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Market Overview
International markets faced substantial pressure during the second quarter, with the MSCI All Country World Ex-U.S. benchmark declining 13.73% as relentless increases in inflation and subsequent interest rate hikes from global central banks resulted in tighter financial conditions and investor concerns of entering a global recession.
Disruptions in global supply chains, COVID-19 lockdowns and depressed commodity inventories have ignited inflationary forces that have laid dormant for decades. The U.S. and U.K. registered multidecade highs in inflation indicators across both goods and services, particularly in energy prices, which spiked in June. The growing impact of price increases prompted a reversal in policymakers’ outlooks as rising prices, not an economic slowdown, became the primary concern.
In response central banks, with the notable exceptions of the Bank of Japan and the People’s Bank of China (PBOC), embarked on a monetary tightening cycle through interest rate increases and shrinking their balance sheets. In the U.S., the Federal Reserve voted to raise interest rates twice during the quarter, including by 75bps in June — the highest single U.S. interest rate increase since 1994.
Europe continued to face headwinds stemming from the Russian invasion of Ukraine, as its impact on global supply chains and spiking energy prices weighed on investor sentiment and contributed to growing fears of a recession. In a major deviation from the global march toward higher rates, the PBOC elected to cut a key interest rate in an attempt to offset slowing domestic growth.
While China continues to maintain their zero-tolerance COVID-19 policy, the country has begun to moderate some of the restrictions surrounding them and is gradually learning to live within the system, widely applauded as a step toward rectifying global supply chain disruptions and bolstering global growth.
Market- and sector-specific performance during the quarter was driven by what we are calling a rotation within a rotation. What do we mean by that? The dual bombardment of inflation and interest rate increases pummeled the valuations of global growth stocks and longer-duration assets earlier in the quarter. Market multiples in high-growth sectors such as information technology (IT) faced the crushing weight of increases in risk premiums and discount rates, helping drive a first and broad market rotation in investor preference out of higher-growth areas of the market into the traditional value sectors such as materials and industrials.
This benefited portfolio performance, as we maintain significant overweights to these cyclical sectors. However, a combination of declining manufacturing indicators, weakening consumer sentiment and expectations of negative revisions to corporate earnings estimates shifted investor concerns away from spiraling inflation to the impact of tightening monetary policy and central banks removing liquidity, leading to an economic deceleration and raising the prospect of a recession.
These growing concerns led to a second rotation as investors (who continued to sustain a broader rotation out of growth and into value) redirected away from traditional value sectors susceptible to slowing growth, such as our aforementioned overweights in the materials and industrials sectors, into even more defensive sectors including consumer staples, health care and utilities — seen as having persistent and predictable earnings and strong balance sheets, and being more resilient to an economic deceleration.
While we had been anticipating and positioning the portfolio for an eventual rotation from growth into value, we believe an economic deceleration is more likely than an outright synchronized global recession, as the jobs market and consumption remain robust, there is plenty of fiscal support, particularly in Europe, and China is coming out of COVID-19 restrictions and is stimulating.
Such a selloff in cyclicals has left our portfolio companies’ valuations discounting some probability and magnitude of a recession. While this worked against our overall performance for the quarter, we were nevertheless able to take advantage of the ongoing first rotation from growth into value to help buoy overall performance.
“Investors have overlooked the fact that banks, particularly in Europe, maintain high capitalization ratios.”
The quarter ended with all sectors of the benchmark and all major regions posting negative returns for the quarter. The materials and industrials sectors constituted two of the leading absolute detractors for the period, as these sectors suffered due to a deteriorating economic outlook. The energy sector, supported by low global inventories, strong demand recovery and a tight market, led performance.
Other leading sectors, utilities and health care, benefited from increased demand from investors for businesses perceived to be more resilient in a recession. Against this tumultuous backdrop, the ClearBridge International Value Strategy outperformed its MSCI All Country World Ex-U.S. benchmark for the second quarter.
The Strategy benefited from its exposure to the energy sector, as we believe it broadly offers attractive earnings and high cash flows at subdued prices compared to the rest of the market. We retain significant exposure to the sector through holdings such as TotalEnergies (TTE), a French integrated oil and gas company. As European nations reduce their reliance on Russian energy imports and negotiate significant long-term liquefied natural gas (LNG) contracts on an EU-wide level, TotalEnergies’s strong position as a leading global LNG producer places it in a prime position to benefit from the increased demand.
Additionally, its strategy to forgo future oil production growth and instead refocus its capital expenses on energy transition businesses, including LNG, batteries and renewables, should lead to value preservation and allow it to be substantially more resilient as we navigate the global energy transition.
Our stock selection within the financials sector also positively contributed to performance. Financials suffered due to a rising risk of recession, and the perception that a decline in loan growth would offset the benefits of higher interest rates. Investors have overlooked the fact that banks, particularly in Europe, maintain high capitalization ratios that provide downside protection. We continue to have high conviction in our holdings such as Standard Chartered (OTCPK:SCBFF), a British multinational banking and financial services company whose commodity trading business benefited from elevated price volatility during the period.
Additionally, the company’s exposure to Asia, Africa and the Middle East, and comparatively small footprint within Europe, allowed it to avoid much of the growing recessionary fears that plagued other European banks.
The consumer discretionary sector proved to be a detractor from relative performance. Inflation sparked a shift in consumer attitudes toward staples, prompting investors to retreat to more defensive sectors. Companies such as Marston’s (OTCPK:MARZF), a British pub and restaurant operator, declined due to the inflationary impacts of rising input costs in food, alcoholic beverages and rising wages in the face of weaker demand.
