Market Overview
After the stimulus-fueled rebound from the 2020 depths of the Covid-19 dislocations, the capital markets, in our view, appear to have entered a more complicated phase as a result of a variety of historical aberrations and growing imbalances. This is well illus - trated by the coexistence of negative real interest rates and very low levels of risk premia such as credit spreads. Under normal conditions, low or negative real interest rates are the result of some sort of macro distress, and credit spreads widen to reflect the perceived greater risk of default. This was clearly evident upon the outbreak of Covid-19 in early 2020, as the nominal yield on the 10-year US Treasury hit modern-era lows, real rates turned negative for the first time since 2013 and credit spreads spiked to levels not seen since the global financial crisis.1
Today, while nominal Treasury yields have roughly doubled off their 2020 trough, they remain far closer to their record low than to their historical average, repressed by unabated central bank stimulus; combined with markedly higher inflation readings, this has kept real rates well into negative territory. Credit spreads have retightened, approaching the levels first seen when the Fed stepped into the primary and secondary bond markets last year.
Recent inflation reports have come in at multi-decade highs. While Federal Reserve Chairman Powell and other board members have consistently stated that recent pricing pressures are transitory, we are mindful that disrupted supply chains have not been easy to repair, as evinced by the ships waiting to dock on the West Coast and the stacks of containers waiting for delivery in transportation hubs across the country. In fact, the Fed has grown more hawkish in recent meetings, and there are sugges-tions it may begin to taper its monthly bond purchases before the end of 2021 and potentially hike the federal funds rate as early as next year. While the impact of central bank tightening on global capital markets remains to be seen, our experience over the past decade-plus suggests caution is warranted.
Geopolitical risks, meanwhile, are pronounced and can be traced most prominently to China. Chinese equities finished the third quarter down about 30% from their February peak, a decline prompted in part by concerns about increased government regu-lation. In pursuit of what Mao Zedong called “common pros-perity,” President Xi Jinping has reasserted the Chinese Communist Party’s primacy over large companies and the oligarchs who lead them. While such a stance may improve China’s socioeco - nomic balance, a sweeping realignment of the power between the government and business risks upsetting a private sector that has been key to economic growth both in China and across the rest of the world. A test to Xi’s resolve may come from the Chinese property sector, which accounts for 29% of China’s economic activity, as recent government efforts to curtail credit growth have resulted in liquidity issues among some of the country’s most heavily leveraged developers, most notably Evergrande Group.2
Equities: Little Room for Error
Equity market dynamics in third quarter 2021 suggested to us that investor confidence may have begun to wane even as widespread vaccine distribution prompted many jurisdictions to adapt their approach to managing the risk of Covid-19. While the MSCI World Index was flattish for the three-month period, September’s 4.2% decline—the first down month for the index since January—highlighted the challenges ahead for investors.3
Equity markets appear fully valued even after the ho-hum third quarter. Not only is the S&P 500 Index, for example, trading at a high multiple of trailing earnings, but these earnings them-selves are the product of a generational peak in profit margins.4 Mounting cost pressures—whether from commodity prices or logistical bottlenecks or supply chain breakdowns or labor avail-ability problems—suggest that these very high margins may be at risk even if economic growth persists.
Despite low interest rates and low risk premia, we have a hard time accepting that investment risk is low at this point. We’ve exited the Covid-19 recession with a much higher ratio of public debt to GDP than we entered it, and legislation winding its way through Congress would further add to that. Fiscal deficits have pulled back from 2020 levels but remain very high, and the Federal Reserve has kept the stimulus flowing even as employ-ment conditions have improved markedly and inflation has spiked.
Fixed Income Markets: What, Me Worry?
The third quarter once again saw leveraged credit markets outperform their investment grade brethren in what was a fairly volatile period for rates and fixed income securities. Duration generally had a negative impact on bond performance during the quarter as benchmark yields began to back up in August, which acted as a headwind for more rate-sensitive assets like 10 -year Treasuries and investment grade corporates. In contrast, lower-quality paper continued to shine—with less realized volatility— as investors showed little hesitation moving down the credit spectrum in search of yield.
