FMXUF - First Eagle Overseas Fund 2nd Quarter 2023 Commentary

2023-08-20 10:35:00 ET

Summary

• First Eagle Investments is an independent, privately owned asset management firm dedicated to serving the needs of individuals and institutions worldwide as well as the financial professionals that advise them.
• Overseas Fund A Shares posted a return of 0.67% in second quarter 2023.
• The second quarter of 2023 saw a rebound in technology stocks, driving gains in equity markets.
• Equity and fixed income markets are sending conflicting signals, with equity markets pricing in a soft landing while fixed income markets show warning signs.
• Shifting international dynamics, such as weak currencies in China and Japan and appreciation in Latin American currencies, may create investment opportunities.

Overseas Fund Market Overview

The continued rebound of beleaguered technology stocks-which were among the hardest hit during last year's selloff-was the story in equity markets during the second quarter of 2023.

Enamored with the potential of generative artificial intelligence ((AI)), investors bid up a narrow cohort of mega cap growth companies, and most broader indexes came along for the ride. The S&P 500 Index and MSCI World Index posted their third consecutive quarter of gains, returning 8.7% and 6.8%. ¹ While growth continued to outperform value, the spread between the two styles was far less extreme than it was in the first quarter, as investors slowly began to accept the Federal Reserve's guidance that policy rates would need to be higher for longer.

Equity and Fixed Income Markets Sending Conflicting Signals

While the excitement around the AI narrative helped boost US equity markets to varying degrees, a paradox seemed to emerge under the upbeat surface. Even though the Federal Reserve has raised rates considerably over the past year-plus, financial conditions haven't actually tightened all that much thanks to ongoing fiscal expansion. As a result, equity and fixed income markets appear to have fallen out of sync.

Equity markets appear to be pricing in a soft landing. The year-to-date rally in the S&P 500 Index brought its P/E ratio back up to around 20x, while implied volatility receded to pre-Covid levels. In contrast, fixed income markets are flashing warning signs. The yield on two-year Treasuries backed up to the 5% level that preceded March's bank failures, further inverting the yield curve, while measures of interest rate volatility remained elevated. ² At the same time, capital is being rationed within certain parts of the economy; leveraged credit new issuance continues to be muted, and bank-lending standards have tightened to levels consistent with recession in the aftermath of the regional bank crisis. ³

For its part, the Fed has continued to prioritize the fight against inflation, and market-implied rates suggest investors have begun to accept that this policy cycle may peak higher and later than previously expected. Though the central bank left the federal funds rate untouched at 5-5.25% following its June 13-14 meeting, messaging strongly suggested it was not done. Minutes released a few weeks later pointed toward a divided committee, though a "strong majority… expect that it will be appropriate to raise interest rates two or more times by the end of the year," per Chair Powell. ⁴ Indeed, the Fed's new dot plot shows rates peaking at 5.6% this year. Additional hikes would not come as a surprise; while headline inflation has improved markedly on the back of falling energy and food costs, core inflation remains sticky, reflecting resilient economic activity and a still-strong labor market. ⁵

So, while we're seeing a continued gradual disinflation from last year's peaks amid a still-resilient economic backdrop, the fiscal largesse that has eased this transition appears likely to fade. Combined, these factors may increase the risk of stagflation, which for those who do not remember the 1970s was bad for growth stocks, bad for US versus international equities, and bad for financial assets compared to real assets like gold and oil. Furthermore, by the end of the 1970s, equity multiples were about half of their current level, while fixed income yields were about double. Were a similar trajectory to emerge in the 2020s, we could be in for a long period of adjustment.

Shifting International Dynamics May Create Opportunities

Though not as headline-grabbing as AI, a number of global developments during the quarter caught our attention. In Asia, the currencies of China and Japan have been notably weak, as central banks in both countries, for similar but nuanced reasons, are pursuing accommodative monetary policy as much of the rest of the world tightens. While a disappointing post-Covid recovery in China has forced the People's Bank of China to intervene, the Bank of Japan remains committed to yield-curve control despite signs that Japan's economy may be breaking out of its multidecade malaise. This nuance likely explains why Japan's Nikkei 225 Index outpaced China's Shanghai Shenzhen CSI 300 Index by more than 2,000 basis points in the second quarter. ⁶

In China, aging demographics, massive private-sector and local-government debt, property-market woes and slowing productivity growth have continued to weigh on the economy, while an emergent slump in exports-which account for about one-fifth of economic activity-is a more recent headwind. After spiking with the government's loosening of Covid restrictions in late 2022, activity in the services sector has cooled as well. ⁷ Though policymakers have introduced small stimulus measures in recent months, large fiscal deficits limit their ability to respond forcefully to China's economic malaise. The country's GDP growth target for 2023 is only 5%, the lowest in more than three decades; the Chinese economy expanded only 3% in 2022 amid its extended zero-Covid strategy. On a positive note, recent rhetoric suggests that the contentious relationship between China's regulators and its tech industry-which is estimated to have resulted in the loss of more than $1 trillion in market value since it began two years ago ⁸ - may be on the mend, providing greater clarity for these businesses.

