Investment Vlog with David Eiswert - March 2016

March 2016
David J. Eiswert , Portfolio Manager, Global Focused Growth Equity Strategy

 

MR. EISWERT: Hi. My name is Dave Eiswert. I'm the portfolio manager of the Global Focused Growth Strategy at T. Rowe Price, and this is a virtual PM session where we try to bring our clients a little closer to our current thinking and how we're dealing with the current market situation.


So 2016 started off a pretty painful month and a half, and really a very powerful barren narrative around recession and credit and another round of QE sort of dominated the way investors have thought about the market. So if we look at what's happened since the beginning of 2016 we've really seen a pretty dramatic risk-off, selling around factors.


We've seen a crowding into telecom, staples and utilities for safety, and we've really seen a lot of pain in the area of financials, and we'll talk about why financials have been so painful year to date. So let's look at what has driven this sentiment and what has driven the way the financial markets have reacted early this year.


So of course there's China, and China started off the year with some circuit breakers going off in Shanghai, and again a focus on the devaluation of the yuan and how that would affect the global economy, and EM is definitely wrapped up in China. When China catches a cold EM definitely feels it, but there's a bigger part of this, and I think if you look for the real driver of volatility this year it's really been around oil.


And why is that? And I think the way we're talking about oil today is that we are coming through or coming out of what, you know, I think we'll look back and call a shale bubble in the United States, not so much because shale is hype or not real, or horizontal drilling is hype or not real, but because there was a tremendous amount of capital allocated towards energy in the United States at very high oil prices, and as oil prices have come down it's left a lot of that capital stranded. 


Now, why oil prices have come down? Is it because of lack of demand? We don't think so. It's really driven by how the Saudis and OPEC have responded to both U.S. shale and to Iran and sanctions being lifted from Iran and their oil coming onto the market. OPEC and Saudi Arabia have simply said we're not going to lose share, and that has led to too much oil, too much oil in the world. 


Now, how does that lead to a big risk-off trade? I mean, low oil prices should be good for global growth, and they are good for global growth. The problem is that in this shale capex cycle in the United States there was a lot of high yield credit used to fund that. That high yield credit has now come under stress as oil prices have fallen. 


That has led to the fear of contagion around financial institutions and banks, and that has led to high yield spreads blowing out. That has led to, I mean, even pressure on European banks related to, you know, the stability of the global financial system, I think very exaggerated, but I do think that that is at the core of what has been going on.


And if you look at oil prices relative to financials as a global equity class you'll see a very high correlation. What's really important to think about, though, is that low energy prices are being driven by too much supply, by the innovation of horizontal drilling, not by somehow a big step down in demand. There hasn't been a big step down in demand, so that's very important to keep in mind. 


So what has the bursting of the shale bubble done? It's driven down oil prices, it's driven up the risk of financial contagion. It's also distorted U.S. growth and it's distorted U.S. growth and the impact it's had around capex and industrial production, and that's led many people to talk about the U.S. economy going into a recession. 


We contrast that with what we see in the consumer and other parts of the U.S. economy which are very strong and show no signs of recession, so it's very acute what energy has done to the U.S. economy. I understand why people leap to that recession conclusion, but we think it's a stretch. 


That fear of recession, though, has led to calls for more central bank intervention, more QE. This has driven gold prices higher, it's driven risk aversion higher, and it's again really had a negative impact on the financial institutions because the introduction of negative rates of course would be very bad for returns on equity for financials.


There are a couple of other key issues that I think we should touch on that have been powerful and negative this year, and one is populism in politics. I mean, from the United States we usually think about populism as being some Latin American phenomenon or maybe southern European in Spain or Italy or Brazil, but really in the United States we do see a risk today from populism.


Both Bernie Sanders on the democratic side and Donald Trump on the republican side really introduce a lot of uncertainty into how U.S. politics will evolve, and it's really a phenomenon that's new to the country. I mean, we're traditionally used to very stable political parties producing a candidate that looks somewhat similar to candidates we've seen before. That's different this year, and that's introducing some risk.


