ClearBridge Value Trust commentary for the second quarter ended June 30, 2016; titled, “Brexit And Market Risks: Real vs. Perceived”
“Then the unstable equilibrium generates a critical situation, which history has diversely met by legislation redistributing wealth or by revolution distributing poverty.” — Will & Ariel Durant
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ClearBridge Value Trust – Brexit and Market Risks: Real vs. Perceived
Brexit surprised me, but not in the way you might think. What surprised me was the overwhelming flood of questions and concerns the final Brexit vote elicited from clients, colleagues, family members and friends across the political spectrum. With a few exceptions, they were all shocked by the scale of the potential risk and uncertainty inherent in such an abrupt policy change, and they were all looking for context and answers. I certainly tried to provide what context I could without the full benefit of time, but I personally was left with many more questions than answers. However, the core of my surprise is that I do NOT see Brexit as a dramatic departure from the risks and uncertainties that have dominated this market cycle: how do investors navigate a highly indebted world characterized by secularly challenged economic growth, monetary policy experimentation on an unprecedented scale and occasional bouts of deflationary tail risk? Isn’t Brexit just the latest vivid example of deflationary tail risk, or is it something more? To be sure, there is a fair amount of irreducible uncertainty related to all things macro and certainly Brexit, but there are always risks we can price through the discipline of valuation and subjective probabilities.
What Brexit did reinforce is that political and policy risks are extremely elevated. Simply, there are a lot of very angry voters in the world who feel ignored and excluded by the status quo and the creative destructive forces of global markets. From an angry voter’s perspective, the “elite” benefit from the global wealth creation of open markets, while the populist voter is left with destroyed manufacturing jobs. This gets to the heart of the Durant quote at the top of this letter, where wealth disparity leads to an “unstable equilibrium” that eventually elicits a direct redistributive policy response or broad wealth destruction through revolution. This populist signal was certainly amplified by the Brexit vote, and it will play a key role in the upcoming elections in the U.S. as well as several western European countries. The challenge for investors is that political risk is incredibly difficult to price, meaning it’s a real struggle to put an expected value on a political event through a quantifiable potential outcome and a subjective probability. This challenge was really driven home by the overwhelming confidence that got priced into betting markets and currency markets in favor of Bremain before the vote. Clearly, these London-centric markets did not price the risks well, most likely due to a lack of cognitive diversity that did not reflect populist sentiment outside the City. The key question, however, is what are the real enduring market risks from Brexit?
A key psychological wound that has been ever present since the financial crisis is that many investors have a heightened and constant awareness of “tail risk,” which is broadly defined as an extreme event that destroys risk capital by triggering a bear market in stocks, and cannot be modelled on a linear or normally distributed scale. Brexit clearly pulled this scab right off that wound, as people prepare for a deflationary impulse and possible global recession. We fully understand these concerns, but we believe there is a large gap between the perceived and real risks from a true “tail” event.
As referenced above, we think Brexit did not surprise markets with new risks but reinforced existing concerns that are already broadly priced across assets. This reinforcement manifested itself in a deflationary playbook that is now as well-known and executed as Vince Lombardi’s Packers Power Sweep: sell stocks, especially pro-cyclical and higher-price-volatility stocks, and hedge out this equity risk with bonds. As a result of this rinse-wash-repeat exercise, we are seeing modest elevation in already elevated equity risk premiums and valuation spreads, and continued explosion in negative-yielding sovereign debt, which has now reached a staggering $10.25 trillion globally, as seen below in Exhibit 1. Certainly, deflationary risks in this environment are very real, and we are anxiously watching for signs of Brexit contagion by monitoring credit spreads globally. However, this playbook is completely blind to value, as central banks, risk management priorities, and the increasingly powerful machinery of asset allocation and their favored passive vehicles are solving for one variable: low volatility. We believe periods of material misallocation of capital have historically happened when a dominant world view coalesced in extreme valuations and crowding, which potentially leads to a real tail risk.
