Market Overview
The move down in long-term interest rates in recent quarters has shed an ominous light. We’ve seen the yield curve invert in the United States, and there is evidence of softening in the underlying economy. The manufacturing sector has been weak globally, and momentum in the service sector has started to fade. In the United States, services account for more than twothirds of the economy, and weakness here can have a deleterious effect; we’ve seen signs of this in a year-over-year deceleration in average hourly earnings and potentially a third consecutive quarterly decline in S&P 500 earnings growth once third quarter results are tabulated. The United States had been the bright spot in the global picture, but it has begun to dim, and the world economy appears to have stalled.
This slowdown is attributable to a number of headwinds, all of them having emerged amid a backdrop of elevated debt levels globally. One is the lag effect of Federal Reserve monetary tightening, the bulk of which took place in 2017 and 2018, and the deceleration in money supply growth that accompanied it. Another is the fact that the US economy appears to have cycled through the fiscal stimulus that was introduced in late 2017 and 2018.
Heightened geopolitical uncertainty also has been impactful. As we have noted for some time, the current environment is one in which global and local political developments can outweigh normal business cycle fundamentals. Perhaps most notable has been the US trade disputes with China and others; the concern here is not just the negative impact of tariffs on certain industries, but also the broader uncertainty that can undermine CEOs’ confidence as they formulate capital spending plans. In addition, we saw a move toward the impeachment of President Trump in the United States, while the UK’s Brexit plans have been further complicated by the emergence of various constitutional challenges. In September a drone attacked Saudi Arabia’s oil production facilities, halving their output. Hong Kong has experienced dramatic and persistent protest activity in recent months, and its economy, which is very important for China and the rest of the region, is going through a soft patch.
It’s also noteworthy that a host of significant banks around the world have depressed stock prices. These stocks have fallen, in large part, because low interest rates have limited the banks’ ability to profit from their fundamental business of lending. Yet banks are also the transmission mechanism for monetary policy. If easing—especially into negative territory—is damaging to banks, how efficacious can it be? Are central banks effectively pushing on a string?
Nevertheless, central banks have continued to move toward an easier posture in response to the weaker economic data. During the quarter, the European Central Bank lowered rates further into negative territory. In the United States, the Fed cut its benchmark rate and appears biased toward additional easing, driving the price of gold higher. (Historically, the gold price and real interest rates have been inversely related.) The Fed also introduced a $75 billion liquidity facility in response to a breakdown in the market for repurchase agreements; in the repo market, banks and certain other financial concerns extend very short-term loans to one another in exchange for safe collateral, typically Treasuries. We were troubled by this evidence that after just a short period of quantitative tightening, liquidity pressure started to build in the US banking sector
Softer economic conditions have not driven the investment markets down as much as one might have anticipated. This is probably due to investors’ expectations of easier monetary conditions, as lower real interest rates often have a positive impact on the prices of assets, whether equities or gold. Though equities as a whole have levitated at a reasonably high level, decent segments of the market have de-rated underneath the surface, in some cases creating interesting investment opportunities.
Credit—especially higher-quality credit—continued to perform well in the third quarter of 2019, but the rally was driven by the ongoing decline of long-term Treasury rates in the face of renewed Fed accommodation rather than by strengthening credit or macroeconomic fundamentals. As has been the case through much of the post-crisis period, investors in the third quarter generally saw bad news as good news: Signs of a slowing economy were deemed benign because they were likely to provoke greater accommodation from the Fed.
At this point in the credit cycle and economic cycle, we would have expected to see more deleveraging across credit markets, as the tailwind of economic growth typically allows companies to grow into their capital structures. This has not occurred in the current cycle because economic growth was tepid through 2016, and stronger growth in 2017 and 2018 did not provide a large enough boost to borrowers’ cash flows. On the investment grade side, however, some of the additional leveraging clearly has been deliberate. The low absolute yields made possible by global central banks have allowed investment grade issuers to add more leverage to their balance sheets and use the proceeds for activities that typically benefit equity investors at the expense of bondholders—paying dividends, undertaking mergers and acquisitions, and recapitalizing their capital structures, for example.
Within the investment grade market, the BBB cohort has grown massively in response to investors’ strong appetite for yield. When the economy turns, we see the potential for a portion of these BBBs to become “fallen angels” that destabilize the high yield market. Investment grade bonds tend to be longer in duration than high yield bonds and have a different investor base, so longer bonds that drop into the high yield category may require a higher risk premium. As the credit rating agencies begin to downgrade some cuspy BBB companies, market volatility could potentially increase. The volatility could be substantial given the absence of traditional countercyclical capital allocations from banks and brokerages, which have largely withdrawn from their role as market makers.
