With the Covid-19 pandemic in retreat in some—but certainly not all—parts of the world, many investment markets were swept by a warm breeze of optimism in the second quarter. Risk assets continued to climb. The MSCI World Index rose 7.7% in the quarter, while the S&P 500 Index was up 8.5%. The Barclays US Aggregate Index returned 1.8% after falling 3.4% in the first quarter, and high yield continued to perform well, with the Bloomberg Barclay’s High Yield Corporate Index returning 2.7%.1
The performance of risk assets year-to-date can be traced in part to a striking rebound in business confidence. Despite the emer-gence of Covid variants, large regional imbalances in vaccine rates and still-significant slack in global employment, a number of purchasing managers indexes worldwide reached new multi-year peaks during the second quarter, suggesting high spirits in corporate boardrooms after a deeply depressing 2020.2 Histori-cally, business confidence has often signaled GDP growth.
While we cannot be certain how long confidence and valua-tions will remain at these high levels, we suspect the time may be shorter than the markets appear to anticipate; in our view, the economic recovery may already be fully priced in. The MSCI World Index trades at approximately 20 times forward earnings estimates, and those estimates represent a roughly 20% increase from the prior peak levels of earnings in 2018 and 2019.3 This multiple strikes us as extreme. Meanwhile, spreads in the fixed income markets are very tight, with little scope for upside or adequate compensation for risk.
Equities: Can They Stay Aloft?
Although the equity market continued on its upward track, there were changes in market dynamics during the second quarter. The reflation trade that had prevailed since September 2020 appeared to run out of steam during the second quarter, as many of the themes that dominated the markets’ initial pandemic rebound returned to the fore. For example, during the quarter investors returned their focus to growth stocks from value stocks and to large caps from smaller names, with a bias toward US-listed companies.4
Unsurprisingly, given the stimulus-fueled pace of the economic recovery, we’ve seen the emergence of some supply-chain bottle-necks. Anecdotally, we are also hearing from our portfolio companies about difficulties in hiring and about rising prices for raw materials. Meanwhile, we have heard very little bottom-up concern about fiscal unsustainability—likely because corporate margins have benefited from ultra-easy fiscal policy. As the recovery progresses and the stimulus eventually moderates, we will probably see a more complex picture emerge and, more likely than not, some moderation in business sentiment.
Fixed income: Prices Leave Little Room for Error
Fixed income investors, undaunted by diminishing yields, continued to buy bonds and loans even though they had to travel further down the credit spectrum and out the duration curve to obtain desired yields. Though positive returns could be found across the credit spectrum in the second quarter, lower-quality bonds generally outperformed higher-rated issues, and CCC bonds were the top-performing cohort. After a pause earlier in the year, duration again became a tailwind for performance as the rate of the 10 -year US Treasury drifted from around 1.75% at the beginning of April to near 1.45% at the end of June.5 In contrast, shorter-term yields broke higher in response to the unexpectedly hawkish dot plot that emerged from the Federal Reserve’s June policy meeting. Hemmed in below 0.20% for most of the past year-plus, the yield on the two-year US Treasury approached 0.30% as the quarter drew to a close, flattening the yield curve.6 This move was accompanied by a dip in the gold price, strength in the US dollar and moderation of long-dated inflation expectations.
During the second quarter, conditions continued to be very favorable for non-investment grade issuers—and less so for inves-tors—as the trend toward aggressive pricing, tighter spreads and limited covenant protections persisted in the new-issue markets for both bonds and leveraged loans. The first half of 2021 ended with close to $300 billion in high yield issuance, a rate at which the market could easily surpass last year’s record of $450 billion.7
In our judgment, default activity is likely to remain subdued over the next few quarters. The peak default rate in this high yield market cycle was close to 6% in July 2020, and it was estimated to be below 3% in May 2021 and trending lower still.8 Default activity is a lagging indicator; with corporate earnings improving and access to credit markets remaining easy, even unprofitable or marginally profitable companies should be able to avoid default. Distressed credits, meanwhile, are the raw material for future defaults, and we have seen the distress rate decline precipitously to 1.4%, the lowest level since 2015.9
A Time for Resilience
Government authorities face a sort of Catch-22: if they tighten policy prematurely, they may stifle the recovery before full employment is reached. On the other hand, if they keep fiscal and monetary policy too easy too long, they may increase the potential for inflation in a low-growth world—in other words, stagflation. As we learned from the 1970s, stagflation can have very negative effects on both stocks and bonds. Without a fiscal consolidation or increase in labor productivity, the continua-tion of the current very easy policy may lead to a series of much tougher future choices and outcomes.
