U.S. Cedes Leadership in Global Rotation

Global Growth Strategy Commentary Q3 2024

Key Takeaways

• The third quarter was characterised by sharp reversals in policy and market leadership, with global equities delivering broad gains with a locus of strength in China and greater Asia.
• The Strategy underperformed in an environment favouring value and international shares primarily due to weakness among our U.S. holdings.
• Positioning activity was geared toward upgrading into new ideas with better growth and valuation support. Convinced that Japan’s move to upgrade profitability, capital allocation and shareholder returns is authentic, we added four new ideas in the region.

Market Overview

Broadening participation sent global equities higher in the third quarter, with value and cyclical shares leading the way as financial conditions eased across most developed markets. The benchmark MSCI All Country World Index advanced 2.63%.

From a regional standpoint, Asia Ex Japan, emerging markets and the United Kingdom outperformed the index. Europe Ex U.K. performed in line while Japan and North America underperformed in a period that saw currency volatility as a rising yen forced carry trade investors who were short the currency to cover their losses. Chinese equities surged to end the quarter following the announcement of aggressive stimulus from Beijing, lifting the performance of broader emerging markets.

In the U.S., which represents the largest weight in the benchmark and the Strategy, signs of cooling inflation and an ambitious start to the Federal Reserve’s rate-cutting cycle drove equity markets to widening gains, led by smaller capitalisation companies. The large cap Russell 1000 Index rose 6.08% (in U.S. dollars) while the small cap Russell 2000 Index jumped 9.27%. Volatility spiked following a series of weak employment reports that saw the unemployment rate increase to 4.3%, its highest level since late 2021. In September, the Fed followed through on its concerns about labour market weakness by cutting interest rates by a half point, a move that sparked a stock rally through the end of the period that saw value shares outperform growth as equity leadership broadened beyond the Magnificent Seven. Now markets are nervously anticipating the upcoming U.S. election and what that could mean for international trade. The USD was broadly weaker throughout the quarter against all major currencies.

Sharp reversals were also the order of the day outside the U.S., with some of the worst-performing markets such as Hong Kong staging a sharp turnaround after the announcement of large stimulus packages from Chinese officials. Nearly a year’s worth of trading took place in the last day of the quarter. This led China-focused segments, like materials, to make significant moves higher. Japan’s choice of a new Liberal Democratic Party head to be prime minister also surprised the market, raising fears that he might not follow the corporate policies of the previous administration — something that has since been put to rest — and led to money going back into China from Japan from shorter-term players in the market. Year to date, Japan had been one of the better-performing markets, while China had been unquestionably the worst, hence the strong reversion.

Global growth stocks rose for the quarter but underperformed their value counterparts as a market rotation away from previously narrow leadership in health care and technology ensued.

Exhibit 1: MSCI Growth vs. Value Performance

As of 30 September 2024. Source: FactSet. Currency: USD.

The ClearBridge Global Growth Strategy underperformed the benchmark in a third-quarter environment favouring value shares primarily due to weak results among our larger cap U.S. holdings. Mega caps Alphabet, Microsoft, Amazon.com and Nvidia suffered losses during the quarter due to slowing revenue growth at Alphabet’s YouTube, scepticism over higher AI capex at Microsoft, weaker than expected margin expansion for Amazon’s core retail business as well as delays in the rollout of Nvidia’s next generation GPUs that power AI computing. We believe these companies remain well positioned in their respective leadership markets and their defensive characteristics could prove beneficial should the Fed not follow through with its full slate of projected rate cuts.

Partially offsetting weakness in these names, the Strategy saw solid performance from fellow U.S. mega caps Apple and Meta Platforms. Apple was lifted by optimism over a strong iPhone upgrade cycle with generative AI features a catalyst for consumers to buy up to more premium models while Meta continued to expand its leadership position in digital advertising.

As a diversified growth manager, we are not just invested in Magnificent Seven names but strategically will own them and maintain an active portfolio management approach to positions and active weights in line with our view of these companies’ intrinsic value. 

