Market Overview
In the fourth quarter of 2015, the MSCI World Index rose 5.50% while in the United States, the S&P 500 Index increased 7.04%. The Barclays U.S. Aggregate Bond Index and the Barclays U.S. Corporate High Yield Index returned −0.57% and −2.07%, respectively. In Europe, the German DAX climbed 8.22% and the French CAC 40 Index rose 1.29%. In Japan, the Nikkei 225 Index increased 8.98% over the period. Crude oil fell 17.85% to $37.04 a barrel, and the price of gold fell 4.95% to $1,060 an ounce. The US dollar gained 0.44% against the yen and strengthened 2.68% against the euro.
In the fourth quarter of 2015, many equity markets recovered from the global declines of late August and September, which had been sparked by extreme volatility in Chinese equity markets. With China the epicenter of the market selloff, sentiment in the fourth quarter favored US over international markets: The S&P 500 index regained almost the entirety of its third-quarter decline, but the MSCI EAFE index clawed back barely one-third of its prior quarter’s fall.
While we believe that the Chinese authorities want to modernize and liberalize their economy by moving it away from its historical focus on fixed-asset investment, we are not convinced that they are willing to endure some of the necessary consequences. For example, the liberalization of the yuan in August was quickly followed by a step backward in the form of massive currency intervention when the market reaction was deemed undesirable. Similarly, the pivot to a more consumer-oriented economy may require the restructuring of unprofitable industries and the elimination of subsidies—steps that will likely cause higher unemployment. It is certainly reasonable to expect continued volatility while the world waits to see whether Chinese leadership will push forward with reforms or will revert to the old model of debt-fueled, fixed-asset-intensive economic growth—a model that has led to overcapacity, high debt levels and environmental damage. Either way, China’s multi-decade role as the global engine of growth seems to be in question.
With another bout of China-fueled market volatility greeting the new year, generally the equity recovery of the fourth quarter feels quite ephemeral. The investment world again faces the risk of hard landings and abrupt currency devaluations. While Chinese policymakers are clearly set against such outcomes, there is always the risk that they could lose control of their country’s markets.
Meanwhile, the landscape for income investors improved moderately. Fixed-income assets as a whole saw declines, as benchmark 10-year-bond yields increased moderately from 2.04% to 2.27%.1 More pronounced was the widening in credit spreads during the second half of 2015. Initially, the impact was relatively contained within commodity credits, but more recently we have seen some modest spread widening among non-commodity issuers.
Another prominent theme in 2015 was the increase in yields of emerging-market sovereign bonds. While economic results have deteriorated sharply in many Emerging Markets geographies, investors at least can now avail themselves of yield levels that are a little more commensurate with the risks that are always present in EM investing. While Japan and Europe are firmly entrenched in quantitative easing, there has also been some (very) modest tightening in the US. The Federal Reserve has finally moved off the zero bound and hinted, to the disbelief of some market participants, that three or four further rate hikes lie in store for 2016. With the current bout of risk aversion triggering a “flight to safety” and with yields on 10-year Treasuries falling below 2%2 , we have yet to see the Fed’s policy shift translate into change at the longer end of the US rate curve. Traditional equity-income sectors such as US REITs and utilities will likely require more pronounced increases in longer-term bond yields to come back down to more normalized valuation levels. Still, as we write, we think the overall income outlook for fixed-income investments may have reached its most attractive point since we launched this fund nearly four years ago.
Portfolio Review
As a flexible, multi-asset income fund, we have the ability to look across income assets and allocate capital in response to the opportunities provided by market volatility.
We found an increasing number of investment opportunities in international and US equities late in the third quarter, but the rapid recovery in the fourth quarter from the August-September market declines reduced the opportunity set somewhat and led us to sell some equities that had climbed back toward our estimates of their intrinsic value. Despite equity-market appreciation, the fund’s equity exposure actually declined modestly during the fourth quarter from 51.55% to 51.36% as a result of these sales.
Late in the fourth quarter of 2015, as spread-widening began to take root even in non-commodity issuers, we found opportunities in corporate credit. This is where most of our credit buying was centered. However, we also tried to take advantage of some aggressive selling to pick up bonds of an energy services company with significant asset coverage that were available at highly stressed levels—likely as a result of fund liquidations. Overall, despite modest declines in bond prices, our fixed-income exposure increased from 38.73% to 39.76%.
Top contributors to performance during the fourth quarter were Microsoft Corporation, Plum Creek Timber Company, Inc., HOYA Corporation, HeidelbergCement AG, and Bouygues SA.
Over the same time period, top detractors included San Juan Basin Royalty Trust, Asian Pay Television Trust, Sanofi, Potash Corporation of Saskatchewan Inc. and Overseas Education Limited.
Top contributors to performance for the year-ending December 31, 2015 were Microsoft Corporation, Bouygues SA, Bi-Lo LLC 9.25% due 02/15/2019, HOYA Corporation, Mayr-Melnhof Karton AG.
Top detractors for the year were Potash Corporation of Saskatchewan Inc., Comtech Telecommunications Corp., Goldcorp Inc., Cloud Peak Energy Resources, LLC 6.375% due 03/15/2024 and San Juan Basin Royalty Trust.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
