SIVBP - ClearBridge Appreciation Strategy Q3 2022 Portfolio Manager Commentary

Summary

• We believe material negative earnings revisions for the stock market are ahead and remain a headwind to equities searching for a durable bottom.
• With low unemployment, credit costs and delinquencies, strong consumer balance sheets, significant pent-up demand for houses and cars and many raw materials off sharply from recent spikes, we remain hopeful that any economic slowdown can be short-lived.
• We recommend a balanced approach, including both growth and value stocks, with an emphasis on quality companies; businesses that produce stable free cash flow with a track record of steady capital return should fare best in the near term.

Recession Threatens Earnings, But Could Be Short-Lived

Market Overview

The S&P 500 Index had a roller coaster third quarter. By mid-August, it had risen over 13% (and 17% from June lows). However, by the end of September the market gave back those gains —and then some — to close at fresh year-to-date lows. All said and done, the S&P 500 declined 4.9% for the quarter, leaving the year-to-date decline at 23.9%. We consider this pattern consistent with the last two extended bear markets (2008–09 and 2001–02), as each included at least one significant rally before making a final low.

The mid-quarter pivot was driven by hawkish comments by the Federal Reserve. Before this, investors had been optimistic the Fed could quell inflation and engineer a soft landing, perhaps even cutting interest rates in 2023. However, sentiment soured in mid-August with stocks taking another leg down as the reality of a more prolonged fight against inflation permeated market expectations.

The signposts we have referenced in recent commentaries as predictive of future economic activity and equity market opportunity deteriorated further in the third quarter. Credit spreads continued to widen (Exhibit 1) and the yield curve fully inverted, with the 10-year/2-year spread the most negative in over 20 years (Exhibit 2). The Fed remained intent on draining liquidity via aggressive interest rate increases and shrinking its balance sheet. BAA spreads reached 2%, high enough to indicate strain in the financial system.

Exhibit 1: Credit Spreads Indicate Some Strain

Exhibit 2: Yield Curve Fully Inverted

Consistent with prior tightening cycles, economic fundamentals started to deteriorate about six months after the first rate hike in March. PMIs are in steady decline, and railcar loadings declined mid-single digits during September. The number of ships waiting to be unloaded at the Port of Los Angeles fell from over 100 to less than 10. Commodity prices other than oil and natural gas plummeted. We believe material negative earnings revisions for the stock market are ahead and remain a headwind to equities searching for a durable bottom.

"The signposts we have referenced in recent commentaries as predictive of future economic activity and equity market opportunity deteriorated further in the third quarter."

International economies are even more challenged than the U.S. Europe is in a recession compounded by mid-double digit inflation caused by natural gas shortages. The U.S. dollar is up +17% this year, the strongest in more than 15 years. Dollar spikes in 1984 and 1997 created third world debt crises. We have not yet seen any signs of this, but we need to be mindful that a high dollar is stressful for other countries.

As we discussed last quarter, not all is gloom and doom. We start from a very good place. Unemployment at 3.5% is full, credit costs and delinquencies are at or near all-time lows, consumer balance sheets are in good shape, significant pent-up demand exists for houses and cars and many raw materials are off sharply from first-quarter and early second-quarter spikes. We remain hopeful that any economic slowdown will be short-lived.

The energy and consumer discretionary sectors were the only two sectors in the S&P 500 with positive absolute returns in the quarter. Energy remains the market-leading sector, having outperformed in each of the first three quarters of 2022, and it is the only sector that has produced positive returns year to date: up a whopping 35%.

Surprisingly, the best performing sector in the third quarter was consumer discretionary, which caught our attention as a potential early indicator of a more favorable risk environment. However, upon further analysis, outperformance was dominated by Tesla ( TSLA ) and Amazon.com ( AMZN ), which returned +18.2% and +6.4%, respectively. Although consumer discretionary outperformance bears monitoring, such narrow performance is not indicative to us of a sustainable change in leadership (indeed, much of Tesla’s third-quarter outperformance unwound in the first week of October).

The communication services, real estate, and materials sectors were the most notable laggards. Communication services has lagged in each quarter of 2022 and was the worst performing sector in both the first and third quarters. Third-quarter underperformance was driven by telecom and cable providers. The intensely competitive wireless industry has struggled with inflation-driven margin pressure and higher customer churn while the cable companies have vied for subscriber growth in the face of increased competition from fixed wireless and continued cord cutting.

