YLDE - ClearBridge Appreciation Strategy Q2 2023 Portfolio Manager Commentary

2023-07-13 12:30:00 ET

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Although mega cap technology garners headlines given its contribution to index performance, market breadth and industry group performance suggest investors are in a risk-on mood with the prospect of a recession still in the distance.
• The current combination of increased optimism and elevated multiples suggests that patient investors will be rewarded with better buy opportunities in the future.
• We are positive on property and casualty insurers due to broad-based pricing power, industrials tied to the energy transition, and materials companies —such as coatings — that benefit from moderation in raw material costs.

By Scott Glasser, Michael Kagan, & Stephen Rigo

Equity Market Risks Have Only Grown in 2023

Market Overview

The S&P 500 Index’s ( SP500 , SPX ) 8.7% return in the second quarter felt nearly identical to its 7.5% return in the first quarter as mega cap technology continued to dominate index performance. Thematically, the same crosscurrents were also evident. On the positive side, investors remain exuberant over the potential of generative AI to revolutionize how we work and live; the economy is expanding and consumer spending resilient; and goods inflation, primarily food and energy, continues to moderate. On the negative side, the banking system remains under stress, making access to credit scarcer and more costly; wage inflation is high and sticky; the Fed is steadfast in its fight against inflation; and leading economic indicators and the yield curve suggest a recession is inevitable.

In 2022 there was a growing chorus that — after years of S&P 500 performance being dictated by a handful of mega cap technology companies — that higher rates would benefit a well-diversified portfolio and lead to a sustained rebound in value stocks relative to growth. Although we still believe this to be true, it belies the reality of the past six months, in which the Nasdaq 100 ( NDX ) posted its best first half ever, up 38.75%. Year to date, the sensational seven (Alphabet, Amazon.com, Apple, Nvidia, Meta Platforms, Microsoft and Tesla) contributed 73% of the S&P 500’s return, despite accounting for “only” 24% of the benchmark weight (Exhibit 1).

Exhibit 1: Contribution to S&P 500 Performance Year to Date

Although the quarter started strong with the S&P 500 up 2.7% in April, it was Nvidia’s ( NVDA ) eye-opening earnings report in late May that fanned the flames of the technology bull market. Nvidia shares surged 24% after guiding July quarter revenue and EPS 53% and 90% above consensus, respectively. The July quarter revenue outlook was a whopping $11 billion versus $7.2 billion consensus, the largest post-earnings upward revision in semiconductor industry history. Tech momentum carried on into June where the S&P 500 tacked on another 6.6%. In another analog to the first quarter, only three sectors outperformed the S&P 500: IT, consumer discretionary (driven by Amazon and Tesla), and communication services (driven by Alphabet, Netflix and Meta), leaving these sectors dramatically ahead of the market year to date.

On the flip side, the eight other sectors underperformed the S&P 500 for a second consecutive quarter, with energy and utility shares pacing the laggards. Energy continues to struggle as the price of oil is trying to find a bottom near year-to-date lows of $70 per barrel. Utilities appear to be a victim of higher interest rates, a heavy investment cycle and a risk-on market mentality despite reasonably strong trends in power consumption.

Although mega cap technology garners headlines given its contribution to index performance, market breadth and industry group performance suggest investors are in a risk-on mood with the prospect of a recession still in the distance. Breadth improved materially in the second quarter. Today 69% of stocks are trading above their 50-day moving average, up from a paltry 34% at the end of March (and above the long-term average of ~51%). Moreover, away from technology, economically sensitive industry groups such as homebuilders, construction materials, travel & leisure (specifically airlines and cruise lines) and machinery are outperforming, while traditionally defensive corners such as utilities, telecoms, and consumer staples are lagging. In the short term, there is little doubt the market is in an uptrend with offensive industry groups leading.

It has been our view for the past few quarters that a Fed-induced recession is a matter of “when,” not “if.” We still believe this to be true, albeit the economy’s resilience to this point has caught us by surprise. However, with wage inflation persistent (+6% YoY) and the job market still strong (the unemployment rate is only 3.6%), the Fed will need to further restrict financial conditions. Over time, this should slow economic growth, create labor slack and ultimately quell inflation. In addition, money supply is shrinking (for the first time in over 25 years), credit is more expensive and harder to access, the COVID-19-driven consumer savings glut is nearly spent, student loan repayments will shortly resume, and capital spending intentions are in decline. In the past 60 years, the rolling six-month average of leading economic indicators has never been below -0.25 without a recession. The current reading is -0.72, and it has been below -0.25 since June 2022 (Exhibit 2).

