Global stock markets were strong in the third quarter with the MSCI World index providing a total return of close to 5% in US dollar terms*. This strength was not broad-based however, with the US and Japan the only major positive regions. Investors experienced negative returns in emerging markets.*Source: msci.com as at 28 September 2018
Part of the problem? The US economy steams ahead
The US economy grew at an annual rate of more than 4% in the second quarter of 2018, one of its strongest performances in years. The job market is tight with the jobless rate falling to 3.7%, its lowest level since 1969. Notably, Amazon has just announced a 50% increase of its minimum wage to $15 per hour. While the aggregate statistics show inflation is still low, the Federal Reserve is pursuing its course of tightening with another raise in interest rates, to 2.25%.
The tightening in US monetary policy is in stark contrast to many other countries around the world and it is starting to cause problems. Turkey and Argentina have been the two most visible casualties over the last three months but other emerging markets have also underperformed due to fears of contagion. Meanwhile, European markets have remained under pressure thanks to the ongoing political strife around Brexit and the populist budget from the new Italian government. European banking stocks recorded some of the worst performance in developed markets.
Beyond monetary policy, the relative strength of the US economy is contributing to global problems in other ways. A strong economy is emboldening the US government’s nationalist agenda. In Q3 there was escalation in trade tensions between the US and China as President Trump announced 10% tariffs on a further $200bn of Chinese goods, with a potential increase to 25% in January 2019. In response, China has imposed its own tariffs on $60bn of US goods.
Climate change unleashed
The rising frequency of extreme weather events is arguably more concerning than tightening monetary policy, trade tensions and populism. Thus far, 2018 has borne witness to a continuous stream of record-breaking events, such as the number of forest fires in the Arctic Circle, heatwaves in Europe and Japan, and more devastating storms and floods all across the world. The effects of climate change are no longer a future risk. They are playing out in real time and they are having a negative impact on global economic prosperity.
Trade war escalation hits IT
During the third quarter, the strategy’s best-performing sectors were information technology, health care and industrials and so the overall underperformance is disappointing given that these are significant sector weights in the portfolio. Therefore, stock-specific factors were the main reason behind the lagging returns. In information technology, several of the strategy’s holdings were caught up in the trade war escalation. In September, there were some early signs that this is causing a slowdown in the pace of investment by companies operating in the industrial, technology and automotive end markets. Our investments in factory automation, semiconductor and advanced manufacturing companies, such as IPG Photonics, Microchip, Omron, AMS and Aptiv, were negatively impacted.
In healthcare, the strongest sector performance came from pharmaceutical and biotechnology companies where the strategy has no investments. This was another drag to relative performance, notwithstanding the fact that two of the strategy’s major healthcare investments – Humana and Encompass Health – performed strongly. Finally, an underweight stance towards Apple and Amazon was negative for the strategy’s performance.
Key contributors to performance:
Hubbell (Efficiency theme),a North American manufacturer of electrical, lighting and power components recovered from its steep decline post Q1 results when it reported weaker-than-expected margins due to inflationary pressures. The management team indicated that it would be raising prices to compensate so we took the opportunity to add to our portfolio position. Q2 results showed evidence that the company’s performance was improving and management raised free-cash-flow guidance. Hubbell’s products are designed to increase electrical efficiency, reliability and safety, and include low voltage systems, wiring devices, LED lights, and smart controls and power components used in electrical grids. The increasing electrification of the economy is a necessary requirement for a successful transition to a low carbon world and Hubbell supplies the infrastructure to enable this.
Progressive (Safety theme),one of the largest automotive insurance companies in the US, continued its strong run. Progressive is currently benefitting from its expansion into the home insurance market and is having success in bundling property and auto insurance together. This expansion into new markets is resulting in structurally higher premium growth and margins. Progressive considers itself a data science company, focused on the insurance industry. The company uses data analytics, including tracking driving habits, to identify and attract lower risk drivers. This encourages safer driving practices amongst its policy holders and allows it to offer lower insurance rates; which results in a competitive advantage and higher rates of growth.
