First Eagle Global Value Team commentary for the second quarter ended June 30, 2016.
First Eagle Global Value Team – Market Overview
In the second quarter of 2016, the MSCI World Index rose 1.01% while in the United States the S&P 500 Index increased 2.46%. In Europe, the German DAX Index was down ?7.73% and the French CAC 40 Index fell ?5.79%. In Japan, the Nikkei 225 Index rose 1.83% over the period. Brent crude oil increased 26.06% to $48.33 a barrel, and the price of gold rose 7.87% to $1,318.40 an ounce. The US dollar weakened ?8.72% against the yen and rose 2.12% against the euro.
From both a political and an economic perspective, we believe we are living in very uncertain times. Political issues came to the fore in late June when the UK voted to leave the European Union. This decision dramatized the rise of populism and nationalism–forces that have also surfaced in the United States and other countries. We believe the resurgence of populism and nationalism is rooted in three economic developments:
- Globalization–Over the last 15-25 years, globalization has reduced inequality between countries, but it has also increased inequality within developed nations, where the lower end of the labor market has been left behind. This has led a sizable segment of the public to conclude that globalization is unfair.
- Factory automation–Automation has added to these workers’ woes. The proliferation of robots on the factory floor is displacing a significant share of human labor. Over the long term, we think this shift could be positive, as people transition to service jobs that are more local in nature, but the interim period is challenging for segments of the labor force that have been stranded.
- Easy monetary policy–We believe easy monetary policy has also spurred nationalism and populism in the developed world. Financial repression has inflated asset values. For the wealthy, this can mean larger returns from their stock portfolios, but for people with modest income, it means negative real returns from their bank accounts.
As we look beyond these political uncertainties, we see other clouds on the investment horizon. In the United States, the scenario is complicated. The value of the dollar is already well above its long-term norm, and if real rates go up at some point, the risk of further exchange rate appreciation could lead to a material decline in net exports. Nevertheless, risk perception is low, implied volatility is below historical norms and stock valuations are above historical norms. In the immediate aftermath of Brexit, risk aversion seemed to return to the market, but not for long, and the S&P 500 Index quickly rebounded.
In China, the world’s second-largest economy and largest source of fixed capital investment, we continue to see a stealth depreciation of the yuan. If this trend continues, it could send a deflationary pulse throughout the rest of the world. In China we also see a continuing trend toward centralization of power and growing nationalism. Tensions have been rising between China and the Philippines over territory in the South China Sea.
Japan, with 6% fiscal deficits and negative interest rates going out more than a decade, has run out of conventional policy options and may go further into unconventional territory.
Europe has its challenges, too. While the UK has a large economy, its impact is modest on a global scale, and we think the greater risk from Brexit is the potential for contagion elsewhere in the EU. The EU has a lot on its plate over the next two years: weakness in the banking sector, French and German elections next year, renegotiation of the trade agreement with the UK, a workout for Italian banks, and the tail of a Greek restructuring that has yet to be finalized. The European economy is clearly below trend, with aggregate unemployment still around 10%.4 Some of the more cyclical sectors of the European markets, such as construction and telecommunications stocks, have been out of favor with investors. In an ordinary state of the world, we might think there’s opportunity here, but we are keeping a wary eye on Europe. The widening of credit default swaps on European banks could bode ill for sovereign risk perception in Europe.
In the Middle East, we see Saudi Arabia as an area of particular risk. The currency appears to be materially overvalued, oil prices are low, and the country has recently suffered a series of terrorist strikes. Saudi Arabia is also in the midst of an inter-generational leadership transition.
The rise of populism and nationalism and the absence of traditional central bank policy options create a picture of geopolitical uncertainty. Ironically, this uncertainty is not being met with correspondingly high return potential for risk assets. In fact, the outlook in the developed world is for low real returns and more volatility.
This is a challenging climate, but it is not all bad for active investors. As we have written in the past, we look for opportunities in four areas:
- Episodic stock opportunities–Even if the markets are at peak levels, individual stocks may not be. Our active, bottom-up process continues to uncover persistent businesses with attractive free-cash-flow yields.
