By Albert Grosman & Brian Lund
Market Returns Overshadow Interest Rate Concerns
Market Overview
Whatever happened to “Don’t fight the Fed?” U.S. equity markets rose across the board in the second quarter, with the Russell 2000 Index (RTY) up 5.21%, the Russell 1000 Index up 8.58% and the tech-heavy NASDAQ Composite (COMP.IND) up over 13%. Among small caps, the companies with the lowest returns on equity (ROEs) jumped 11% in the quarter, those with no earnings 12%, and those with no sales 21%, according to Jefferies. Large caps outperformed small caps and growth outperformed value yet again, while IT, industrials, biotechnology and consumer discretionary industries led the value index. The outlook seemed to be one of low interest rates and avoiding a recession, a sort of Goldilocks combination.
Meanwhile, the federal-funds target rate rose another 50 bps, with expectations for further increases this year, pushing the elusive and much anticipated easing cycle out of 2023 into 2024. The long-term bond rates didn’t keep pace, as the 10-year U.S. Treasury yield rose 37 bps and the 30-year just 21 bps. The result was the biggest inversion between the 2- and 10-year Treasury yields since the early 1980s (Exhibit 1).
Exhibit 1: Yield Curve Reminiscent of the 1980s
As of June 30, 2023. Source: Bloomberg.
The last two small inversions began in January of 2000 and 2006, both presaging recessions and drops in federal-funds rates and the equity markets, with the Russell 1000, 2000, and NASDAQ all down more than 7% annualized over the following three years. Yet, this time around, equity investors in the most speculative asset classes seem to think it’s time to buy, and bond investors want to anticipate Fed cuts years in advance by keeping long-term rates low.
As we wrote last quarter, these market movements are making it harder for the Fed to reduce rates. With long-term rates relatively low (10-year Treasurys rarely yielded 4% or less prior to the 2008 global financial crisis) and corporate investment-grade and high-yield credit spreads below their 20-year averages, financing is widely available and affordable, especially in light of ongoing inflation. Employment continues to surprise to the upside and wages continue to rise, creating all the conditions necessary for inflation to continue. The Fed has no reason to stop increasing rates.
The Fed has another tool it could use to address this conundrum: quantitative tightening (QT). It still has almost $7.7 trillion worth of long-dated Treasurys and mortgage-backed securities on its balance sheet, compared with $3.6 trillion prior to the March 2020 pandemic. While it has sold about $800 billion of securities from its peak a year ago, the Fed had to reintroduce a few hundred billion during the banking crisis in the first quarter. We believe that QT is perfectly suited to the situation where the Fed needs long-term rates to rise to slow economic growth. Those securities, however, are the backbone of a huge amount of investment portfolios, including in banks and insurance companies. An increase of 100 bps in the 10-year Treasury yield, which may be necessary to break this logjam, could lead to more failures in financial institutions or at least require more bailouts.
We believe the Fed will continue the path it has chosen so far — moving slowly to increase rates and trickle out its long-term securities, hoping the market will correct itself. However, it hasn’t worked so far, as inflation is not tamed, and the most vulnerable banks have already failed. The rubber band continues to stretch further, with yield-curve inversion at levels few investors have ever seen. We think the most likely outcome will be a sharp rise in long-term rates and higher overall interest rates than currently expected in market prices. The setup is not good for long-duration equities with high valuations and low returns/earnings — exactly the ones that outperformed in the second quarter.
Market enthusiasm for these types of companies notwithstanding, the ClearBridge Small Cap Strategy outperformed its Russell 2000 Index benchmark for the second quarter, as strong contributions from stock selection in the IT, financials and industrials sectors offset detractors from the health care sector.
“Quantitative tightening is perfectly suited to the situation where the Fed needs to slow economic growth.”
Investor enthusiasm for AI-related companies and strong idiosyncratic catalysts helped drive our outperformance in the IT sector. Our top individual performer was SMART Global (SGH), which designs and manufactures specialty solutions for the high-performance computing, memory and LED markets. The stock caught the AI tailwind and got an added kicker from news it will sell the majority of its Brazil-based memory business to focus on higher-value products in computing and specialty memory. We believe the company is poised to deliver higher growth and better incremental margins than the market anticipates.
Another IT holding, Photronics (PLAB), also posted substantial returns for the quarter on the back of strong quarterly earnings and the AI-driven tech rally. Despite growing demand for high-end photomasks, the industry is capacity constrained and outsourced manufacturers such as Photronics stand to benefit. This has created a much more favorable environment for the company, which has shown increasing pricing power and longer-term contracts with major semiconductor manufacturers. We believe that the company’s investment and expansion of its manufacturing capabilities will allow it to continue to capture greater market share and extend its lead as the top merchant option in the industry.
