Q1 2019 Commentary
During the first quarter of 2019, equities experienced one of its strongest quarters in recent memory. The MSCI ACWI Index (Gross) returned 12.35%. The gains were led by the two largest economies in the world -- the S&P 500 Index was up 13.65% and the MSCI China Index climbed 17.74% during the quarter.
There were three main drivers of the equity rally. First, was the FED. The Fed’s shift to a highly dovish stance helped to ease financial conditions allowing investors to have more confidence in the potential to extend the expansion cycle. Second, news leaks from the Sino-U.S. trade negotiations suggested that good progress was being made and that there was the potential for a deal to be signed in the near future.
And finally, Chinese policymakers continued to provide stimulus to stabilize and reflate the economy. The rally also extended to the energy and base metal complex. Oil prices rallied more than 30% and copper prices had double-digit gains.
However, while risk assets were rallying, economic fundamentals around the world deteriorated further. The Manufacturing Purchasing Managers Index in Japan and Germany both dipped below 50 (a reading below 50 means contraction); the U.S. Manufacturing PMI also decelerated. Bellwether companies such as Fedex, Dow, DuPont reduced earnings expectations sighting the challenging macro environment. The Fed’s sharp dovish turn triggered a sharp decline in sovereign bond yields across developed markets and toward the end of the quarter it resulted in the 3-month/10-year U.S. Treasury yield curve inversion. This had not happened since 2007.
The 3-month/10-year curve inversion triggered a brief pullback in equities, but they soon snapped back and climbed to higher levels. The yield curve inversion turned out to be short-lived, and we believe it does not necessarily signal an imminent end to the U.S. economic expansion. We believe the brief inversion was similar to what had happened in September 1998, when the Russian default and overseas weakness led to a brief inversion. Indeed, overseas markets have started to weaken since the middle of 2018, however, there are currently no convincing signs of a bottoming. That said, one positive development was the release of China’s manufacturing PMI data for March, which rose above 50.
For the global equity market, as measured by the MSCI ACWI Index, the best performing sectors during the first quarter of 2019 were information technology and REITs. Fundamentals for the technology sector were mixed at best, as the semiconductor sector was still in the midst of a cyclical downturn. However, investors were looking past this down cycle in anticipation of the eventual upturn. REITs performed well due to its bond proxy characteristics. The weakest sectors during the first quarter of 2019 were healthcare and financial services. The former may have been affected by rising populist rhetoric among politicians on both sides of the aisle in Washington, and the latter was hurt by concern over the flattening and inverting yield curves.
The equity holdings in Mackenzie Global Sustainability and Impact Balanced Fund lagged the benchmark during the quarter largely due to a challenging second half March. Idiosyncratic issues took place during a span of a few trading sessions and hit a few positions especially hard. We believe some of these pullbacks were overdone and expect them to recover in the coming months. We believe the portfolio is well-positioned and we remain confident in the prospect for outperformance.
The financial services and utilities sectors were the biggest detractors during the quarter. Banking stocks were hit hard by the continued yield curve flattening and inversion. The Fund also had an idiosyncratic issue with Swedbank’s shares being down 30% on the allegations of having facilitated money laundering in their Estonia branches years ago. We believe Swedbank has already tightened its anti-money laundering procedures in recent years, and that the fallout from the past issues should be contained.
The biggest contributor to relative performance was the communication services sector, with Facebook rising 27% during the quarter. Spark Therapeutics was also a significant contributor as it agreed to be acquired by Roche at a substantial premium.
The Fund initiated several new positions. Two, Continental AG and TE Connectivity, were in auto-related space as we tried to position for a potential recovery in the auto sector. Continental AG traded at a low valuation despite its strong position to capture a growing share in automotive parts for electric vehicles. TE Connectivity should see greater bill of materials per vehicle as the industry embraces more technology and sensors. These purchases were partially funded by selling Hyundai Motor Company.
