Q1 2018 Commentary
Global equities kicked off 2018 with strong upward momentum, as gains at one point in late January exceeded 7%. Institutional and retail investor sentiment had also reached multi-decade highs. Investors were optimistic that the recently passed U.S. tax cuts would help to materially boost corporate earnings growth.
Stronger-than-expected U.S. hourly wage growth report in early February served as the catalyst that triggered the long over-due correction. There were also concerns that the Fed would have to react by quickening the pace of monetary tightening. The VIX Index surged and created panic amongst various investment strategies that were shorting market volatility.
However, the inflation concern turned out to be rather short-lived, as subsequent economic data failed to confirm broad-based inflation. Equity markets then proceeded to rally again, albeit with much narrower leadership – Internet and semiconductor stocks hit new highs while value stocks continued to lag.
Then came an eventful March in which President Trump’s unconventional presidency seemed to have finally rattled the market. His cabinet was hit with turnovers at key positions. He imposed tariffs on steel and aluminum imports, which prompted the resignation of Gary Cohn, the White House’s top economic advisor. The Administration then announced tariffs to be levied on an additional $50 billion of Chinese imports. To make matters worse, President Trump also went after Amazon while Facebook’s data breach managed to upset regulators in multiple regions. Unsurprisingly, these developments weighed on performance and resulted in a down quarter for equities.
Ironically, while investors grappled with the Trump Administration’s shifting policy stance and continued controversies, the U.S. economy could achieve its strongest economic growth since the Great Recession. The combination of tax cuts and increased federal spending will likely inject fiscal stimulus of around 1.5% of GDP. The repatriation of off-shore profits will likely lead to more than $500 billion of inbound cash to be deployed for capital spending, acquisitions, share repurchase, and debt repayment. In short, the U.S economy appears to be well positioned for the next 12 to 18 months. This positive outlook drove U.S. Treasury yields higher during the quarter.
Outside the U.S., Europe has seen somewhat softer-than-expected economic data and inflation, which will likely keep the European Central Bank on the dovish side for now. Politically, Italy remains perennially fractured, while Chancellor Merkel was finally able to put together a coalition government. Similarly, Japan also appeared to lose a bit of momentum, and Prime Minister Abe was mired in a political scandal. However, both regions have remained firmly on the expansion camp.
The prospect for emerging markets also appeared steady. China and India remain the two strongest growth drivers, while Brazil benefited from lower inflation. Higher oil prices also helped Russia to achieve strong stock market returns in the first quarter.
For the global equity market, as measured by the MSCI ACWI Index, the best performing sectors during the first quarter of 2018 were information technology and consumer discretionary; the latter had a lot to do with Amazon’s strong performance. Investors have continued to favor semiconductor-related and Internet-related stocks. However, Facebook’s data breach and Trump’s twitter attacks on Amazon appeared to have dented these sectors’ momentum.
The worst performing sectors during the first quarter were telecom services and consumer staples. Rising interest rates make these bond-proxy like sectors less appealing. Investors also seemed to have become concerned that many consumer staples companies have had several years of disappointing growth in spite of the global economic recovery. As interest rates move higher, it would likely become more difficult for these companies to pursue financial engineering to boost EPS growth.
The Fund underperformed the benchmark during the first quarter of 2018 largely due to idiosyncratic issues that hit several of our large-sized positions.
The aforementioned idiosyncratic issues with some of our largest holdings included Comcast’s bid to acquire Sky PLC and CVS’ proposed acquisition of Aetna. We believe Comcast’s bid for Sky PLC is a shrewd move to enhance its negotiation leverage for content deals, and CVS’ proposed merger with Aetna will likely result in a more defensible business model. As such, we remain comfortable with these positions. Another large position that underperformed during the quarter was Southwest Airlines. Markets were concerned about one of its competitors’ capacity expansion plan, however, we believe Southwest’s business should not be materially affected and that air travel demand has remained robust.
On the positive side, the best relative performing sector was healthcare, which was helped by the 29% appreciation in DexCom, a newly acquired position in 2018. Gene therapy leader Spark Therapeutics also had a strong quarter, rising 29.5%.
On the negative side, Information technology stocks detracted the most from Fund performance, with Kyocera’s 13% decline during the quarter having the largest impact. However, an even greater impact came from not owning highflyers among semiconductor stocks. We continued to believe that the risk-reward of the semiconductor sector to be unattractive as the industry cyclicality will once again usher in a down turn perhaps in as early as the second half of 2018, in our opinion.