Exhibit 2: Leading Economic Indicators Suggest a Coming Recession

Although cautious, we have not been outright bearish as investor consensus had recession as the base case, which we felt was partially reflected in buy-side EPS expectations. In addition, before the current rally, the market’s P/E ratio had returned to near historic averages. However, our view is the investor base case has shifted to a soft landing or no recession while the market P/E ratio is now one standard deviation above its historic average (Exhibit 3). The gap between reported earnings and national income and product accounts (NIPA) earnings, which adjust out non-GAAP items, is the greatest ever, suggesting valuation is even more strained. The current combination of increased optimism and elevated multiples suggests that patient investors will be rewarded with better buy opportunities in the future.

Exhibit 3: S&P 500 12-Month Forward Price-Earnings Multiple

Outlook

We take Chairman Powell at his word that the Federal Reserve will continue to tighten until it achieves its 2% inflation mandate. As such, we believe higher interest rates and tighter financial conditions will ultimately create labor market slack, reduce consumer spending and ultimately lead to a recession. Increasing investor expectations for future sales and earnings (Exhibit 4) in the face of declining GDP (Exhibit 5) and elevated P/E multiples tells us the risk to equity markets has only grown year to date.

Exhibit 4: S&P 500 EPS Growth Year Over Year

Exhibit 5: Nominal GDP Growth Year-Over-Year

We continue to believe high-quality companies with stable and growing free cash flows, ample liquidity, fortress balance sheets and shareholder-friendly capital allocation are likely to outperform. We are cautious on cyclicals tied to credit and the consumer, such as banks, homebuilders, home improvement retailers and brand name apparel. While we are optimistic about the long-term benefits generative AI will have on workplace productivity, we believe the near-term impact is overestimated in share prices for many of the perceived beneficiaries. We are positive on property and casualty insurers due to broad-based pricing power, industrials tied to the energy transition, and materials companies —such as coatings — that benefit from moderation in raw material costs.

Conclusion

Throughout 2022 we asserted investor total return expectations should be muted near term. Despite the powerful year-to-date rally, we continue to maintain this stance. Although the economy has proven to be more resilient to tighter financial conditions than we expected, we believe a recession is inevitable and potentially more severe given higher market expectations and multiples and continued stress on our banks. We expect at least a normalization of credit costs beginning in the second half of the year, with the potential to overshoot in 2024.

We are long-term investors. Rather than trying to project near-term earnings trends, we believe it is better to lookout two to three years and make investment decisions based upon our assessment of a company’s longer-term, sustainable growth rate relative to what is implied in today’s share price. As out-year expectations moderate for growth stocks we would be more comfortable adding risk to the portfolio.

As active managers, fundamental stock pickers, and believers that a diversified portfolio will deliver risk-adjusted alpha over a market cycle, we look forward to a less narrow market with normalized volatility. For the Fed to be successful in achieving its inflation mandate, we believe such an environment will have to return. In the meantime, we are building lists of stocks to own for the long term and stand ready to take advantage of the temporary price dislocations that volatility and bear markets create.

Portfolio Highlights

The ClearBridge Appreciation Strategy underperformed the benchmark S&P 500 Index in the second quarter. On an absolute basis, the Strategy had positive contributions from nine of 11 sectors. The information technology (IT), consumer discretionary and communication services sectors were the main positive contributors to performance, while the real estate and utilities sectors were the detractors.

In relative terms, stock selection contributed positively while sector allocation detracted. In particular, stock selection in the materials, IT, health care and consumer staples sectors and an underweight to the utilities sector contributed to relative returns. Conversely, stock selection in the industrials and communication services sectors, underweights to IT and consumer discretionary sectors and an overweight to the materials sector dragged on relative performance.

On an individual stock basis, the biggest contributors to absolute performance during the quarter were Microsoft ( MSFT ), Apple ( AAPL ), Nvidia, Amazon.com ( AMZN ) and Alphabet ( GOOG , GOOGL ) . The biggest detractors were Thermo Fisher Scientific ( TMO ), United Parcel Service ( UPS ), Progressive ( PGR ), ArcelorMittal ( MT ) and T-Mobile ( TMUS ).

During the quarter, we initiated new positions in Netflix ( NFLX ) in the communication services sector, Marvell Technology ( MRVL ) in the IT sector and Charles River Laboratories ( CRL ) in the health care sector. We exited positions in Palo Alto Networks ( PANW ) and Enphase Energy ( ENPH ) in the IT sector, Bayer ( BAYRY ) in the health care sector and Marriott International ( MAR ) in the consumer discretionary sector.

Scott Glasser, Chief Investment Officer, Portfolio Manager

Michael Kagan, Managing Director, Portfolio Manager

Stephen Rigo, CFA, Director, Portfolio Manager

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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