Q2 2018 Commentary
- During the second quarter of 2018, global equities, as measured by the MSCI ACWI Index, mounted several rallies but ultimately finished at roughly where they had started. The big mover during the quarter was the U.S. Dollar, whose renewed strength depressed returns of non-U.S. markets in U.S. dollar terms. The stronger U.S. dollar also increased the pressure on emerging markets that depended on external funding. The surprise of the quarter, however, was the sharp depreciation of the renminbi in June. Some have interpreted the yuan’s sharp decline as a response to Donald Trump’s protectionist trade policies; however, this speculation was subsequently refuted by the People’s Bank of China.
- The U.S. economy was the standout during the quarter as the global economy has evolved from 2017’s synchronized recovery mode to a rather mixed environment. The positive impacts of the U.S. government’s fiscal policy and deregulation more than offset the effect of the Federal Reserve’s continued tightening of monetary policy. U.S. unemployment rate hit 18-year lows and a shortage of qualified workers has become a widespread challenge for some businesses.
- Europe was hit with policy issues ranging from Italy’s embrace of populist measures to discord within German Chancellor Merkel’s coalition on migrant policies. The euro lost ground as the European Central Bank (ECB) indicated that its negative 40 bps policy rate will be maintained well into 2019. The Chinese economy was confronted with tighter liquidity and the risk of a trade war with the U.S. Many emerging markets were hit with a combination of currency devaluation and rising interest rates as the global liquidity backdrop turned more challenging in the face of continued Fed tightening.
- With Donald Trump having accomplished his major domestic initiative of tax cuts, he has shifted his attention to foreign policies and trade, which have resulted in elevated uncertainty for markets and policymakers. His long-held protectionist instinct has taken over and the trade issue may drag on for a while. Ironically, Trump’s aggressive style made it difficult for other countries to make a compromise with the U.S. as no one wants to be seen as being bullied by the U.S. president. Trump’s unilateral withdrawal from the multilateral agreement with Iran has also pushed up crude oil prices as it is unclear how much of Iran’s oil production will be removed from the market once the U.S. sanctions take effect in November.
- For the global equity market as measured by the MSCI ACWI Index, the best performing sectors during second quarter 2018 were Energy, Information Technology, and Discretionary. These three sectors were also the best performers YTD through June 2018. The Energy sector’s performance reflected rising crude oil prices. However, the outperformance in Information Technology and Discretionary largely reflected the narrowness of the market leadership – the so-called “FAANG” (Facebook, Apple, Amazon, Netflix and Google) stocks and some tech stocks.
- The worst performing sectors during second quarter 2018 were Financial Services and Telecom Services. These two sectors were also the biggest decliners on YTD basis. The underperformance of the Financial Services sector was partially due to the ECB’s dovish stance of late, which hurt the euro and the prospect of European banks improving net interest margins in a rising interest rate environment. In the U.S., money center banks’ underperformance may be partially due to the flattening yield curve. The telecom sector’s underperformance may reflect the rising interest rate environment which typically hurts higher dividend yielding stocks as they are viewed as bond substitutes.
- The Fund’s equity holdings performed well in 2Q18 despite an underweight to technology and an overweight in the financials. The outperformance was led by the consumer discretionary sector and Japan’s Start Today with a 41% gain. Nike also continued its comeback with a 20% gain during the quarter. The industrials sector was the main detractor during the quarter hurt by the performance of KION Group AG’s 22% decline in the absence of any visibly negative news. Southwest Airlines also declined further as the engine issue that led to one fatality has continued to hurt the company’s bookings.
- Toward the end of the first quarter, Facebook’s stock declined sharply on concerns of user privacy after the data misuse by Cambridge Analytica was exposed. Since then, Facebook has rallied sharply and achieved new highs but concerns remain. We continue to own Facebook and to engage with the company. By doing so, we learned that Facebook is taking new steps in investigating and auditing apps and vendors for any misuse of data, and is looking to understand potential misuse of data by third parties. They shut down the practice of retargeting ads. In Europe, Facebook “secured consent” from users on sharing data, and will start implementing the “secured consent” globally. With respect to youth, Facebook is working on strengthening parental controls. Facial recognition for minors is turned off in Europe where the European GDPR imposes age restrictions. A challenge for Facebook is the fact that each country has a different age restriction for obtaining parental consent. Regarding political ads, in the aftermath of Cambridge Analytica scandal Facebook is working on verification of authenticity of all sources of political advertising. Facebook intends to use security sensors for misuse of information.