We are also mindful of the fact that since 1955 all recessions have been preceded by an inversion of the Treasury yield curve.1 After a brief period of inversion in March, the three-month/10- year curve has remained consistently inverted, by and large, since May. Historically, we observe that spreads have typically begun to widen within 12 months of inversion. The persistence of this inversion, the Fed’s effort to unwind its monetary tightening and the generationally high leverage in investment grade bonds all lead us to believe that conditions are ripe for the bond market to begin to reprice risk.
In this environment, we think it’s prudent to prepare early for the market turn. We’ve continued to emphasize higher-quality credits as well as shorter-duration issues, in the belief that liquidity remains underpriced in the current market. We want to have liquidity on hand for the time when we believe we may be sufficiently rewarded for deploying it.
Portfolio review
As of September 30, 2019, the Fund’s allocation to equities was 56.08% (37.75% international stocks and 18.33% US stocks). The Fund’s 28.75% bond allocation included 16.83% in investment grade issues. During the third quarter, Global Income Builder Fund Class A shares (without sales charge)* returned 0.18%, and the composite index returned 1.26%.
The leading contributors to third quarter performance were gold bullion and shares of Nestlé S.A. and NTT DoCoMo, Inc. The top fixed income contributors were Cloud Peak Energy Resources LLC 12.0%, due 11/01/2021; Citgo Petroleum Corporation 6.25%, due 08/15/2022; and Acco Brands Corporation 5.25%, due 12/15/2024.
The third quarter increase in the price of gold was off its second quarter pace, but this position was large enough to produce a sizable impact on portfolio performance.
Shares in Nestlé performed well during this period, as investors seeking to reduce their exposure to risk favored stable companies that have been reliable sources of dividends like the Swiss food company.
NTT DoCoMo is one of three established players in Japan’s mobile phone market, all of which were challenged by the entrance of a fourth participant. However, investors have started to recognize that the new competitor may have a difficult time meeting the low-cost expectations in this marketplace. NTT DoCoMo had the benefit of a relief rally in the third quarter.
Cloud Peak, a coal company operating in Wyoming and Montana, filed for bankruptcy in the second quarter and submitted its reorganization plan in the third. The plan showed better recoveries than investors anticipated, and the bonds moved up in value.
The Citgo bonds—which are secured by refining assets in Lemont, Illinois; Corpus Christi, Texas; and Lake Charles, Louisiana—also contributed to quarterly performance. While the price gain was modest, it meaningfully affected the portfolio due to the larger position size. Although Houston-based Citgo is owned by PDVSA, Venezuela’s national oil company, US sanctions prohibit Citgo from paying any dividends to its parent.
ACCO, which manufactures office products, reported good second quarter earnings and announced positive guidance.
The largest detractors from performance in the third quarter included Jardine Matheson Holdings Limited, Compania Cervecerias Unidas S.A. Sponsored ADR and Schlumberger NV. Among the fixed income holdings, detractors included Diamond Offshore Drilling, Inc. 7.875%, due 08/15/2025; Government of Poland 2.5%, due 04/25/2024; and Government of Singapore 2.25%, due 06/01/2021.
Jardine Matheson, a conglomerate with key assets primarily in Southeast Asia, saw its stock decline because of the continuing protests in Hong Kong, where it has its headquarters and major real estate holdings.
Shares of Schlumberger, an oilfield services company, declined as the price of oil fell in the third quarter.
Diamond Offshore, an offshore drilling contractor with offices around the globe, is a leading operator in a sector beset by latent overcapacity and sluggish growth. Diamond’s credit rating was downgraded in the quarter largely due to expectations of lower contracting activity among the major offshore explorers. Despite continued weakness in the sector, Diamond is consuming marginal amounts of cash and has sufficient liquidity over the coming years to manage through trough conditions.
The Government of Poland bonds declined in price because the zloty lost value versus the dollar.
The decline in the Government of Singapore bonds was due to market weakness.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
The performance data quoted herein represent past performance and do not guarantee future results. Market volatility can dramatically impact 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 September 30, 2019, 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 or an offer to buy, hold or sell or the solicitation of an offer to buy or sell any fund or security.