Some Global Value team members recently traveled to Japan for company visits, and management sentiment there appeared to be the most constructive it has been for quite some time. Notably, we continue to see an uptick in the adoption of corporate governance best practices, including stock buybacks, higher dividends, the appointment of independent directors and enactment of meaningful return-onequity targets. While some of these improvements can be attributed to reforms imposed by the Tokyo Stock Exchange, we are encouraged that a constructive groupthink on the issue seems to have emerged within Japan Inc. We remain vigilant, however; policy settings in Japan are still a long way from home, both in terms of Japan's fiscal deficit and eventual need to unwind yield curve control, and changes here could be disruptive to equity markets.

In contrast with Asia, Latin American currencies have appreciated sharply; the region is home to five of the world's eight best performing currencies during first half 2023. Latin American central banks acted early and decisively in the face of inflationary pressures, and the resulting positive rate carry attracted foreign capital. ⁹

In addition, concerns that the leftward political shift in the region over the past few years-which engulfed its top six economies among a few others- would bring about a populist overhaul have abated as the most-feared policy outcomes of this "new pink tide" failed to come to fruition. ¹⁰ Certain countries also have been outsized beneficiaries of the re-domiciling of manufacturing capacity alongside the rise of protectionism and pandemic-era disruptions to supply chains. Mexico, for example, recently became the US's top trading partner, accounting for 15.4% of bilateral trade for the first four months of 2023; in contrast, China's share fell to 12% after reaching an all-time high of 17.5% in fourth quarter 2019. ¹¹ This vibrancy, combined with what had been very cheap valuations, propelled the MSCI EM Latin America Index to a 14.3% return in US dollar terms during the second quarter. ¹²

Europe, meanwhile, has been a paradox. Despite a wide range of concerns gripping the region-not only the war in Ukraine and its impact on food and energy costs but also riots in France, a rightward swing in Sweden and various other local and geopolitical issues-the euro has been firm. We think this is a good reminder of the opposing impacts price and prospects can sometimes have on financial markets. In our view, the euro had become very cheap relative to its fundamentals prior to Russia's invasion and became cheaper still when it sold off in the months that followed. Despite its fundamentals appearing weaker as a result of the war's impacts, however, the currency has trended steadily higher since bottoming in September 2022.

Volatility May Equal Opportunity

Equity markets have been quite asynchronous among regions and sectors, and currency effects in some cases have amplified these differences. As go-anywhere, benchmark-agnostic investors, volatility like this often creates opportunity-whether to sharpen our pricing in an old-economy stock typical of value investing, or to find an entry point into a less traditional name whose temporary valuation displacement belies a quality operation with still-unrealized potential. As always, we seek resilience in our portfolios from the bottom up, searching for cash-flow-generative companies with strong market positions, healthy balance sheets and prudent management teams, and buying these stocks only when available at a "margin of safety." ¹³

Portfolio Review

Overseas Fund A Shares (without sales charge * ) posted posted a return of 0.67% in second quarter 2023. BY geographic region, emerging markets and Japan were the leading contributors while North America and developed Asia excluding Japan detracted. Consumer staples, industrials and financials were the leading contributors among equity sectors, while materials, real estate and consumer discretionary were the largest detractors. The Overseas Fund underperformed the MSCI EAFE Index in the period.

Leading contributors in the First Eagle Overseas Fund this quarter included Fomento Economico Mexicano SAB de CV ( FMX ) Units Cons. Of 1 ShsB And 4 ShsD, Ambev SA ( ABEV ) Sponsored ADR, Mitsubishi Electric Corp. ( MIELY ), MS&AD Insurance Group Holdings, Inc. ( MSADY ) Unsponsored ADR and Itausa - Investimentos Itau SA Pfd.