The Fed remains data dependent in its decision-making and likely will maintain a wait-and-see approach before taking steps to unwind its extraordinary stimulus. It is important to note that the central bank recently adopted an inflation-targeting policy framework. Rather than tightening monetary conditions in anticipation of inflation pressures and the approach of full employment, as it had in the past, the Fed will tolerate—if not actively seek—above-target inflation for some period to achieve its target rate as an average over time. However, there is some concern that the longer rates stay low in the face of mounting inflation and strong economic growth, the more we risk a violent upward adjustment at some future point—potentially resulting in profound financial market impacts.
We accept that the future is unknowable—including, in the current context, the full consequences of the measures taken to combat Covid’s economic and public health impact. This is among the reasons that we believe so strongly in the value of portfolio diversification. Within the equity portion of the port-folio, our team applies an all-weather approach marked not only by broad geographic diversification but also diversification across and within sectors. And because we focus on resilient businesses available at attractive valuations, we feel our portfolio is well positioned for whatever may come next.
Given the very narrow spreads in the credit markets, we continued to reduce risks that we were not being adequately compensated to take. We remained biased toward higher credit quality, toward higher attachment points in the capital structure and toward secured paper and tighter indentures. Due to our bottom-up approach to finding opportunities in fixed income, we naturally gravitated to a higher quality, more liquid portfolio of bonds issued by companies that in our view generate stable and significant free cash flow.
Global Income Builder Fund A Shares (without sales charge*) posted a return of 5.77% in second quarter 2021, outperforming the composite index in the period. As of June 30, 2021, the Fund’s equity allocation was 67.42%—44.56% international stocks and 22.86% US stocks. The Fund’s 18.96% bond alloca-tion included 8.78% in investment grade issues.
Leading equity contributors in the First Eagle Global Income Builder Fund this quarter included Compagnie Financière Richemont SA, Exxon Mobil Corporation and Nestle S.A. Leading bond contributors included Iron Mountain Incorporated 5.25%, due 7/15/2030; Acco Brands Corporation 4.25%, due 3/15/2029; and Citgo Petroleum Corp. 6.375%, due 6/15/2026.
Richemont (XSWX:CFR, Financial), which counts Cartier and Van Cleef & Arpels among its maisons, has continued to benefit from strong demand for luxury goods and jewelry in particular. The Swiss company has also made notable strides in developing an e -commerce plat-form in partnership with Alibaba and Farfetch, which is expected to give it enhanced access to the growing Chinese luxury market.
The continued recovery in oil prices as economies reopen helped fuel another strong performance across the energy complex, including shares of Exxon Mobil (XOM, Financial). Exxon Mobil recently lost a proxy fight with an activist investor that took three of the company’s 12 board seats. While the press was focused on the investor’s concerns over Exxon Mobil’s long-term energy trans-formation strategy, other factors fundamental to shareholder returns—like capital discipline and balance sheet management— were also at play.
Swiss food giant Nestlé (XSWX:NESN, Financial) has continued to execute on its stra-tegic plan to refocus its portfolio of products to meet evolving customer demand within the consumer packaged goods industry. At the end of the first quarter, the company closed on the sale of its North American water business; subsequently, Nestlé acquired a vitamin and supplement business and a functional hydration company.