Could bonds, primarily the negative-yielding sovereign variety, reach such an extreme level of valuation against historic norms that they quit rising or even fall? What would happen to risk management and asset allocation models if the negative correlation between bonds and stocks reversed? How much would yields have to rise if the crowd started to sell and a real value buyer had to provide a bid? How artificially elevated are all asset prices, including stocks and hard assets like real estate, by the historically low cost of capital? These questions make us uncomfortable, because it is a list of risks that we do not think are priced in, and if current trends reverse, it has all the markings of true tail risk: non-linear volatility and permanent losses of capital.
Of course, timing a reversal is a real challenge as you could have posed these same concerns over the last few years, and deflation and policy concerns are real fundamental risks that support low yields. Outside of simply collapsing under the weight of extreme over-valuation, however, there is a potential policy change that deserves close observation: we believe that monetary policy experimentation will now lead to fiscal policy experimentation. In the spirit of Charlie Munger’s “show me the incentive and I will show you the outcome,” what politician now fails to grasp the need to harness populist anger to get elected and stay elected? From this political perspective, it makes all the sense in the world to finance fiscal programs with record-low-yielding government debt, and we think populist sentiments are powerful catalysts to get fiscal programs underway as new administrations are elected in Britain and the U.S. over the next several months. If we are correct here, and fiscal experimentation helps to harness political power, fiscal policy changes could surprise us as much as current monetary policies would have been unimagined prior to the Great Financial Crisis. More explicitly, just as betting and currency markets blew the Brexit call, the lack of cognitive diversity in broader markets leaves us very wary of what potential outcomes are currently priced.
The key, of course, is how this wariness translates to explicit scenarios for the near to intermediate term and portfolio positioning.
- Perceived Tail Risk: We still put odds of a U.S. recession at less than 20%. U.S. growth will likely slow some due to Brexit, but not materially. In addition, lower rates would act as a direct tailwind to our consumer-led economy, manifested most directly in lower mortgage rates. This would continue to support a steadily improving housing market, while commodity prices remain subdued, and employment continues to improve. What would change these odds? If credit spreads in the U.S. started to gap out, similar to what we saw in early 2016, which would act like shadow market-driven monetary tightening. So far, there is little evidence of that post-Brexit, and our recession probability is essentially unchanged.
- A Continued Muddle-Through: We put 60% probability that the U.S. economy continues to muddle through, with slow but positive real growth of roughly 2%, and modest margin compression from higher unit labor costs. The combination would still allow many U.S. companies to generate ample free cash flow, which would support the market as share buybacks and deal activity offset a continued liquidation of equities by private investors. U.S. equity risk premiums and valuation spreads will probably stay elevated under this scenario, but these will likely not spike. Multiple expansion is unlikely, in our opinion, but with continued stability in oil prices and no major post-Brexit spike in the dollar, we could see an end to the current earnings recession as shown in Exhibit 2 below. This could support mid-single digit earnings growth and a commensurate return in equities over the next few quarters.
- Real Tail Risk: We think a rise in rates is the real risk to be concerned about and our subjective probability is somewhere between 10% and 20%.1 We realize the current market narrative is completely counter to this view, but the potential for REAL surprise is what makes this scenario so dangerous. This outcome would likely trigger a spike in credit and valuation spreads, as the magnitude of mal-investment from an extremely low cost of capital would reverse and trigger forced selling. The silver lining in this scenario is that if it comes with fiscal policies that help reflate the U.S. economy, deep value assets that are tied to reflation could actually do well — especially on a relative basis. This possibility will make this scenario even harder for people to stomach, but the major risk comes from the challenge of selling crowded assets against limiting market liquidity. Assets tied to reflation are not crowded.
