TSLA - ClearBridge Appreciation Strategy Q3 2023 Portfolio Manager Commentary

2023-10-15 05:50:00 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.
• A sharp rise in rates, a higher dollar, and threats to consumer spending from higher oil prices and the end of the student debt repayment moratorium caused the market’s momentum in the third quarter to fizzle.
• Although a 3% third-quarter decline within the context of a S&P 500 up 13% year to date may seem like healthy consolidation within the construct of a longer-term bull market, we are concerned that the average stock is mired in a downtrend.
• We believe 2023’s market increase is a rally in a multiyear bear market and that we need to retain a conservative tilt to our portfolio.

By Scott Glasser, Michael Kagan and Stephen Rigo

Caution: Most Stocks Stuck in the Mire

Market Overview

Despite a strong start in July, the S&P 500 Index finished the third quarter down 3.3% as momentum fizzled in August and September. The most likely explanation for the drop was the relentless increase in interest rates. 10-year U.S. Treasury yields broke above their October 2022 highs in early August, then surged above 4.5% by quarter end. Even with strong earnings reports, Microsoft ( MSFT ) modestly underperformed the market and Nvidia ( NVDA ) managed only a marginal gain, suggesting equity markets may have valued fully the near-term generative AI opportunity. The higher dollar and threats to consumer spending from higher oil prices and the end of the student debt repayment moratorium also weighed on returns.

During the third quarter only two sectors advanced in absolute terms: energy and communication services. Energy stocks rose 12% on the tailwind of an increase in the price of oil from $70 to $90. Communication services stocks posted a much more modest +3% return but hold the distinction of being the only sector to outperform the S&P 500 in all three quarters of 2023. Traditional media stocks contributed to the sector’s relative outperformance while digital advertising and AI momentum drove continued outperformance at Alphabet ( GOOG )( GOOGL ) and Meta Platforms ( META ).

Of the nine sectors that declined, the worst by far were the interest-rate-sensitive real estate and utilities sectors, which have underperformed in all three quarters of 2023. Utilities have now underperformed the S&P 500 by a whopping 28 percentage points in 2023. Real estate is a debt-laden sector facing a dramatically higher cost of capital. New to the underperform list were information technology ((IT)) shares, which gave back a little relative to the market in the quarter but still reign supreme on almost any longer-dated time horizon. The more defensive technology stocks, Apple ( AAPL ) and Microsoft, underperformed, while AI plays held up better.

Why did the 10-year Treasury yield rise so sharply? While many measures of inflation moderated, especially the key Personal Consumption Expenditures Price Index (PCE), the Federal Reserve and the bond market may be looking for an acceleration in wage increases (Exhibit 1). The unemployment rate is low at 3.8% and the surge in union activity — the Air Line Pilots Association and Teamsters settlements, the United Auto Workers and Kaiser Permanente strikes — suggests the job market is tight. Major retailers including Walmart ( WMT ), Target ( TGT ) and TJX ( TJX ) cautioned that higher wages will pressure SG&A. In a soft landing scenario unemployment will fall and keep upward pressure on wages.

Exhibit 1: Wage Growth Remains on Accelerate

As of Aug. 31, 2023. Source: ClearBridge Investments, Atlanta Fed, Bloomberg Finance.

U.S. government debt passed a dangerous line in July and Treasurys are no longer looking like a riskless asset. Growth in interest expense on U.S. debt in dollars now exceeds dollar GDP growth, threatening a debt spiral. The budget deficit is running 7% despite full employment and will be far higher in a recession. To manage the deficit, the government faces stark choices the next few years, specifically higher taxes and lower spending. The term premium on bonds has risen from the -1% to -2% range of the last decade to about 0%, and it could potentially rise to the 2% area that was normal in the 1990s and 2000s.

International markets also contributed to the rate increase. Chinese economic malaise forced China’s central bank to sell Treasurys to support the yuan. Meanwhile, the Bank of Japan was forced to loosen yield curve controls, causing upward pressure on U.S. rates as traders unwound a carry trade.

"We take Fed Chair Powell at his word that policy will remain restrictive until inflation is quelled."

A key for the market going forward is whether higher rates will turn the soft landing into a recession. Although the economy’s resilience to this point has caught us by surprise, we see signs today that the probability of a recession remains high. The yield curve has been inverted for 15 months and the Fed’s balance sheet has shrunk 10% from its peak. The flipping of the yield curve from inversion to its normal upward slope has historically been one of the best indicators of an incipient recession.

Consumer spending generates two-thirds of GDP and has been a stalwart supporting economic growth this cycle. However, the personal savings rate has been below the 2016–19 level for the past year, meaning consumers are spending beyond their means and eating into the savings glut from COVID stimulus. We estimate the excess savings will be fully spent around calendar year-end (Exhibit 2). The student loan payment moratorium has ended. Mortgage and car loan rates are the highest in 16 years. As such, we see a spending slowdown and credit normalization occurring in 2024. We believe slowing consumer spending will be evident after the holiday shopping season as bills come due, manifesting itself in lower 2024 spend and normalization in consumer loan (credit card) delinquencies.