Encompass Health (Health theme), a leading provider of post-acute care in the US, rose as the company reported results that demonstrated robust organic volume growth in its Home Health and Hospice segments. The company also announced an acquisition which will further expand its presence into the US hospice segment. Following strong performance, we reduced our position to a size which takes into account the potential risk of a change to government rebates. Encompass is well positioned to benefit from an ageing demographic pressuring US healthcare costs because its inpatient rehabilitation centres and home care services offer a cost advantage over senior nursing facilities.
Autodesk (Knowledge & Technology theme), the global leader in design software used by architects and engineers, rose following quarterly results. The results showed progress in Autodesk’s transition to a more profitable, recurring revenue model as users transition from software licenses to digital subscriptions. 96% of Autodesk’s revenue is now considered recurring, which we believe should provide greater earnings stability, should construction end markets weaken. Autodesk’s solutions empower customers to optimise the environmental and social impacts of their designs. This can encompass producing designs that dramatically reduce energy needs, provide resilient and environmentally sustainable infrastructure, or allow new approaches to product development and manufacturing.
Key detractors from performance:
IPG Photonics (Efficiency theme), the leading global manufacturer of high-performance fibre lasers, declined. With almost 50% of sales from China, the escalating trade war between the US and China, and subsequent macroeconomic uncertainty has led some customers to delay purchasing decisions. IPG’s products are transforming manufacturing and industrial processes, increasing productivity and reducing negative environmental impacts. Its lasers are more powerful, more reliable and are up to 20 times more energy efficient than traditional industrial lasers and this is resulting in a much wider range of use cases.
Evoqua Water Technologies (Water Management theme), a water technology company with a sole focus on water treatment, fell following results. For the second consecutive quarter Evoqua experienced large projects being delayed in its municipal segment. Management is confident that revenues will improve in the coming months as these projects are completed. Evoqua serves municipal and industrial customers and its solutions span the entire water life cycle from extraction and purification to waste treatment and reuse. Evoqua’s treatment systems and services enable customers to achieve lower costs from the more efficient use of water, as well as ensuring their ability to meet regulatory compliance requirements and environmental sustainability objectives.
Microchip (Efficiency theme), a designer and manufacturer of microcontrollers, declined after reporting signs of a slowdown in activity at some of its customers. Several factors were behind this, such as tariff concerns and passive component shortages elsewhere in the supply chain. Also, Microchip completed its acquisition of Microsemi in the quarter and post deal closure it discovered that Microsemi management had been artificially inflating revenue by ‘stuffing the channel’ (inflating sales and earnings figures by over-supplying their distribution channels). We believe that all of these issues will be temporary and we view Microchip as one of the best-positioned companies in the world to benefit from the Fourth Industrial Revolution. Microcontrollers are the foundational building blocks of a connected world and are found in a vast array of applications. In all cases, they are essential to improving the efficiency with which energy and power is generated and consumed.
ASML (Knowledge & Technology theme), a global manufacturer of semiconductor microchip-making equipment, fell along with the broader semiconductor sector. Investors have become concerned about the impact of trade tensions, potentially peaking demand in various end markets and weak pricing in memory markets. Although these are valid short-term concerns, we continue to see semiconductors as the building blocks of a connected world and view ASML’s tools as key to future semiconductor efficiency gains. ASML’s mission is to invent advanced technology for high-tech lithography (transferring patterns or shapes onto silicon wafers), metrology (measurement) and software solutions for the semiconductor industry. This enables the advancement of ‘Moore’s law’ towards ever smaller, cheaper, more powerful and energy efficient semiconductors allowing technological progress in a number of fields including healthcare, technology, communications, energy, mobility and entertainment.