Fomento Economico Mexicano SAB de CV (FEMSA) is a multinational beverage and retail company headquartered in Mexico. The company maintains a collection of quality assets, including a 48% stake in Coca-Cola FEMSA, the largest franchise bottler of Coke in the world, and 100% ownership of OXXO, the largest convenience-store chain in Mexico and Latin America. FEMSA has made good progress on its strategic growth initiative to expand its bottling, retail and digital businesses while divesting its beer business and other non-core assets and reducing debt. The company divested its minority investment in Heineken and entered into an agreement to sell its minority stake in Jetro Restaurant Depot, a wholesale food service supplier.

Brazilian brewer Ambev, a subsidiary of Anheuser-Busch InBev, reported better-than-expected earnings for its most recent quarter, driven by healthy sales, strong cost controls and disinflation. A macroeconomic rebound in growth and strength in the Brazilian real were also tailwinds. We continue to like Ambev's dominant market position and ability to benefit from favorable demographics and attractive consumption trends in South and Central American markets.

Headquartered in Tokyo, Mitsubishi Electric is an industrial conglomerate. The company has made significant progress in improving governance following a 2021 quality-control scandal, which was an overhang on the stock. The company implemented a number of management and organizational changes, and its board now has a majority of outside directors. During the quarter, Mitsubishi Electric announced plans to restructure its automotive equipment business to improve operational efficiency and growth.

MS&AD was formed through the integration of three well-established Japanese insurers in 2010. The company writes marine, fire, casualty, automobile, life and allied insurance policies, and also operates financial services and agencies. MS&AD shares performed well in the quarter, benefitting from the appreciation of its portfolio of Japanese equities and from incremental evidence that its efforts to improve capital efficiency and reduce earnings volatility are bearing fruit.

Brazil's Itaúsa is an investment holding company whose primary asset is Itaú Unibanco, the country's largest bank. The bank has been performing well and reported earnings growth for its most recent quarter, in contrast to other large Brazilian lenders that have reported lower income. Improvement in Brazil's economy and strength in the real also have been tailwinds.

The leading detractors in the quarter were gold bullion, Nutrien Ltd. ( NTR ), Alibaba Group Holding Ltd. ( BABA ), Newmont Corporation ( NEM ) and British American Tobacco p.l.c. ( BTI )

The relatively small decline in the price of gold during the quarter belied what was a fair amount of intra-quarter volatility as markets anticipated the potential trajectory of Fed policy. March's bank failures inspired dovish expectations early in the quarter, but sticky core inflation and resilient economic prints as time went on guided markets back toward the possibility that rates would be higher for longer. Despite this short-term volatility, we continue to value gold as a strategic holding and potential hedge against economic and geopolitical uncertainty.

Canada's Nutrien is one of the world's largest producers of potash fertilizer and the third largest producer of nitrogen fertilizer. The company guided earnings expectations lower during the quarter as fertilizer prices pulled back sharply from last year's Russia/Ukraine related spike. We remain constructive on our investment thesis, as Nutrien enjoys a dominant market position, has a strong balance sheet, generates substantial cash and is buying back stock.

Concerns surrounding slowing economic growth in China and negative geopolitical sentiment weighed on shares of tech giant Alibaba during the quarter. In pursuit of operational and financial efficiency, the company recently announced plans to split into six semiautonomous units, five of which may seek third-party financing, spinoffs or IPOs. Recent fines to Alibaba and its affiliate Ant are viewed by many as the conclusion of Beijing's two-year regulatory crackdown on its tech sector, removing an overhang on Alibaba's stock and potentially creating a path to an Ant public offering.

Newmont is one of the largest gold miners in the world and also a major producer of silver, and weakness in the prices of these metals during the period weighed on the stock. In addition, some investors were given pause when Denver-based Newmont sweetened its offer to acquire Australia's Newcrest Mining in May. This deal is still subject to regulatory review and requires approval from shareholders. A labor strike at the Peñasquito silver mine in Mexico that began in June was another headwind. We remain constructive on Newmont's strong fundamentals; the company is a well-diversified industry behemoth with reserves in good jurisdictions and a strong balance sheet.

British American Tobacco (BAT) is the world's second largest tobacco company. Shares of the company traded down during the quarter on both financial and operational concerns. Investors were disappointed that the company suspended its share buyback and directed cash instead to the reduction of debt, while combustible product volumes weakened in the US. BAT is enormously cash generative, with potential untapped pricing power in the US combustible market. We believe the stock remains cheap and has an attractive dividend yield. We appreciate your confidence and thank you for your support.

Sincerely,

First Eagle Investments

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