Exhibit 2: Declining Consumer Savings Could Hurt Spending

As of Aug. 31, 2023. Source: ClearBridge Investments, Bureau of Economic Analysis, Bloomberg Finance.

Finally, we take Fed Chair Powell at his word that policy will remain restrictive until inflation is quelled. To quote Powell from September 20, “You know sufficiently restrictive policy only when you see it. It’s not something you can arrive at with confidence in a model or various estimates.” Moreover, Powell is all too aware of the inflation double-dip that occurred during the Burns/Volcker chairmanships of the 1970s and 1980s (Exhibit 3). We believe Chairman Powell understands that getting inflation down is not the same as keeping inflation down. We expect restrictive monetary policy until the data confirms success. Our fear is that once data confirms success in battling inflation, it will be too late for a soft landing as data lags economic realities.

Exhibit 3: Inflation Has Quickly Rebounded in the Past

As of Aug. 31, 2023. Source: ClearBridge Investments, Bureau of Labor Statistics, Bloomberg Finance.

Although a 3% third-quarter decline within the context of a S&P 500 up 13% year to date may seem like healthy consolidation within the construct of a longer-term bull market, we are concerned that the average stock is mired in a downtrend. For example, only 15% of S&P 500 stocks are above their 50-day moving average versus a long-term average of 55% (Exhibit 4). Small cap stocks show similarly weak breadth and are up only 2.5% year to date, having given up the majority of gains accrued post-COVID stimulus. Finally, despite IT underperforming the S&P 500, the concentration of S&P 500 returns got worse in the third quarter. At quarter end, the “Magnificent Seven” (Alphabet, Amazon.com ( AMZN ), Apple, Microsoft, Nvidia, Meta Platforms and Tesla ( TSLA )) accounted for 11 percentage points of the 13% year-to-date advance, an 84% contribution to return despite being only 25% of the index’s weight. This same measure stood at 82% and 73% contribution for the first quarter and first half of the year, respectively. In sum, the S&P 500’s performance remains propped up by a cohort of mega cap growth stocks, while the average security is trending down. In our experience a narrow market with weakening fundamentals is a signal to be cautious.

Exhibit 4: Most Stocks Are Well Below 50-Day Moving Average

As of Sept. 30, 2023. Source: ClearBridge Investments, Bloomberg Finance.

Outlook

We believe that this year’s market increase is a rally in a multiyear bear market and that we need to retain a conservative tilt to our portfolio. We take Powell at his word that the Fed will keep financial conditions tight until it achieves its 2% inflation mandate. We are skeptical that wage inflation expectations can fall enough to meet that mandate without a material increase in the unemployment rate and the recession that would entail.

Today’s market shows many signs of danger. Stock market valuations are in the 90th percentile on almost all measures, leaving little room for error. As shown by the record spread between the National Income and Product Accounts (NIPA) earnings and reported earnings, earnings quality is poor. The federal government has a 7% budget deficit and faces a debt spiral, limiting its options should we face a recession. The average stock is in decline.

While we are optimistic about the long-term benefits generative AI will have on workplace productivity, aggressive assumptions need to be made to justify current valuations. We are positive on much of the health care sector as market expectations for medical device and life science/tool companies have come in markedly. We find the non-cyclical nature and modest valuation of pharmaceutical companies appealing. We are positive on property and casualty insurers due to their broad-based pricing power. Select industrials will see outsize growth from the energy transition. We also like materials companies such as coatings that benefit from moderation in raw material costs.

We believe investor total return expectations should be muted for the near term. But we are long-term investors. 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 upon our assessment of a company’s longer-term, sustainable growth rate relative to what’s implied in today’s share price. As out-year expectations moderate for growth stocks we would be more comfortable adding risk to the portfolio. In the meantime, we are building lists of stocks to own for the long term and stand ready to take advantage of price dislocations if they occur.

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 energy and communication services sectors were the sole positive contributors to performance, while the IT and industrials sectors were the main detractors.

In relative terms, sector allocation contributed the most, in particular an overweight to the energy sector. Stock selection in the consumer discretionary, consumer staples, health care and financials sectors were also beneficial, while stock selection in the IT, materials, industrials and energy sectors detracted.

On an individual stock basis, the biggest contributors to absolute performance during the quarter were Alphabet, Eli Lilly ( LLY ), Exxon Mobil ( XOM ), Automatic Data Processing ( ADP ) and Chevron ( CVX ). The biggest detractors were Apple, Microsoft, RTX ( RTX ), Merck ( MRK ) and Honeywell ( HON ).

During the quarter, we exited positions in Teledyne Technologies ( TDY ) in the IT sector and Verizon ( VZ ) in the communication services sector.

Scott Glasser, Chief Investment Officer, Portfolio Manager

Michael Kagan, Managing Director, Portfolio Manager

Stephen Rigo, CFA, Director, Portfolio Manager

Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

Performance source: Internal. Benchmark source: Standard & Poor's.

Copyright © 2023 ClearBridge Investments, LLC

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