Trevor Williams
By Scott Glasser | Michael Kagan | Stephen Rigo, CFA
Paths to Outperformance Broaden Beyond Tech
Market Overview
The soft landing rally that took hold in November 2023 continued in 2024’s first quarter. The S&P 500 Index advanced in each month of the quarter, bringing the benchmark’s winning streak to five consecutive months and a 27% cumulative return. The S&P 500’s 10.56% quarterly advance was the 11th best start to a year since 1950, with the index making a record high in nearly 40% of the period’s trading days.
Although technology and AI remain a dominant part of the market narrative, benchmark performance has broadened significantly in the current rally. During the first quarter every sector except for real estate posted positive absolute returns. Yes, the technology-heavy communication services sector led performance (on the backs of Meta and Netflix), but energy was the next best performing sector as oil rallied above $80 per barrel. Information technology (IT) outperformed yet again, but returns were essentially in-line with the financials sector. The paths to outperformance have — finally — broadened beyond mega cap tech.
Elsewhere in the S&P 500, real estate, the lone sector to decline, was down just 0.55%. Utilities lagged the benchmark for a fifth consecutive quarter but still rose 4.57% on an absolute basis. Finally, consumer discretionary was a noteworthy laggard as Tesla’s (TSLA) 29% decline in the quarter weighed significantly on the sector’s return.
We noted in our fourth-quarter commentary the market’s powerful year-end advance was broad-based with small cap participation, the type of market internals supportive of a sustainable uptrend (characteristics absent from the highly concentrated market in the first half of 2023). At the close of the first quarter, the average stock continues to perform well with 87% of S&P 500 stocks above their 100-day moving average. Although we harbor some longer-term concerns and believe the market is long overdue for a correction, the current environment is one where pullbacks remain buyable.
We also follow measures of liquidity to assess the environment for risky assets. Although we have been concerned that the Federal Reserve’s withdrawal of liquidity via quantitative tightening (QT) would put pressure on equities and the economy, this has not yet been the case. Although pundits point to COVID stimulus excess savings or alternative liquidity pools such as the NY Fed Reverse Repo facility to explain this phenomenon, the fact is that current financial conditions are expansionary. Measures of liquidity suggest ample liquidity exists for risk assets. Money supply has stabilized, bank deposits are expanding for the first time since 2022, corporate credit spreads are tightening and at benign levels, and debt/equity issuance is expanding (Exhibit 1). Although we remain concerned a QT-driven liquidity drain is a matter of when and not if, we expect the Fed to ensure ample liquidity exists through the presidential election.
Exhibit 1: Tightening Credit Spreads Supportive of Liquidity
As of March 31, 2024. (Source: ClearBridge Investments, Bloomberg Finance.)
Outlook
Incoming data suggests that not only can the economic expansion persist near-term, but activity is also likely accelerating today. In March, the ISM Manufacturing PMI crossed into expansionary territory for the first time since October 2022 (Exhibit 2). Business inventories are lean, and there are signs that increases are required (Exhibit 3). Railcar loadings improved through the first quarter and turned positive in March. Capital spending expectations have firmed from a 2023 malaise and no longer suggest a decline in capex over the coming year. Finally, the employment market remains tight with unemployment under 4%, job openings plentiful and employers still paying higher wages to attract human capital.
This real-time swing in activity is manifesting itself in a firming of industrial commodities such as oil and copper. While inflation data slowed during the quarter, almost all of the reports were somewhat ahead of expectations — enough to spur higher Treasury yields and reduce the number of rate cuts predicted by the Fed’s dot plot.
Exhibit 2: ISM Manufacturing PMI Crosses into Expansionary Territory
As of March 31, 2024. (Source: ClearBridge Investments, Instituted of Supply Management, Bloomberg Finance.)
Exhibit 3: Business Inventories Look to Reload
As of March 31, 2024. (Source: ClearBridge Investments, Instituted of Supply Management, Bloomberg Finance.)