The Fund also initiated a position in Apple Inc. after the company took down guidance on disappointing sales in China. We were cautious about Apple’s pricing strategy and believed that this downward revision has largely reflected the impact of that flawed pricing strategy. However, Apple remains a high-quality company with a loyal customer base that we believe should generate strong and steady free cash flow for the company. Another new holding is Micron Technology. Micron is a U.S. based company operating in the design and construction of computers, semiconductors, and other products. In the healthcare we initiated two new positions – Covetrus Inc. and Neurocrine Biosciences. Covetrus is a spin-off from Henry Schein Inc. and is a provider of animal-health technology and services. We believe there is a lot of growth potential in animal-health and the spin-off will also create a more focused management. Neurocrine Biosciences is a biopharma company focused on neuropsychiatric, neuroinflammatory and neurodegenerative diseases.
Mexico’s Cemex is a company that we have engaged with for quite some time. Recently, our efforts engagement efforts have taken a positive step forward with Cemex announcing that it would nominate a woman to its board in 2019. The company also disclosed ESG information at its capital markets day. Both were specific asks from our ESG team.
Rockefeller Asset Management co-filed a shareholder resolution requesting disclosure on Comcast’s policies and procedures, its direct and indirect lobbying payments. Comcast announced that it would make several changes including leaving the American Legislative Exchange Council (ALEC), disclosing the names of “principal” trade associations and redesigning its webpage that houses its political activity policy and disclosures to make it easier to find.
The total return on Swedbank’s shares is -25% since mid-February when media reports surfaced of money laundering transactions conducted through Swedbank’s Estonian operations from 2009 to 2016. We continue to hold the shares, as we believe there is compelling value at 8x earnings and over 9% dividend yield. It is a well-capitalized institution with good profitability. Further, we believe that the bank has the financial cushion to withstand expenses from regulatory fines, litigation, and other compliance costs resulting from the anti-money laundering scandal. That said, the negative headlines continue. From an ESG standpoint, we believe that ESG-integrated fundamental analysis coupled with active ownership practices can deliver strong long-term results for our clients. Our goal is to build a virtuous cycle of creating shareholder value while improving a firm’s ESG footprint. As this relates to Swedbank, we have identified concerns with their governance structure and are considering collectively engaging with management. The objective is to improve Swedbank’s governance structure, seeking to ensure appropriate checks and balances are in place.
Our macro view remains that the U.S. economy will likely decelerate to around trend-line but avoid a recession in 2019 while the global economy, spurred by China’s reflation efforts will see better growth in the second half of 2019. As such, we believe there is still upside left for the equity market. However, given the strong gains during the first quarter, we suspect the bulk of the potential returns for 2019 may have already been attained.
Following the strong gains in the first quarter, we believe equities are likely to go through a phase of consolidation and a pullback may also be possible. The earnings reporting season in April and May is likely to be a mixed bag at best, as the U.S. economy is decelerating while overseas economies have yet to bottom out. We also observed that, historically, rebounds off deep equity market corrections were consistently followed by another pull-back. It is hard to make the case that the current cycle will be different from the past. That said, we do not expect the market to retest the lows of December 2018 as the Fed has turned very dovish, which should help support sentiment and extend the length of the economic expansion.
In addition to corporate earnings reports, we believe the resolution of the U.S.-China trade disputes could be another catalyst for the market. While investors have come to expect a trade deal, early removals of existing tariffs would be an incremental positive. In short, we have a neutral view for the near term but still expect the market to finish higher by year end.
The market’s roller-coaster ride over the last two quarters had sector rotation trumping stock selections.
Looking forward, we see compelling values in the financial services sector and in auto-related stocks. U.S. banks have the strongest capital positions in nearly eight decades. Higher quality European banks appear to have healthy amounts of excess capital and elevated dividend yields. As such, we have continued to overweight Financial Services and have increased our auto exposure. We also believe stock picking will start to exert more impact than top-down sector rotation. We will continue to look for and be patient with what we consider undervalued stocks as markets grapple with conflicting signals in this extended expansion cycle.