Outlook

In our opinion the market decline to this point reflects higher interest rates but not yet the lower earnings from a likely recession. A cautious stance remains appropriate. We believe the probabilities favor incremental downside before a durable bottom is formed and a sustained uptrend can begin.

With the Fed unequivocal in its commitment to fight inflation, we expect the tightening liquidity environment to persist in the U.S. Moreover, investors today face an era of unprecedented global central bank tightening (Exhibit 3) with roughly half of all major global central banks raising rates (only China and Turkey are cutting rates).

This uncoordinated yet simultaneous global policy tightening initiative creates incremental uncertainty and increases the odds of a policy error and hard landing. We monitor the direction and level of interest rates, the strength of the dollar and corporate credit spreads as key inputs to assess liquidity conditions.

Exhibit 3: Central Bank Policy Rate Changes

Although the initial equity market selloff was driven by multiple compression, we expect the next stage of the downturn to be driven by falling profit expectations. Throughout 2021, we discussed how the S&P 500, although expensive, was buoyed by statistically significant positive earnings revisions. That dynamic has reversed. From a macro perspective, the PMI remains the best way to forecast corporate profit trends and, unfortunately, PMIs continue to decline (Exhibit 4). S&P 500 profit expectations will likely follow suit and turn negative.

Given we are only 90 days since S&P 500 earnings expectations topped, we are cautious heading into the coming earnings season and expect corporate guidance for 2023 earnings to further reduce expectations. Given current economic trends and a lag in consensus forecast changes, we would not be surprised if S&P 500 earnings in 2023 showed little to no growth versus 2022 (consensus currently expects 7% year-over-year growth).

Our emphasis is always to own companies with robust earnings and cash flow throughout the business cycle. Today we continue to favor more defensive industries like pharmaceuticals and insurance. Semiconductor stocks have declined precipitously but are only just starting to see weaker fundamentals and earnings cuts.

We are getting intrigued by valuations but the timing still seems early. Commodity stocks are cheap but also feel too early to buy. From a bottom-up perspective, our focus is on stocks where dominant market positions or “self-help” initiatives (such as overhead reduction plans) can support earnings growth despite a more challenging economic backdrop. Additionally, companies with meaningful capital return programs, either through dividends or large share buybacks, are likely to fare better.

Exhibit 4: ISM Manufacturing PMI a Leading Indicator of Earnings

We continue to believe investors should stay the course in equities although investor total return expectations should be muted near term. We recommend a balanced approach to the markets, including both growth and value stocks, with an emphasis on quality companies. That said, we believe effective Fed policy will reduce inflation over time and will offer patient, long-term investors the opportunity to purchase high-growth shares at better prices. To make a durable bottom, we need to see stock prices decline to a level where investors are willing to add risk and duration to their portfolios and for market breadth to expand to include small and mid cap companies.

It’s important to remember the market is a discounting mechanism and will make its bottom before earnings and the economy trough. Stocks continue to react aggressively to earnings misses or lowered guidance, indicating that the market is struggling to discount an appropriate level of future profits. Given such volatility, rather than trying to project near-term earnings trends, we believe it is better to look out two to three years and make investment decisions based on the longer-term, sustainable growth rates of companies.

Portfolio Highlights

The ClearBridge Appreciation Strategy outperformed the benchmark S&P 500 Index in the third quarter. On an absolute basis, the Strategy had positive contributions from two of 11 sectors. The consumer discretionary sector was the main positive contributor to performance, while the communication services, information technology ((IT)), health care and financials sectors were the main absolute detractors.

In relative terms, stock selection and sector allocation contributed to outperformance. In particular, stock selection in the IT and consumer staples sectors boosted relative returns. Stock selection in the financials sector and an underweight to the consumer discretionary sector detracted the most.

On an individual stock basis, the biggest contributors to absolute performance during the quarter were Enphase Energy ( ENPH ), TJX Companies ( TJX ), Automatic Data Processing ( ADP ), Walmart ( WMT ) and Amazon.com ( AMZN ). The biggest detractors were Microsoft ( MSFT ), Raytheon Technologies ( RTX ), Comcast ( CMCSA ), Adobe ( ADBE ) and Visa ( V ).

During the quarter, we sold our positions in SVB Financial ( SIVB ) in the financials sector, Cisco Systems ( CSCO ) in the IT sector and Toll Brothers ( TOL ) in the consumer discretionary sector.

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

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