I would also say that people are just skeptical of the length of low growth that we've had, the length of stock market appreciation that we've had, and they say look, this has gone on too long, you know, we need a recession or we should expect a recession, or we should expect a big correction in the stock market, and so that gives people pause when they think about buying equities.


All this has led to a very negative narrative coming into 2016 and really driven a pretty significant correction in stock prices. So how do we view the world and how do we set our foundation for thinking about the world? Well, first of all, we do not think the U.S. is headed into a recession. The U.S. is growing very slowly, so slowly it's hard to see a dramatic recession.
We do think industrial production has been impacted by the shale bubble, and that does present some signals of a recession, but the U.S. consumer is very strong, the dollar is strong, interest rates are low, we haven't overbuilt housing or nonres construction and, you know, we think that that's a very positive environment for consumers.


Europe is growing very slowly, but it's growing. It's sort of very slow and steady, and we think that will be a positive. Low energy prices, low commodity prices should be a big boom to the European economy without the capex hit that the United States is taking because continental Europe really doesn't produce much energy.


India, bumpy. There's an asset quality review going on in the banks right now which is creating some opportunities, but we like the long-term positioning of India, again very short commodities which makes it interesting. And China, you know, we see China in a muddled down scenario, not a muddled through but a muddled down, so they're muddling down to lower growth, but we don't see a Lehman-type shock in China that would lead to another global financial contagion.


You know, oil sticks out as a problem, right. It's a problem in the sense that we think there's too much. That will keep prices low, and it's hard to imagine that leading to a lot of capex growth around oil. So the fact is that we're in a slow growth world. It's a grinded out world, and the question is whether we can make money in equities.


The one wrench I'll throw in this whole situation is that we do see wage inflation beginning to happen in the United States, and so despite all the narrative of a recession it puts the fed in an awkward position where on the one hand people are calling for more QE and the fear of a recession.


On the other hand, we're actually seeing wages rise, which we think is very positive for the U.S. economy. So again, a lot of contradictions here, but a low growth world is a world where you can make money if you have insights about improving returns on businesses that are gaining share on the right side of change.


So how do we respond to this market move? You know, our strategy is to look for good companies where we have insights about improving returns and don't pay too much, and January and February gave us a lot of opportunities to buy new names where we love the one, two, three year, five year story, but maybe they were too expensive, maybe there was an issue that we didn't own that stock.


We were able to rotate into a lot of those names, and so there's a lot of turnover in the portfolio in January and February, again always trying to put us on the right side of the way the world's change. We added names in the areas of secular growth. Some names that we hadn't known because of valuation we were able to pick them up.


We added selectively to EM where we thought, you know, there's a very high correlation in how EM was trading earlier this year, and it allowed us to pick off some high quality companies. We continue to think that's an interesting place. It's one of the places around the world where valuation is compelling if you can own the right companies in the right countries.


We added to our energy portfolio. Now, we're very underweight energy but there were some select names that we thought where we can see a good story of improving returns on capital even in a low oil price world, and we took advantage of that. Finally, we added to industrials kind of to lean against the idea of a recession in the United States and really to look forward to improving returns and better comparisons as we move into '17.


So looking ahead we continue to see oil as very volatile, there's just too much oil. That will lead to credit being volatile so that will create opportunities in the next three to six months, but we think there's enough growth in the world to give a portfolio like ours an opportunity to add alpha by picking off that right name and making big enough bets in those names to matter.


We're going to lap the energy capex hit and industrial production hit in the United States as we move through '16 which will make some of those companies look less risky, look less vulnerable. We think we're going to continue to see a lot of M and A, and that matters both if you own companies that are acquired but also if you own industries where the industry structure is improving.

So we're always looking to be positioned for improving industry structure, and so in the end we're going to grind out in this kind of low growth world. We're going to look for those places where we have insights about future improving returns, right, and try to position the portfolio to own the best names in those spaces and really take advantage of how the market panics one way or the other, because if we're in those right names we think we'll do very well. Thank you very much. I hope this has been helpful.

 

2016-GL-3551

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The views contained herein are as of March 2016.

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