- Episodic currency hedging–In a world of zero interest rates, exchange rate shifts may be quite pronounced. Hedging may potentially shield or enhance real returns, and there may be opportunities to invest in the sovereign debt of nations that have depressed currencies.
- A counter-cyclical use of cash5–We put cash to work in periods of market discomfort and raise cash in windows of market ebullience. These shifts are not driven by top-down calls but by our bottom-up stock selection criteria.
- Gold–In a world of paper money, gold cannot be printed. Despite the recent rally in the price of gold and the possibility of short-term volatility, we think gold offers potential for long-term returns.
Portfolio Review – First Eagle Global Fund
In the second quarter of 2016, the Global Fund Class A shares (w/out sales charge) returned 3.20% versus 1.01% for the MSCI World Index.
Our position in gold–both bullion and mining stocks–once again led our quarterly results. This potential hedge performed as intended. Gold bullion, Barrick Gold Corporation, Fresnillo PLC, Newcrest Mining Limited were among the leading contributors. In the depressed gold environment at the end of last year, we believe a number of miners were trading at discounts to the runoff value of their reserves. We have seen two things happen this year: The price of gold has gone up, and, in our opinion, the discount between gold and gold-mining shares has narrowed. Given the market environment, we remain comfortable with our overall gold position.
Finally, Keyence Corporation a leading player in the world of electronic sensors for factory automation, contributed to quarterly performance as well.
Detractors for the period included European companies that are perceived to be economically cyclical, such as Bouygues, Berkeley Group Holdings and HeidelbergCement. Bouygues, a French holding company, lost value both because of its exposure to the European construction market, where margins are under pressure, and because the planned sale of its telecommunication assets fell through. The collapse of this deal heightened investor fears that consolidation of the French mobile phone market will be delayed. Shares of Berkeley Group, a leading property developer in the UK, fell sharply following the Brexit vote.
Microsoft also declined at the end of the quarter in reaction to the company’s acquisition of LinkedIn. The price Microsoft paid may have looked expensive on an enterprise value/EBITDA basis, but we think LinkedIn’s EBITDA margins could potentially move up meaningfully over time.
Liberty Global, which owns the dominant cable-TV network in Europe, declined along with other companies that have leverage in their capital structure. We have been comfortable with the level of leverage and we also believe the company has opportunities for long-term earnings, but we have concerns about short-term volatility in its generation of free cash flow.
First Eagle Overseas Fund
The Overseas Fund Class A shares (w/out sales charge) returned 2.56% for the quarter versus -1.46% for the MSCI EAFE Index.
The top five contributors to performance for the quarter were gold bullion, Newcrest Mining Limited, Agnico-Eagle Mines Limited, Barrick Gold Corporation and KDDI Corporation. KDDI Corporation, a Japanese mobile and fixed-line telecom, contributed largely because it was perceived to have relatively little exposure to the business cycle.
Detractors for the period included European companies that are perceived to be economically cyclical, such as Bouygues SA, Berkeley Group Holdings PLC and HeidelbergCement AG. Bouyges, a French holding company, lost value both because of its exposure to the European construction market, where margins are under pressure, and because the planned sale of its telecommunication assets fell through. The collapse of this deal heightened investor fears that consolidation of the French mobile phone market will be delayed. Shares of Berkeley Group, a leading proprerty developer in the UK, fell sharply following the Brexit vote.
Like Bouygues, French telecom SFR Group (formerly Numericable), lost ground. Concerns over pricing and more pressured margins have weighted on SFR, and we will continue to monitor these developments. Lotte Confectionary Company Ltd. was another detractor to returns over the quarter.
First Eagle U.S. Value Fund
The US Value Fund Class A shares (w/out sales charge) returned 2.87% for the quarter versus 2.46% for the S&P 500 Index.
The top five contributors to performance for the quarter were gold bullion, Agnico-Eagle Mines Limited, Comcast Corporation, Newcrest Mining Limited and Alleghany Corporation.
The largest detractors for the quarter were Comtech Telecommunications Corporation, Microsoft Corporation, Synchrony Financial, Vista Outdoor Inc. and Weyerhaeuser Company.
We appreciate your confidence and thank you for your support.
First Eagle Investment Management, LLC
See full PDF below.