Also detracting from performance was the near 10% decline in Facebook. When we first purchased Facebook in October 2016, we viewed the company as providing an innovative way to connect people with their family and friends over the world; a technology giving a voice to anyone with an internet connection; a way for small businesses to attract new customers and a potentially powerful tool for social change as news could be spread instantaneously. Facebook provides a platform and gives everyone, regardless of class, income, gender, race, or sexual orientation the ability to disseminate and receive information, which has not only led to important social justice movements, but has also held our society to greater accountability as transparency increased. That being said, we also noted that the commodification of the data it collects presented some unknown risks.
Since the first allegations of the spread of political propaganda, Facebook has raised a flag for the Sustainability and Impact (“S&I”) team. The most disturbing aspect of recent news regarding the mishandling of 50 million users’ data however, has been that Facebook knew about the breach back in 2015 and did not disclose the issue to its users or shareholders at the time. In fact, had it not been for a NY Times article and the cooperation of Christopher Wylie, who helped found Cambridge Analytica and worked there until late 2014 it is possible that Facebook may never have come forward to disclose the breach. It has also been reported that internal disagreements within Facebook’s legal, policy and security teams have led to the prioritization of business imperatives versus increased disclosure and transparency. These actions have been speculated to have been linked to Facebook’s recent announcement of the impending departure of the company’s chief information security officer. These issues raise serious governance concerns as well as a lack of product assurance on the part of Facebook; thus, the S&I team has placed Facebook under review and its inclusion in the S&I Strategy is currently being reconsidered.
We have sent a letter to the company demanding specific details on corrective action it plans to take in the aftermath of the data breach and the manipulation of the platform by nefarious actors. We have also initiated a coordinated engagement with other shareholders, particularly those in the EU Pension space, to amplify the voice of concerned stakeholders.
During the first quarter of 2018, the Fund initiated three new positions.
In the healthcare sector, we entered into a position in DexCom, a medical device company focused on continuous glucose monitoring systems for people with diabetes. The company’s share had declined precipitously since the autumn of 2017 on the concern over its competitors’ new product introductions. However, after conducting in-depth research, we believed DexCom’s product remains well-positioned in a growing market. Additionally, in our view, DexCom’s business model is inherently aligned with the promotion of health and is a positive contributor to society. Furthermore, we believe the company follows best-practices at the board level in terms of full independence of the audit, compensation and nomination committees and split roles of the Chairman of the Board and CEO.
The Fund initiated a position in EOG Resources, one of the leading E&P companies in the U.S. EOG Resources has been focused on high rate-of-return, premium drilling opportunities. It holds a large position in the Permian Delaware Basin, and has historically generated industry-leading returns on invested capital. With respect to its ESG performance, while EOG Resources lags its peers on disclosure for some material ESG issues, the company is a leader on others, such as water usage and leak detection and repair programs across all assets. The company has indicated an openness to ESG engagement on several issues from our initial dialogues, and we believe that EOG Resources is a leader in its performance on operational efficiency.
In the consumer sector we initiated a position in Japan’s Start Today, a leading internet shopping destination for apparels in Japan. Start Today was originally pitched to the investment team late in 2017; however, we felt the need to speak with the company and conduct further due diligence on their supply chain management. After multiple discussions and an in-person meeting at their headquarters in Japan, we felt comfortable initiating a position in Start Today with the intent to pursue ESG engagement.
The Fund eliminated Quest Diagnostics, Noble Energy and Chubb Limited to fund the purchase of these new positions as well as additions to existing holdings.
We believe financial services remain one of the most attractive sectors as they should benefit from the gradual tightening among major central banks. We believe net interest margins for banks should continue to expand, and rising rates could also create investment opportunities for insurance companies.
While the economic and earnings backdrop have remained supportive, President Trump’s unconventional approach to governing and his penchant to stay unpredictable in negotiations could create market jitters from time to time. We are concerned that the escalating trade tension with China could roil markets and affect business investment plans. However, our base case is that both sides achieve an acceptable compromise to avoid a lose-lose trade war.
We believe the market correction since February has created a healthier environment as some of the euphoria and irrational exuberance appears to have been washed away. As a case in point, the price of bitcoin, which had surged to close to $20,000 in December 2017, have now collapsed to below $7,000 at the time of this writing.
Global growth should remain on the expansion path, in our opinion, and U.S. economic growth will likely surprise on the upside after a softer start in the first quarter. With S&P 500 EPS projected to growth in the range of 15% to 20%, it is hard to see the market slipping into a sustained downturn.
With the current bull market and the U.S. economic expansion having entered its 9th year, low-hanging fruits appeared to have already been picked. As such, the Fund strives to find relatively undervalued stocks that may be temporarily out of favor. We believe stocks of some of the domestically focused U.S. companies could outperform due to the significantly lower tax rate triggered earnings upgrade. The Fund also continued to have an overweight in Financial Services on the belief that banks and insurance companies should benefit from monetary policy normalization