GLP-1 pharmaceutical developer Novo Nordisk and semiconductor equipment maker ASML, European portfolio holdings that had led in a previously narrow global market environment, gave back gains in the rotation. We maintain confidence in these franchises as leaders in the secular growth market of diabesity treatments and the broadening adoption of Gen AI.

The Strategy also benefited from a handful of holdings participating in the rotation toward more cyclical and rate-sensitive areas of the global economy, namely U.S. capital markets firm Intercontinental Exchange, U.S. utility and renewable power producer NextEra Energy as well as Irish building materials provider CRH.

Engaging with Part-of-the-Solution Companies

In an environment of transitory macro crosswinds, we believe a stock-specific approach to analysing environmental, social and governance (ESG) risks and opportunities remains all the more important. In our pursuit of positive outcomes for our clients, we are guided by research-driven stock selection as we seek to generate portfolios distinct from the market and supported by positive ESG characteristics. For example, environmental factors such as climate change remain material issues for investors to consider on a stock-by-stock basis, and the energy transition remains central to our company conversations as our holdings continue to reduce their emissions, often through cost-saving efficiency improvements, and set goals for further reductions.

Our fundamental research process includes engaging with companies that are acknowledged leaders in the energy transition, such as NextEra Energy and its subsidiary NextEra Energy Partners LP (NEP), two companies accounting for 20% market share of the domestic renewable market. NextEra is still capitalising on the Inflation Reduction Act through investing in solar and battery power, where it expects stronger growth in the near term, while wind generation additions are expected to see some catching up over the subsequent years. As we discussed recently in engagements with NextEra’s management team, growth for both entities is underpinned by a bullish power demand outlook, with a 38% increase in demand expected through 2040, driven by decarbonisation and electrification.

More recently, the already strong demand for renewables is being amplified by AI and data centre expansions, which are expected to double the current 4% of overall power demand currently represented by data centres. The share of AI and data centre companies represents 6 GW, but growth in this customer segment will start impacting NextEra’s growth estimates more significantly after 2027. Management has conveyed to us that it will take time to add incremental demand from data centres onto the grid given existent grid constraints (transmission access) that are present across all power markets. For example, even in the unregulated Texas power market, where customer growth is faster and generation additions are typically easier, the regulated grid remains a big bottleneck. Adding data centre customers to the grid is complicated, as it involves both grid operators and power producers.

In an environment where transmission interconnects (connections between segments of the grid that allow for the transfer of electricity from power generation sources to customers) take years, NextEra’s 150 GW of interconnect queue positions become more valuable. Having surplus interconnections reduces renewable projects’ timelines. In the meantime, NextEra’s analytics tools have been helpful in identifying the best data centre locations and putting NextEra at a competitive advantage through access to land and transmission.

Portfolio Positioning

We were active in the quarter selling positions where we feel growth is on the decline, upgrading into new ideas with better growth and valuation support. Such moves included swapping out Swiss eye care products provider Alcon for U.S. robotic surgery manufacturer Intuitive Surgical, which is benefiting from accelerating procedure growth, and swapping Belgian biotechnology firm UCB, which expects to receive approval for more indications of its psoriasis treatment, for struggling U.S. medical device and pharmaceutical distributor McKesson.

At this point we are convinced that the Japan move to upgrade profitability, capital allocation and shareholder returns is authentic and added four new ideas that reflect this confidence. In the secular bucket, we purchased Terumo, a Japanese manufacturer of medical equipment for blood management, cardiac and vascular procedures as well as general hospital uses. Its core cardiovascular and vascular device business is growing at above-market rates due to better patient outcomes and improved hospital economics. New product launches in its blood and cell technologies business should further bolster Terumo’s growth. We see the company expanding margins through steady growth in core markets, new business and more aggressive M&A that is possible under its new CEO.