Volkswagen (OTCPK:VWAGY), the German auto manufacturer, also suffered from weaker consumer confidence and slowing demand for personal vehicles. Despite near-term concerns, we continue to have high conviction in Volkswagen and its long-term prospects to deliver value as increasingly viable as a leading competitor to Tesla in electric vehicles.
Industrials companies faced high hurdles to performance from disruptions in global supply chains, rising costs and the perception of a slowing global economy. This was exemplified by KION (OTCPK:KIGRY), a German manufacturer of materials handling equipment including intralogistics, warehouse automation equipment, and industrial trucks, and one of our top detractors during the quarter. The company faced headwinds to its manufacturing and delivery schedules due to depleted component inventories.
Additionally, the company has seen a slowing in new orders as customers choose to delay orders while assessing emerging economic data. Despite the supply chain disruptions, we believe those very dynamics have highlighted that companies have significantly underinvested in their logistical operations and require the kind of modernization and automation products and services that KION offers, benefiting the company’s long-term growth runway.
Portfolio Positioning
We were opportunistic during the quarter, making tactical adjustments to exit positions where conditions had weakened and adding to industry leaders we believe will use this opportunity to capture market share. From a regional standpoint, we capitalized on recent conditions to exit some of our higher-valuation European investments and redeploy capital toward opportunities with greater value creation potential within Asia. We remain overweight to Europe but continue to find compelling opportunities and increase our investments in Asian companies.
We added to our position in Industria de Diseno Textil (OTCPK:IDEXY) a Spanish multinational fashion apparel leader. Headwinds from cost inflationary pressures and the impact of China’s COVID-19 restrictions on shoppers’ mobility further derated the company’s shares. We believe the company’s share price is disproportionately depressed for a high-quality retailer with a best-in-class supply chain network, and which is poised to benefit from the lifting of COVID-19 restrictions, and we increased our investment due to the enhanced upside opportunities that the current entry point offers.
We also consolidated exposure to the industrials sector through additional investment in existing holding Jardine Cycle & Carriage (OTCPK:JCYCF), a Singapore-based conglomerate with many diverse lines of business including automotive, financial services, heavy equipment, and IT. The company’s shares derated to a deep discount as a result of COVID-19 restrictions that shuttered its business operations. In addition to lifting restrictions, the underlying fundamentals are gradually improving, the company is well capitalized, and the price decline has created a highly compelling entry point for upside potential.
We exited our position in Compagnie Financiere Richemont (OTCPK:CFRHF), a Swiss luxury goods business in the consumer discretionary sector, which produces high-end goods including jewelry, watches and leather goods. The company has significant exposure to the Chinese luxury goods market, which was negatively impacted by COVID-19 lockdowns.
Additionally, the luxury goods market is materially exposed to rising wealth and employees of the higher-paying tech sector, which has suffered layoffs due to the Chinese government’s regulatory clampdown. We felt the stock’s current valuation did not provide a comfortable margin of safety to account for a slowdown in revenue and earnings and elected to exit the position.
We also exited our long-time industrials holding A.P. Moller-Maersk (OTCPK:AMKBY), a Danish shipping company that provides ocean and inland freight transportation and logistics. The company has seen its stock price climb in conjunction with increasing shipping rates on inflationary price increases and high demand for shipping and logistical services resulting from supply chain disruptions. We believe this has pushed the company toward peak operating margins and, with concerns over slowing global growth, we elected to exit the position on its recent strength.
Outlook
While the market may see further down drifts as central banks use rate hikes to starve inflation and fuel fears of recession, we remain confident that our current positioning balances short-term against long-term opportunities. Our portfolio is constructed of the highest-quality businesses across the globe, with strong balance sheets and ample cash flows, and trading at attractive valuations and, as a result, we only needed to make slight tactical adjustments in response to recent market conditions. While the future is uncertain, we are confident our investment process and philosophy will persevere through future market tremors.
Portfolio Highlights
The ClearBridge International Value Strategy outperformed its MSCI All Country World Ex-U.S. Index benchmark during the second quarter. On an absolute basis, the Strategy had losses across all 10 sectors in which it was invested (out of 11 sectors total). The industrials, materials and financials sectors were the main detractors during the quarter, while the communication services and real estate sectors were the top performers.
On a relative basis, overall sector allocation effects contributed to performance but were offset by a negative contribution from security selection. Specifically, stock selection in the IT, materials and financials sectors, an underweight to the IT sector, an overweight allocation to the energy sector and the portfolio’s cash position aided performance. Conversely, stock selection in the consumer discretionary, industrials and health care sectors and an overweight to the industrials and materials sectors weighed on returns.
On a regional basis, stock selection in Asia Ex Japan and an overweight to the U.K. contributed to performance. Stock selection in North America, an overweight to Europe Ex U.K. and an underweight to emerging markets weighed on performance.
On an individual stock basis, TravelSky Technology (OTCPK:TSYHY), Standard Chartered, TotalEnergies, Jardine Cycle & Carriage and Coca-Cola (KO) were the leading contributors to absolute returns during the quarter. The largest detractors were Glencore (OTCPK:GLCNF), KION, Marston’s, CNH Industrial and Schneider Electric (OTCPK:SBGSF).
During the quarter, in addition to the transactions mentioned above, the Strategy exited positions in JD.com in the consumer discretionary sector and Greatview Aseptic Packaging (OTCPK:GRVWF) in the materials sector.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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