- We also continue to engage and own Nike (which performed well in the 2Q18). In April, as Nike was dismissing several executives due to improper workplace conduct, we spoke with the company to discuss how it was looking to address this issue and reverse the negative workplace culture. Nike informed us that besides establishing a new “respect hotline” to deal specifically with these types of issues, they were investing heavily into their recruitment process by conducting unconscious bias training for their recruiting managers (which would be extended to all employees) and revising their recruitment channels and language used in job descriptions.
- The Fund initiated two positions in Hexcel Corp. and Total SA. Hexcel Corporation, is a leading manufacturer of composite materials for the aerospace industry and appears to be well positioned for long-term growth as aircraft manufacturers seek to improve fuel efficiency by using the lighter composite materials. What are the ESG arguments for buying Hexcel? Hexcel’s advanced compounds enable fuel efficiency, reduce carbon emissions and seek to provide a safer and stronger material for commercial aircraft. Hexcel also contributes to the transition to a lower carbon economy through their advanced carbon fiber compounds utilized in wind turbine blades. Although 17% of Hexcel's sales are exposed to defense and space end markets, we deem the materials produced and provided by Hexcel are non-lethal in nature.
- We believe Total SA, a vertically integrated energy company, is poised to be a strong free cash flow generator in the coming years as the company has completed a multi-year period of elevated capital investments. From an ESG perspective, why buy Total SA? Total SA has appropriately implemented climate change into its overall business strategy. Total seeks to expand its exposure to renewable energy to about 15-20% of its entire portfolio; this goal suggests positive directionality of its business model towards a lower-carbon economy. Additionally, in preparation for regulatory changes, Total seeks to measure the robustness of its future long-term investments by using an internal carbon price of $30-$40 per ton, depending on the price of oil. As Total operates globally, including in countries considered at risk of corruption, the company has implemented rigorous human rights practices, including policies and human rights assessments. Finally, Total receives high marks in terms of governance as 50% of its board includes women; the board includes appropriate expertise with backgrounds in energy, international regulation, human resources, renewable energy, financials, and the automotive sector.
- The Fund eliminated several positions, including profit-taking on U.K.’s Berkeley Group Holdings and Italy’s Luxottica Group. The Fund also sold its position in BMW out of concern for the brewing trade war.
- Since the start of 2017 growth companies, led by the FAANG stocks, have been outperforming value stocks by a wide margin. We believe the big divergence between growth and value stocks will not likely be sustained, and that select value stocks now offer attractive values and may be poised to outperform due to relatively subdued investor expectations.
There is the risk that President Trump’s dangerous “game of chicken” in trade policy could go too far. We suspect Trump’s initial expectation was that, given the U.S. market’s large size, he could pressure its trading partners into making concessions to reduce the U.S. trade deficit, as was the case with South Korea. However, with China and the EU unlikely to publicly back down, the risk of lose-lose trade war escalation is now on the rise. It may take a market correction as a circuit breaker to pressure President Trump to back off some of the contentious demands.
- Global growth should remain on the expansion path, in our opinion, as the U.S. economy has benefitted from aggressive fiscal stimulus and deregulation. With S&P 500 EPS projected growth at roughly 20% from last year and the probability of a recession in the next 12 months remaining low, we believe the bull market is still intact and further gains are more likely than not.
The Fund is maintaining its overweight position in the Financial Services sector on the expectation that many U.S. financial institutions will continue to expand their net interest margins. We also believe some of the non-U.S. financial services stocks appeared to have discounted much potential bad news, which could set them up for outperformance as the macro-environment stabilizes. The Fund will remain opportunistic and seek stocks that are temporarily out of favor but possess the ability to be turned around. We also suspect value stocks may finally start to outperform growth as the U.S. reflation theme plays out.