So where does this leave us on portfolio positioning? As always, our valuation-driven investment process is focused on buying stocks where a price-to-value gap suggests absolute value potential. Most importantly, we are focused on equities where absolute value is not driven by an artificially low cost of capital or unsustainably high cash flows and earnings. Broadly, we are finding absolute value opportunities where the stock price is volatile, and thus shunned by most investors, but where the underlying business model and cash flow is much less volatile than the price. The vast majority of the time, price is much more volatile than underlying business value, but these volatility-driven opportunities are even more prevalent in the current market environment where low volatility is prized.
Financials remain a key source of absolute value, but also price volatility. We lowered our bank and interest rate exposure in the second quarter, with a shift to consumer credit names that enjoy very high returns on equity (ROE), but are valued at levels below historic norms and those of most regional banks. We added one new financial during the quarter, MetLife, which is sensitive to interest rates, but where the current management team is driving material business and structural improvements rather than simply waiting for the environment to get better. We would also highlight that both our bank holdings, Citigroup and Wells Fargo, passed the annual Fed stress test and the Fed had no objections to their capital return plans supporting a total shareholder capital return yield of approximately 9% and 8%, respectively. Just so no one thinks the Fed is becoming easy on the hated banks, the 2016 tests had the harshest severe stress scenario ever that the banks had to hurdle, including an assumed 7.5% drop in real U.S. economic growth, an 11.3% unemployment rate, a 51% stock market decline, a spike in equity market volatility to 79 (400% increase from current levels), house prices down 24% and a 10-year Treasury yield of 0.2%. Like investors, regulators can explicitly imagine a deflationary tail risk, and they are treating the banks accordingly.
We also continue to find value in technology, where the Brexit correction gave us a valuation window to invest in Alphabet at a price-to-value gap that was accretive to the portfolio’s potential upside. Most importantly, the portfolio now owns all three dominant providers of commercial cloud services: Alphabet, Amazon and Microsoft. We think the ongoing structural shift to the cloud will drive technology fundamentals over the next several years, and our goal is to own the likely winners at the right price.
We also allocated more capital to drug companies during the quarter, and initiated a new position in the generic company Mylan. We think drug pricing risk is a real issue during this political cycle. However, there are an increasing number of opportunities where the stock price is reflecting a collapse in the underlying business model that is unlikely, or where we are getting the current commercialized drug portfolio very cheaply and the future drug pipeline essentially for free. From a portfolio perspective, drug companies also give us a defensive portfolio block, but without paying the extremely high valuation levels currently embedded in most other defensive sectors like staples and regulated utility stocks.
Finally, on the materials side we bought the potash and phosphate fertilizer company Mosaic. We think fertilizer prices should follow the recent rebound in crop prices higher, especially if the current El Niño weather pattern shifts to a disruptive La Niña pattern as expected by most long-term weather forecasters and historic patterns. This weather transition could put further upward pressure on crop prices, driving farm income and subsequently fertilizer demand. Similar to our bullish view on natural gas and power prices, we like finding mispriced stocks that have distinct fundamental drivers separate from the classic economic cycle. We think Mosaic fits the bill, and is an example of the broad value drivers at work in the portfolio.
Our biggest challenge remains portfolio construction. The market has clustered assets into two correlating blocks: volatile “risk-on” assets that are deemed highly sensitive to economic risks, and low-volatility “risk-off” assets that correlate directly with bond yields. This binary state would be manageable, except that the tradeoff between volatility and value has never been higher. As seen in the gray line in Exhibit 3 below, this un-nuanced pricing behavior has driven the valuation gap between the equity risk premium and the risk-free rate to historic highs. Essentially, it has never been more expensive to hedge equity price volatility with bonds or bond-proxy stocks. The resulting valuation risk in the so-called risk-free rate leaves us uncomfortable, and at odds with the asset allocation machine that is dominating the marginal pricing of assets. As we survey the widening gap between real and perceived risks, we think long-term investors must stay focused on absolute value and accept the price volatility that is an inherent part of harvesting a valuation-driven risk premium. We appreciate your interest and continued support.
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