Corporate bond issuance was again robust in the third quarter, as companies from across the credit spectrum seized opportuni-ties to raise capital and push out maturities. Though investment grade issuance is lagging last year’s record-setting pace, high yield issuance appears poised to establish a new high-water mark.5 It’s worth noting that duration in the Bloomberg Barclays US Corporate Bond Index ended the quarter at the very high level of 8.7 years compared to about 3.9 years for the high yield market, making the former highly sensitive to changes in interest rates.6
Investors generally have been willing to absorb this massive issu-ance, and valuations in the high yield market appear tight, with a variety of metrics—including Treasury spreads, yield-to-worst and compensation per turn of leverage—near or at all-time lows.7 Improving fundamentals have provided some support to these moves, however. Both the issuer default rate (a lagging credit indicator) and the distress ratio (a leading indicator) returned to pre-Covid levels, and the upgrade/downgrade ratio soared.8 With debt in aggregate declining while EBITDA was growing, gross leverage in the high yield market improved somewhat, though it remained at elevated levels.9
The Path of Prudence
Despite mounting risks and full valuations in equity and fixed income markets, investors generally appear undaunted. We, however, believe the current investment environment calls for prudence.
In the equity markets, we are trying to identify, bottom up, pockets of long-term opportunity in the face of markets priced for very high expectations. This may include companies that we believe are likely to benefit from a fuller return to pre-Covid norms in areas like travel and hospitality, energy, retail and real estate, among others. It may also include high-quality names likely to benefit from secular changes in their industries, whether it’s cloud computing or lasers or trucking.
In the fixed income markets, we are looking for opportunities to deploy capital while reducing risks we aren’t being compensated to take. As always, we manage risk on a bottom-up basis, looking for paper that offers what we consider an attractive risk-return profile and for issuers positioned to succeed as the credit cycle continues. We are remaining up in quality and attaching higher in the capital structure. Our duration profile currently is shorter than that of the market, but a backup in Treasury yields may prompt a repricing of risk and provide opportunities for us to extend.
Portfolio Review
Global Income Builder Fund A Shares (without sales charge*) posted a return of -2.97% in third quarter 2021, underper forming the composite index in the period. As of June 30, 2021, the Fund’s equity allocation was 68.47%—44.44% international stocks and 24.02% US stocks. The Fund’s 19.50% bond alloca-tion included 8.66% in investment grade issues.
Leading equity contributors in the First Eagle Global Income Builder Fund this quarter included Oracle Corporation, HCA Healthcare Inc., and Power Corporation of Canada. Leading fixed income contributors included Acco Brands Corporation 4.25%, due 3/15/2029, Mexico Remittances Funding Fiduciary Estate Management Sarl 4.875%, due 1/15/2028, and DCP Midstream LLC 6.45%, due 11/3/2036.
Oracle (ORCL, Financial) continues to make progress reinventing itself for the cloud-computing environment. Impressively, it has affected this turnaround primarily through organic research & development and smaller, well-priced acquisitions rather than expensive, head-line-grabbing mergers. Results in recent quarters have suggested Oracle’s subscription-based model is gaining traction, and we believe the company will be a strong competitor in the huge addressable public cloud market. With a high level of insider ownership and a strong balance sheet, Oracle has been a strong cash flow generator and has historically returned excess cash to shareholders in the form of dividends and share buybacks.
HCA Healthcare (HCA, Financial) owns and operates 185 hospitals and approxi-mately 2,000 sites of care in the US and UK. Admissions to its facilities, depressed during the worst of the Covid-19 outbreak in 2020, have begun to rebound. HCA reported a nearly 20% year-over-year increase in admissions during the second quarter and a 14% increase in revenue, and forecast that volume would continue to improve throughout the year. We maintain our posi-tive opinion of the company’s management team, believing them to be effective stewards of both the balance sheet and HCA’s business operations.
Power Corporation of Canada (TSX:POW, Financial) is a family-owned holding company with interests in a diversified lineup of insurance and asset management companies in North America, Europe and Asia. These companies generally have performed quite well from an operational perspective of late. At the end of 2020, the company completed a reorganization of its ownership structure, eliminating an intermediary-level subsidiary and providing addi-tional transparency in the process.
ACCO Brands (ACCO, Financial) is an Illinois-based manufacturer of office products. Though demand for ACCO’s products has been challenged in the Covid-related work/school-from-home environment, the company’s focus on expense management has helped preserve its earnings and free cash flow. The relatively uneventful re-intro-duction of in-person schooling in many areas this fall helped support the company’s back-to-school sales and its ongoing effort to reduce its leverage ratio.
The Mexico remittances paper was issued by a special-purpose vehicle (SPV) secured by assets flowing from the US to Mexico through the money-transfer business of Nueva Elektra del Milenio, the retail subsidiary of Mexican conglomerate Grupo Elektra (MEX:ELEKTRA, Financial). Given the bankruptcy-remote structure of the SPV, the notes carry an investment grade BBB- rating, one notch above the parent company’s BB+. The bonds benefitted from continued strong remittance volumes during the third quarter.
