What started as a ‘COVID-19 recovery trade’ after the vaccine news in November of last year, with a steep rotation towards higher beta, lower quality, and very cyclical stocks, has morphed into a broader equity rally with fewer defining features, but more focus on earnings growth. There was however a reversal of the rotation towards the end of the quarter after the Federal Reserve (Fed) said it could be raising interest rates by 2023, a year earlier than previous guidance. At a macro level, there was excitement among investors regarding the speed of re-openings and vaccine roll-outs.
The main focus of the markets during the second quarter was whether recent inflationary pressures are transitory or permanent. MFS believes it is still too early to tell since year-over-year price changes are distorted by falling prices during the lockdown. The long-term debate is whether the deflationary forces holding prices down (demographics, debt, globalization, technology) are still as strong as they were. Globalization led to a huge transfer of production from high-cost economies to lower-cost economies in Asia and Eastern Europe, which may now be reversing. Low inflation has become a global phenomenon and inflation has been falling for 30 years. So far, central banks and most investors believe inflation is transitory, with price pressures caused by supply and demand imbalances distorted by the pandemic.
Relative calm has descended across bond markets, with yields actually falling, as fears of an interest rate shock are dissipating, at least for now. An interest rate shock could have punctured high equity valuations, especially for long-duration assets, that have been bid up in technology and other thematic areas (e.g. clean energy stocks). The yield on the benchmark 10-year US Treasury has eased back below 1.5%, having peaked close to 1.8%. Falling interest rates have been the engine for several bull markets in bonds and equities over the last decade or more.
The Fund’s focus on high-quality, above-average growth companies continues to drive portfolio positioning. MFS seeks to invest in companies that can compound above-average growth at high returns. These companies typically are market leaders with durable business models that have experienced management teams and competitive advantages that should allow them to maintain higher returns and earnings growth than their peers.
The portfolio was overweight consumer staples and materials. The Fund has favored consumer staples companies that have strong brands, sustainable, above-average growth and geographically diverse revenue sources. MFS has spent significant time analyzing prior deflationary and inflationary periods and have come to a rather ordinary conclusion: businesses with pricing power fair best in either extreme. Many of the Fund’s consumer staples companies have pricing power and derive a significant portion of their revenues from underpenetrated emerging markets countries, which typically leads to higher revenue growth and more stable earnings growth than the overall market.
Within materials, two of the Fund’s largest active positions are industrial gas producers Linde and Air Liquide. These high-quality cyclicals have generated returns above their cost of capital and have generated significant free cash flow over a full cycle, driven in part by long-term contracts that have built-in price escalators. MFS believes these companies are likely to be beneficiaries of re-shoring as many global companies revisit their supply chains.
The portfolio was underweight Communication Services as a result of not owning many telecommunications companies that typically do not have sustainable above-average growth, returns and free cash flow characteristics.
During the quarter the Fund continued to build or initiate positions in high-quality businesses that MFS believed had attractive risk/return profiles while trimming or eliminating companies that it believed had become more fully valued or were facing structural headwinds.
Key trades during the second quarter included the following:
- The Fund initiated a position in Swedish Match, which makes moist smokeless tobacco products, cigars and lighters. MFS believes their tobacco free nicotine pouch, Zyn, will be a key growth driver for the company.
- The Fund initiated a position in London Stock Exchange and Deutsche Boerse. Both companies have diversified away from the more cyclical parts of their businesses (financial exchanges and clearing) towards market data. This has increased the proportion of revenues that come from less volatile and more recurring income streams versus the more cyclical part of the business.
- The portfolio Manager added to Hitachi, the Japanese conglomerate with several world-class technologies, including robotics, factory automation and medical electronics equipment. Management has done a credible job of changing the corporate culture to one more focused on shareholder returns, highlighted by a simplification of their corporate structure, which has resulted in a more focused and profitable business with better growth prospects.
- The Fund sold out of Danone due to the deteriorating attractiveness of their main categories: water, infant formula and dairy. The infant formula business is challenged by declining births and emerging Chinese competition, while the bottled water business is impacted by increasing consumer aversion to plastic packaging.
- The Fund exited its position in Chinese online job recruitment business 51Job Inc. on news of the completion of the take-out by a consortium of Chinese investors.
- The Fund trimmed LVMH Moet Hennessey and L'Oreal at higher valuations after strong share price gains. MFS continues to believe these are attractive businesses with strong fundamentals.
It is pleasing to be able to look ahead with optimism and enjoy the economic boom as countries emerge from the pandemic, with some of the easiest financial conditions on record and unprecedented fiscal and monetary support in place. The market is certainly more focused now, looking closely at the near-term and long-term earnings growth of companies once again, as we move beyond the disruption phase. Although, after the volatility of the past year, it will no doubt take time for market imbalances to work through the system. There will be bumps in the road ahead, not least the risk of COVID-19 variants, and markets could stay volatile and unpredictable as we work through this in the coming months. One of the biggest questions soon will be the extent to which governments and citizens are prepared to live with the virus. That answer will have crucial implications for the shape of the recovery and the new steady-state we are heading to. The inflation debate will rumble on, with investors looking for tell-tale signs of transitory or permanent change. As we move further into 2021, MFS believes the strategy is positioned to benefit from a combination of market leadership broadening out, a return to fundamentals driving stock price returns and a renewed investor focus on valuations. MFS believes the portfolio is attractively positioned with exposure to high-quality companies that have significant exposure to long-term secular growth trends, including the growth of the emerging markets middle class consumer and aging demographics across the developed world.
Significant impacts on performance