From an equity investor standpoint, the economic news is great, hence the 10.56% jump in the market. But stock market investors are obsessed with interest rate cuts supporting a soft landing. How does the Fed cut rates into an environment of rising demand, higher input costs and full employment? Cut too soon and run the risk that the Fed ushers in an Arthur Burns-esque re-acceleration in inflation, a situation Powell has repeatedly stated he will not tolerate. Hold rates high too long — until labor markets and wage inflation crack — and risk losing too much economic momentum to avoid a recession.
In sum, although near-term risks to the economy have seemingly abated, we continue to monitor the same risks that existed at the outset of the interest rate hiking cycle. In fact, we would argue those risks have heightened as the soft landing narrative is consensus among investors and largely factored into today’s stock market valuation. We are monitoring crosscurrents, including the winding down of excess consumer savings (COVID stimulus payments are largely exhausted) and a housing market still sluggish and unaffordable versus the potential productivity enhancement and deflationary impact of AI. In addition, the recent influx of immigration could prove a boon for businesses desperate for labor at a reasonable cost.
Longer-term, we worry about the sustainability of government debt and the increasing burden of higher interest rates on the budget deficit. At some point, the U.S. will need to increase taxes or cut spending to prevent debt costs from spiraling out of control. Neither will happen in an election year, but the next Congress faces stark choices. By no means is the U.S. dollar’s status as reserve currency our birthright.
While we are optimistic about the long-term benefits generative AI will have on workplace productivity, aggressive assumptions need to be made to justify current valuations. We admire the business models of the large technology companies but are mindful of their regulatory risks as well as the concentration risk they create for our portfolio. We are positive on much of the health care sector as market expectations for medical device and life science/tool companies have come in markedly, while we find the non-cyclical nature and modest valuation of pharmaceutical companies appealing. We are positive on select cyclicals such as rails, where expectations are low and sustained economic growth would create upside. We believe stable financial conditions and the potential for rate cuts and a steeper yield curve will benefit select financial companies such as banks. We do not expect the top-heavy market of 2023 to continue and believe a diversified portfolio with investments focused on durable growth at attractive valuations is best positioned in this transitioning interest rate regime.
Conclusion
Although we remain constructive on the near-term outlook, we believe total return expectations should be closer to long-term trend (high single digits) versus the larger swings that have become common in the post-COVID environment. We believe the market is overdue for a correction but that any pullback will be short-lived and buyable.
We are long-term investors. Rather than trying to bet on near-term earnings trends, we believe it is better to lookout two to three years and make investment decisions based upon our assessment of a company’s longer-term, sustainable growth rate relative to what is implied in today’s share price.
Portfolio Highlights
The ClearBridge Appreciation Strategy outperformed the benchmark S&P 500 Index in the first quarter. On an absolute basis, the Strategy had positive contributions from nine of 11 sectors. The IT and financials sectors were the main positive contributors to performance, while the real estate sector was the main detractor. The utilities sector’s contribution was largely flat.
In relative terms, stock selection and sector allocation contributed positively. Specifically, stock selection in the consumer discretionary, financials and health care sectors and a consumer discretionary underweight contributed the most, while stock selection in the IT and materials sectors detracted.
On an individual stock basis, the biggest contributors to absolute performance during the quarter were Nvidia (NVDA), Microsoft (MSFT), Meta Platforms (META), Berkshire Hathaway (BRK.A)(BRK.B) and Eli Lilly (LLY). The biggest detractors were Apple (AAPL), Adobe (ADBE), UnitedHealth Group (UNH), American Tower (AMT) and Crown Holdings (CCK).
During the quarter, we initiated positions in Icon in the health care sector, Synopsys (SNPS) and Intel (INTC) in the IT sector and Nestle (OTCPK:NSRGY) in the consumer staples sector. We exited positions in Pfizer (PFE) and Becton Dickinson (BDX) in the health care sector and Air Products and Chemicals (APD) in the materials sector.
Scott Glasser, Chief Investment Officer, Portfolio Manager
Michael Kagan, Managing Director, Portfolio Manager
Stephen Rigo, CFA, Managing Director, Portfolio Manager
Past performance is no guarantee of future results. Copyright © 2024 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: Standard & Poor’s.