Structural growth companies provide us the opportunity to generate alpha from turnarounds and restructurings as well as broader cyclical drivers. The other three Japan additions fall into this category — Asics, Tokio Marine and Nippon Sanso Holdings, an industrial gases supplier. All three stand to benefit from both company-specific actions as well as broader reforms in the Japanese market aimed at improving return on equity and shareholder engagement while promoting M&A activity.

Asics is a specialty running shoe designer whose newer management is committed to bringing the business back to industry-like profitability. In addition to its iconic running shoes, the company also develops footwear for the sports lifestyle and health/comfort markets. With better operational focus, inventory management and a move to specialty sales channels, we believe Asics’s well-known quality will allow it to sell more products with better pricing and margins, leading to significant earnings growth.

Tokio Marine is a top global property and casualty insurer. M&A among its smaller rivals in the past few years has created greater parity but Tokio Marine remains the largest insurer by market cap due to its larger overseas portfolio, mostly based in the U.S. We see three sources of price appreciation for the company going forward: premium increases in its domestic P&C business, the selling off of cross holdings that could unlock up to 30% of the company’s current value and bolt-on acquisitions funded by its high cash generation.

China’s struggle through a post-pandemic recovery has not impacted every sector the same way, presenting an opportunity to purchase EV maker BYD. While Beijing’s late-quarter stimulus measures are a good start, ongoing weakness in the world’s second-largest economy has caused us to pare back our direct holdings in the market over the past year. We are now evaluating our indirect exposure as well, which resulted in several exits and trims during the quarter, including the sale of Hong Kong-based life insurer AIA Group. Although AIA’s business has started to improve, wages and employment, particularly among younger consumers, have slowed dramatically, creating concern of less disposable income insurance purchases. Government stimulus through lower rates will also lower investment income for insurers.

Outlook

With its September rate cut, the Federal Reserve joined central banks in the eurozone, the U.K., Switzerland and Canada in easing financial conditions. The Fed move has ramifications well beyond the U.S. and is supportive of broadening participation across both developed and emerging equity markets (Exhibit 2). Combined with China’s aggressive stimulus measures announced late in the quarter, we expect global economic activity will remain positive through the end of the year and into 2025.

Exhibit 2: Global Equity Leadership Following the Cut

Data as of 30 September 2024. Sources: FactSet, MSCI, NBER. Currency: USD.

We are encouraged by the improving conditions across our investable universe as they create a more conducive environment for our diversified approach to growth. Recent performance has highlighted the benefits of complementing core secular growth positions with opportunistic ownership of structural growers and selective exposure to emerging growth names.

Portfolio Highlights

During the third quarter, the ClearBridge Global Growth Strategy underperformed its MSCI ACWI benchmark. On an absolute basis, the Strategy delivered gains across six of the 10 sectors in which it was invested (out of 11 total), with the financials sector the primary contributor and IT and communication services the main detractors.

On a relative basis, overall stock selection and sector allocation detracted from performance. In particular, stock selection in the health care, industrials, communication services and consumer discretionary sectors and an overweight to IT weighed on results. On the positive side, stock selection in the IT and materials sectors and a an overweight to health care contributed to performance.

On a regional basis, stock selection in North America, emerging markets and Europe Ex U.K. weighed on performance while stock selection in Japan and the U.K. proved beneficial.

On an individual stock basis, the largest contributors to absolute returns in the quarter included Apple in the IT sector, Intercontinental Exchange in financials, Haleon in consumer staples, Meta Platforms in communication services and NextEra Energy in utilities. The greatest detractors from absolute returns included positions in Alphabet in communication services, Novo Nordisk and DexCom in health care, Microsoft in IT and Amazon.com in consumer discretionary.

In addition to the transactions mentioned above, we added positions in T-Mobile US in communication services, Equinix in real estate, Danone in consumer staples, KKR and Lloyd’s Banking Group in financials as well as Dollarama and Starbucks in consumer discretionary. The Strategy exited positions in Haleon in consumer staples, Brambles, SMC and Daifuku in industrials, as well as Monday.com, Hexagon and Guidewire Software in IT.