The 2030 maturity paper of Iron Mountain (IRM, Financial), a leader in the North American storage and information management market, traded higher in an environment that rewarded duration. With a large base of recurring storage rental revenues, Iron Mountain is a fairly stable business in our view.
ACCO Brands (ACCO, Financial), an Illinois-based manufacturer of office prod-ucts, also benefited from falling interest rates in the second quarter, having extended the tenor of its debt during the previous quarter. Though demand for ACCO’s office products has been challenged in the Covid-related work-from-home environment, the company’s focus on expense management has helped preserve its earnings and free cash flow.
Despite materially weaker earnings due to Covid-19 and weather-related disruptions to its largest refinery in Louisiana, refiner Citgo was able to refinance debt and improve its liquidity posi-tion, leaving it well-positioned for the recovery of oil-product demand, especially gasoline, that followed. Moreover, given this bond issue’s strong asset coverage, it tends to be relatively insu-lated against short-term changes in cash flow.
The leading equity detractors in the quarter were Secom Co., Ltd., Bangkok Bank Public Company Limited NVDR and Jardine Matheson Holdings Limited. Fixed income detractors included three Government of the United States of America bonds: 2.625%, due 6/30/2023; 1.75%, due 6/30/2024; and 2.5%, due 1/31/2024.
Tokyo-based Secom (TSE:9735, Financial) is a security services and surveillance systems company with operations in multiple jurisdictions across Asia and Australasia as well as in the UK, though it generates most of its revenue in Japan. While Secom participated in the general weakness in Japanese stocks during the quarter, we believe it maintains a strong core business. It recently consoli-dated subsidiary Secom Joshinetsu—a trend among Japanese companies as corporate governance continues to improve in the country—at a premium to its pre-announcement share price.
Bangkok Bank (BKK:BBL, Financial) is the largest bank in Thailand and the sixth largest in Southeast Asia. After keeping Covid-19 mostly in check during 2020, Thailand has been hammered by the pandemic over the past several months. The outbreak has the government considering additional lockdown measures, weighing on the Thai economy and delaying a revitalization of its important tourist industry.
Jardine Matheson Holdings (LSE:JAR, Financial), which controls a diversified collection of business franchises predominantly across Greater China and Southeast Asia, traded modestly lower in conjunction with the relative weakness in Asian equity markets. During the second quarter the company completed its previously announced acquisition of the shares it didn’t already own in sister company Jardine Strategic Holdings. The simpler organizational structure should provide Jardine with greater operational efficiency and balance sheet flexibility.
The three US Treasury securities mentioned above had a very modest negative impact on performance, as their relatively short durations were a headwind in an environment of falling interest rates.
We appreciate your confidence and thank you for your support.
First Eagle Investment (Trades, Portfolio) Management
- Source: FactSet; data as of July 1, 2021.
- Source: Institute for Supply Management, International Federation of Purchasing and Supply Management, IHS Markit; data as of July 9, 2021.
- Source: MSCI, FactSet; data as of July 1, 2021.
- Source: FactSet; data as of July 1, 2021.
- Source: FactSet; data as of June 30, 2021.
- Source: Federal Reserve Bank of St. Louis; data as of July 9, 2021.
- S&P Global Market Intelligence; as of July 15, 2021.
- Source: Fitch Ratings; data as of May 31, 2021.
- Source: S&P Global Ratings; data as of April 27, 2021.
The performance data quoted herein represent past performance and do not guarantee future results. Market volatility can dramatically im-pact the Fund’s short-term performance. Current performance may be lower or higher than figures shown. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance data through the most recent month-end are available at www.feim.com or by calling 800.334.2143. The average annual returns for Class A Shares “with sales charge” of First Eagle Global Income Builder Fund give effect to the deduction of the maximum sales charge of 5.00%.
The commentary represents the opinion of the Global Income Builder portfolio managers as of June 30, 2021, and is subject to change based on market and other conditions. The opinions expressed are not necessarily those of the entire firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The information provided is not to be construed as a recommendation to buy, hold or sell or the solicitation or an offer to buy or sell any fund or security.