this monthly cap to $95 billion by September.
Aggressive rate hikes combined with QT are designed to slow the economy in order to combat unacceptably high inflation, with May CPI of 8.6% and June expected to hit 8.8%. Following the outlook for higher short-term rates, 10-year Treasury yields broke through 3% in June, the first time since 2018, and peaked near 3.5%, before falling back to 3% by the end of the month, as investors started pricing in the growing probability of a recession as the result of aggressive Fed actions.
As the economic outlook began to sour, materials stocks tumbled, with commodity-focused companies bearing the brunt of the selloff after several months of strength. The Strategy’s materials holdings held up well, however, led by Air Products and Chemicals (APD), which reported decent results driven by better execution, pricing and margin improvements, particularly in Europe, as well as a shift in management comments from cautious to more positive on China. APD continues to execute on its energy transition mega projects including blue and green hydrogen and sustainable aviation fuel (SAF), and also announced several traditional long-term projects during the quarter. Hydrogen, along with liquified natural gas, has been getting renewed focus in recent months as Europe attempts to reduce its reliance on Russian gas.
While in recent quarters we have maintained an underweight to health care, in the second half of 2021 we added to our managed care exposure in anticipation of overall market vulnerability given high inflation and valuations. This proved helpful in the second quarter, although our overall underweight was a drag on relative results. We have continued to look for attractive opportunities in the sector, understanding its characteristic stability in challenging markets, and in the second quarter we added Becton Dickinson (BDX), a broadly diversified manufacturer of hospital supplies, laboratory research equipment and therapeutic medical devices. The company’s reasonable valuation and razor-razorblade business model should help it deliver stable mid-single-digit topline growth with a steady valuation multiple. For the quarter, Merck (MRK) was one of the top contributors, receiving positive approvals for several of its drugs and taking action to secure its pipeline in the years ahead through M&A.
Main detractors came from the communication services and financials sectors. In communication services, telcos performed well in a shaky market, while cable and satellite services were weaker. Our main detractor here was Dish Network (DISH), a leading provider of pay-TV services, which is in the midst of its multiyear efforts to build a greenfield, cloud-native 5G wireless network. While it met its interim build-out requirements, Dish needs to raise capital in the short-to-medium term to continue. Given current market conditions, capital needs combined with execution challenges were not well-received during the quarter. In financials, recession fears outweighed the benefits of rising interest rates; in the Strategy, Bank of America (BAC) and American Express (AXP) felt these concerns most acutely, although we remain comfortable with these businesses and their strong fundamental positions over the medium-to-long term.
In the industrials sector, farm equipment manufacturer Deere (DE) was down on cyclical concerns, with higher interest rates potentially impacting farmers’ purchase decisions. A selloff in agricultural commodities, albeit off their recent highs, along with ongoing supply chain disruption and overall inflationary pressures may present potential headwinds for agricultural equipment demand. We continue to like the business and Deere’s competitive position; its leadership position in precision agriculture brings benefits to both farmer profitability and the environment.
Strength continued for Raytheon Technologies (RTX) and Northrop Grumman (NOC); the war in Ukraine has underscored the need for defense spending and it remains at the forefront of geopolitics with broad and potentially lasting macroeconomic implications including energy and food security. European reliance on Russian natural gas is being dealt with as we speak but will take years to achieve independence; in the meantime high energy costs are pressuring economic growth in Europe, including Germany, one of its economic engines. Nor is the war the only source of geopolitical risk. Concerns of slower growth out of China, where zero-COVID-19 policy lockdowns have only recently been lifted, may one day be surpassed by geopolitical risks such as growing tensions with Taiwan, where much of the world’s semiconductors are manufactured.
In anticipation of a more challenging economic environment, over the past year we have positioned the Strategy more defensively, lowering our consumer exposure, most recently through the sale of TJX (TJX), as well as reducing our financials weighting. At the same time, we have added to health care, and continue to look for attractive opportunities there, as well as the consumer staples sector, where we remain underweight. Although we do not have a crystal ball, amid large economic and geopolitical uncertainties it is more important than ever to be investing in high-quality, defensible franchises that can weather periods of uncertainty and take advantage of weakness as they come out on the other side of a downturn.
Portfolio Highlights
The ClearBridge Large Cap Value Strategy underperformed its Russell 1000 Value Index benchmark during the second quarter. On an absolute basis, the Strategy had gains in three of the 11 sectors in which it was invested for the quarter. The strongest contributions came from the health care and real estate sectors. The financials, IT and industrials sectors were the main detractors.
On a relative basis, overall stock selection contributed positively to performance while sector allocation detracted. In particular, stock selection in the health care, IT, materials, real estate and industrials sectors were positive for relative returns. Conversely, stock selection in the communication services, utilities and financials sectors as well as underweights to the health care and consumer staples sectors and an overweight to the IT sector detracted.
On an individual stock basis, the largest contributors were Northrop Grumman, Merck, American Tower, UnitedHealth Group (UNH) and Progressive (PGR). Positions in Deere, Bank of America, American Express, Dish Network and JPMorgan Chase (JPM) were the main detractors.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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