An electric and gas utilities and infrastructure company, DCP Midstream (DCP, Financial) benefitted from high prices for natural gas liquids during the quarter. It has been proactive in rebuilding its balance sheet to support a higher rating while transitioning away from exposure to commodity prices and shifting to a fee-based busi-ness model.
The leading equity detractors in the quarter were Jardine Matheson Holdings Limited, CompañĂa CervecerĂas Unidas S.A. Sponsored ADR, and Compagnie Financière Richemont SA. Fixed Income detractors included Government of Mexico 8.0%, due 12/7/2023, Government Of South Korea 1.25%, due 3/10/2026, and Government Of Colombia 5.75%, due 11/3/2027.
Hong Kong-headquartered holding company Jardine Matheson Holdings (LSE:JAR, Financial) controls a diversified collection of business franchises predominantly across Greater China and Southeast Asia. The company’s stock price lagged in the third quarter as renewed Covid-related restrictions in markets like Indonesia and Thailand impacted sales volumes there. Further, the debt crisis at Chinese property developer Evergrande may have dented investor enthu-siasm for companies exposed to Asian real estate; in 2020, 38% of Jardine’s earnings were attributable to the property segment. Jardines has taken advantage of price weakness to buy back stock, and given its solid balance sheet and attractive franchises, we continue to believe it offers attractive value.
After an impressive first-half run, Chilean beverage company CCU’s (CCU, Financial) path back from the dislocations of Covid-19 grew bumpy. CCU has production facilities and distribution centers across South America, though it derives most of its revenue and earn-ings domestically. Weaker copper prices and mounting political uncertainty during the quarter pushed the Chilean peso to a one-year low and the Chilean equity market down nearly 8%.10 Chile, like much of Latin American, has been dealing with mounting inflationary pressures; after quarter-end, the central bank hiked its key rate by 125 basis points to 2.75%.
Richemont (XSWX:CFR, Financial), which counts Cartier and Van Cleef & Arpels among its maisons, has a very large exposure to the Chinese luxury market, which has been hurt by curbs on international travel. In addition, recent rhetoric from the Chinese Communist Party has suggested a renewed focus on the “common prosperity” of its population and raised concerns among equity investors about the potential impact this could have on the spending habits of wealthy Chinese, many of whom likely recall the personal uncertainty that surrounded the country’s anti-corruption campaign launched in 2018. Though the degree to which China’s redistribution efforts will impact the revenues of luxury retailers like Richemont remains unclear, a broadening of economic growth could increase disposable income within the country’s middle- and upper-middle -class cohorts, aspirational buyers that typically serve as drivers of luxury sales volumes.
Sovereign bonds issued by a number of emerging markets— including Mexico and Colombia—repriced during the quarter on a combination of higher US Treasury rates and inflation concerns at home. While Mexico has been able to maintain its low-end investment grade rating despite the impact of Covid-19 through cautious debt issuance and prudent fiscal and monetary policy, Colombia saw its credit rating downgraded to junk at the beginning of the quarter due to large fiscal deficits and concerns about its ability to manage its rising government debt levels.
South Korea, in contrast with Mexico and Colombia, stands at the higher end of the sovereign issuer ratings spectrum. The Bank of Korea in August became the first major Asian bank to hike its benchmark interest rate, citing mounting inflationary pressures and ballooning consumer debt.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management
- Source: Federal Reserve Bank of St. Louis; data as of October 12, 2021.
- Kenneth S. Rogoff and Yuanchen Yang, “Peak China Housing,” NBER Working Paper Series (August 2020).
- Source: S&P Global Ratings, Moody’s Investors Service; data as of September 30, 2021.
- Source: FactSet; data as of September 30, 2021.
- Source: JPMorgan; data as of September 30, 2021.
- Source: Bloomberg; data as of September 30, 2021.
- Source: JPMorgan, Morgan Stanley Research, Bloomberg, S&P LCD; data as of September 30, 2021.
- Source: S&P Global Ratings, Moody’s Investors Service; data as of September 30, 2021.
- Source: Morgan Stanley Research; data as of September 30, 2021.
The Fund’s portfolio is actively managed and holdings can change at any time. Current and future portfolio holdings are subject to risk.
The opinions expressed are not necessarily those of the 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 views expressed herein may change at any time subsequent to the date of issue hereof. The informa-tion 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.