The industrials sector also generated strong returns during the quarter, as stronger than expected corporate earnings and strong economic data helped to subdue recessionary fears. Textainer, which purchases, leases and resells marine cargo containers, saw its stock price climb after a major private equity firm announced plans to acquire a rival container leasing company for a substantial premium, shining a spotlight on the industry’s attractive valuations. With easing fears of a deep recession, signs of economic resiliency and growing optimism over an economic soft landing, we believe the supply-constrained shipping container industry will see greater demand than previously anticipated. Additionally, the company made substantial investments in containers during the COVID-19 pandemic, with the majority going into long-term leases that have bolstered the company’s excellent returns on equity. We believe that, even in the event of an extended downturn, the company continues to trade at a significant discount to its fundamental value. The market may be starting to come to the same conclusion.
The health care sector proved to be the main detractor from relative performance due to idiosyncratic factors impacting our portfolio holdings and our being underweight the sector as greater investor focus on long-term earnings growth helped to bolster many of the growth-oriented small cap health care names. For example, NovoCure (NVCR), an oncology company that makes devices for treating solid tumor cancers, was a detractor due to concerns about the commercial potential for the company’s Tumor Treating Fields in non-small-cell lung cancer. The data from the trial was positive but concerns were raised over the trial design and thus how effective the treatment may be. However, we remain investors and believe NovoCure will continue to grow in already approved indications as well as the potential for ongoing trials.
Portfolio Positioning
We were active adjusting our positioning across sectors following our bottom-up, fundamental process.
We initiated a position in Crane (CR), in the industrials sector, which then split into two separate companies, Crane and Crane NXT (CXT), both of which we retained. Under the split, Crane will continue to be a diversified manufacturer of highly engineered industrial products for the Aerospace & Electronics, Process Flow Technologies, and Engineered Materials industries. Crane NXT designs and manufactures banknotes for over 50 central banks, including the Fed. It is also the market leader in currency, coin and credit card payment devices in self-service retail machines, vending machines and back-office cash processing equipment. We believe both Crane NXT and Crane Company were undervalued within the former consolidated Crane, based on their strong competitive advantages and incremental returns on capital.
We also added indie Semiconductor (INDI), in the IT sector, which provides automotive semiconductor solutions for a variety of applications. The company is in the early innings of a rapid revenue ramp with a huge backlog to come as the company rapidly takes share in a growing market. We believe the market underestimates the long-term potential for this business as the company continues to sign high-profile contracts with major auto manufacturers and their suppliers.
We exited our position in Syneos Health (SYNH), a clinical research company that provides clinical trial services. The company’s share price has faced sustained pressure over the last few quarters due to difficulty in the company rebounding to pre-COVID testing levels and internal mismanagement. As a result, Syneos agreed to be acquired as part of a takeover deal with a private investment consortium, and we capitalized on the offer to sell and capture the premium offered by the acquirers as we concluded a higher offer was unlikely.
Outlook
Like Odysseus, forced to choose between sailing closer to the sea monster or the whirlpool, the Fed now also finds itself between Scylla and Charybdis. Either it keeps increasing short-term rates, pressuring consumers and businesses funded with floating-rate loans, or it ramps up QT and risks institutional instability. Despite an uptick in investor optimism, we see substantial evidence of turbulence underneath the market’s calm exterior and recognize the risks the rest of the market is discounting. We believe our approach of investing in companies with strong balance sheets, pricing power and managerial competence will allow us to persevere through whatever conditions emerge and generate attractive, long-term returns over the full market cycle.
Portfolio Highlights
The ClearBridge Small Cap Strategy outperformed its Russell 2000 Index benchmark during the second quarter. On an absolute basis, the Strategy had gains across all 11 sectors in which it was invested during the quarter. The leading contributors were IT and industrials sectors, while the energy and utilities sectors lagged.
On a relative basis, overall stock selection positively contributed to performance while sector allocation effects detracted. Specifically, stock selection in the IT, financials, industrials, consumer discretionary, communication services, materials and utilities sectors positively contributed to relative returns. Conversely, stock selection in and an underweight allocation to the health care sector weighed on relative performance.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were SMART Global, Photronics, Murphy USA (MUSA), Textainer (TGH) and Itron (ITRI). The largest detractors were Everi (EVRI), WesBanco (WSBC), MP Materials (MP), Washington Federal (WAFD) and Olin (OLN).
In addition to the transactions listed above, we initiated a position in Gambling.com (GAMB) in the communication services sector and exited a position in WSFS Financial (WSFS) in the financials sector.
Albert Grosman, Managing Director, Portfolio Manager
Brian Lund, CFA, Managing Director, Portfolio Manager
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Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. |
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