Activity and positioning
Our strategy positioning remains skewed towards our Knowledge & Technology and Efficiency themes resulting in our continued overweight towards the information technology and industrial sectors versus the index. The strategy remains underweight the energy, consumer staple and financial sectors and regional weighting remains in line with the MSCI World benchmark. The strategy is managed to keep regional weightings in line with the MSCI World benchmark while sector weightings are an outcome of where we are able to find the most compelling bottom up stock ideas while maintaining a balanced risk profile.
During the quarter, new positions were initiated in Nintendo and MasterCard. Positions in Analog Devices and Tetra Tech were divested.
Nintendo (Quality of Life) is a Japanese consumer electronics and video game company. It is a company with strong principles and its mission is to find unique ways to explore play with the aim of putting smiles on its customers’ faces. Nintendo’s products are family-focused and demonstrate a strong social element. It is very different to other gaming companies in this respect and we feel any company which sees its purpose as bringing joy to as many people as possible – irrespective of age, gender or ethnicity – has a strong place in the portfolio. Studies have also shown that gaming improves reading and mathematics, multi-tasking, perseverance, and fine motor skills. We are encouraged that Nintendo has developed technology that allows parents to remotely monitor and control a child’s usage and is taking steps to minimise the negative impacts from overuse.
Mastercard (Sustainable Property & Finance) operates a global payments processing network in more than 200 countries around the world. Its mission is to make payments safe, simple and smart and it is regarded as a leader in the field of electronic payments innovation. There are many benefits to the electrification of payments, including security, convenience and also economic development and financial inclusion. Mastercard has numerous initiatives around the world focused on providing affordable financial services and programmes to promote inclusive growth.
In the first week of October, bond yields around the world moved up sharply. This coincided with a sharp style rotation in global equity markets. On Thursday 4th October, the MSCI World Value index outperformed the MSCI World Growth index by 1.3%, which was the largest one-day outperformance since May 2009. Stocks in the information technology sector were hit particularly hard, while among the best performing sectors were energy, financials, consumer staples and utilities, in which the strategy is underweight. This is a challenging environment for the strategy given its growth style tilt and overweight stance towards the information technology sector.
With a portfolio active share in excess of 90%, periods of underperformance (and outperformance) are statistically inevitable and we would encourage our investors to regard this as a potential opportunity. Mean reversionary events are inevitable over shorter time periods and when they do happen, it is important to remind ourselves of the difference between value and valuation. Many factors can cause fluctuations in near-term valuations, with one of the most important being the level of interest rates. Valuation is not the same thing as value, however, and – over the long term – we believe that growth will always generate the most value for investors.
A strong feature of our strategy is our investment framework, which is based on sustainability with reference to environmental and social trends. This provides us with incredible clarity and consistency in the way we go about identifying attractive investment opportunities exposed to strong thematic growth drivers. The low carbon energy transition and the fourth industrial revolution, characterised by rising penetration of technology into all sectors of the global economy, are two investment trends that are so powerful that we regard them as generational in nature. The portfolio is positioned to take advantage of these two trends, both of which are inextricably linked to harmonising the many conflicts between environmental and social sustainability.
We believe that oil prices will start to decline again. In fact, a high oil price is self-defeating since it only serves to accelerate innovation and substitution. In ten years’ time there will be more renewable energy, many more electric cars, and billions more connected devices with semi-conductors and microchips capturing and generating vast amounts of data. All of this will be stored in the cloud, requiring memory and then analysed and made useful by software, in order to create efficiencies, increase productivity and generate value for our societies. As well as holding many leading companies related to these areas, the portfolio also has exposure to consumer companies leading the way in the circular economy; and to companies in health and life insurance, healthcare services, water technology, electrical safety, architectural design, education and entertainment. When we think about sustainability we see a world of opportunity – there is great diversity within the strategy’s portfolio, together with a clear focus.
Discover more about our favoured stocks in our Positive Impact Stocks document.