UGIC - First Eagle U.S. Value Fund 2nd Quarter 2023 Commentary

2023-08-20 11:20:00 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.
• US Value Fund A Shares (without sales charge) posted a return of 4.74% in second quarter 2023.
• Technology stocks rebounded in Q2 2023, 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 may create opportunities, with weak currencies in China and Japan and appreciation of Latin American currencies.

U.S. Value 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 megacap 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-on equity 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

US Value Fund A Shares (without sales charge*) posted a return of 4.74% in second quarter 2023. Among equity sectors, communications services, information technology and healthcare were the leading contributors while materials and utilities detracted, and energy lagged. The US Value Fund underperformed the S&P 500 Index in the period.

Leading contributors in the First Eagle U.S. Value Fund this quarter included Meta Platforms, Inc. ( META ) Class A, Oracle Corporation ( ORCL ), HCA Healthcare Inc., Universal Health Services, Inc ( UHS ), Class B and Microsoft Corporation ( MSFT ).

Meta—the parent company of Facebook, Instagram and WhatsApp, among others—reported better-than-expected results for its most recent quarter, driven by sales growth and cost controls. This was a reversal of declining sales trends over the last few quarters. The ongoing rebound in technology stocks was also a tailwind for the stock, as was its demonstrated commitment to cost discipline. We continue to like Meta’s potential ability to generate cash and its unique portfolio of assets.

Oracle is one of the world’s largest independent enterprise software companies. Oracle has been executing well and reported better-thanexpected earnings for its most recent quarter. The acquisition of Cerner, which designs software to store and analyze medical records and other health care data, has helped boost Oracle’s cloud-computing business. The increased interest in generative AI applications is fueling demand for Oracle’s cloud services.

Shares of HCA Healthcare, the largest for-profit US hospital operator, performed well as the company continued to recover from pandemic-related disruptions that caused patient volumes to decline and labor costs to rise. HCA reported better-than-expected results for its most recent quarter and raised its full-year outlook. Results were driven by both growth in visits and procedures as well as improved labor costs, which are approaching pre-Covid levels.

Hospital and health care services provider Universal Health Services has continued to recover from pandemic-related disruptions that caused patient volumes to decline and labor costs to rise. Volume increases have been driven by elective procedures, acute-care services, behavioral-care services and higher inpatient occupancy.

Microsoft reported better-than-expected results for its most recent quarter—driven by its software and cloud-computing businesses— and raised guidance. Shares of Microsoft have been boosted by the excitement around the deployment of generative AI across its products. We continue to like Microsoft’s dominant market position, ability to generate cash and commitment to returning cash to shareholders through dividends and share repurchases.

The leading detractors in the quarter were gold bullion, NOV Inc., Nutrien Ltd. ( NTR ), Newmont Corporation ( NEM ) and UGI Corporation ( UGI ).

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.

NOV is a Texas-based oilfield service provider specializing in complex rig equipment for higher-cost extraction settings such as deep-water fields. Weakness in the quarter may reflect disappointment in the free cash flow reported for the first quarter, as the company focused on building working capital in support of strong revenue growth; this is a typical seasonal behavior of oilfield service and equipment companies. In addition, some temporary supply-chain issues resulted in an inventory buildup. Although normalized oil prices have led to reduced drilling by marginal players, we anticipate continued strong capital spending from the larger publicly traded drillers, to the benefit of companies like NOV.

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/Ukrainerelated 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.

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.

UGI is a natural gas, propane and electric power distribution company with operations in the US and Europe. Warm weather in its AmeriGas footprint hurt propane demand against a backdrop of rising expenses; AmeriGas also ran into customer-service issues, largely due to a shortage of drivers.

We appreciate your confidence and thank you for your support.

Sincerely,

First Eagle Investments

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