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By Grace Su & Jean Yu, CFA, PhD
Improvers Outpace Broader Value Gains
Market Overview
Global markets generated positive returns in the first quarter driven by optimism over an economic soft landing, improving economic data, the prospect of rate cuts in the U.S. and Europe and structural economic and corporate reforms in Japan. The MSCI World Index returned 8.88% for the quarter. Growth stocks outpaced value for the quarter with the MSCI World Growth Index returning 10.24% versus the 7.49% return of the MSCI World Value Index.
Gains were spurred by broadly positive economic data, particularly in manufacturing. Both European and U.S. manufacturing PMI entered expansionary territory, breaking a 16-month streak of contractions in the U.S., amid signs that inventory orders and better inventory management could turn into a growth tailwind, further bolstering their respective markets. Economic and manufacturing data in China continues to be lackluster but showed some signs of stabilization on positive export and travel data.
Global inflation continued to moderate, albeit at a slower than expected pace, causing central bankers to largely push back their expected magnitude and timing of rate cuts in 2024. By the end of the first quarter, the Federal Reserve had revised its 2024 rate hike projections to three quarter-basis-point cuts, while the market expects the European Central Bank to cut approximately 90 basis points, further bolstering a bullish outlook in the market.
Like the U.S., international markets were supported by enthusiasm over AI beneficiaries, though in a much smaller pool of stocks with limited exposure, benefiting a handful of semiconductor equipment stocks and helping to spur growth outperformance.
“AI promises to create demand for new skills around model training, prompt engineering and data science.”
Japan was the best-performing market globally in the first quarter, benefiting from the Bank of Japan beginning its path to monetary policy normalization by ending yield curve control policies. Additionally, the annual pay negotiations with the country’s largest trade union yielded a 5% increase in wages, the largest in 33 years, fueling optimism that Japan may see signs of inflation for the first time in three decades.
The ClearBridge Global Value Improvers Strategy targets companies which are both undervalued and underappreciated for their ESG progress. The Strategy outperformed its benchmark in the first quarter, as strong stock selection in the industrials and communication services sectors overcame headwinds to our holdings in the health care sector.
The industrials sector continued to see robust performance from both secular growers as well as cyclical beneficiaries. Top-performing holding Vertiv (VRT), a data center electrification solution provider, saw its share price rise on continued demand for AI-related companies and beneficiaries and anticipation of greater demand for data center components. Japanese conglomerate Hitachi (OTCPK:HTHIY), having now successfully completed its transition from a dependence on heavy industry and tech hardware customers to serving IT services and energy businesses, is seeing strength from digitization initiatives across its customer base. Hitachi’s energy division also continues to deliver record bookings driven by the need modernize energy transmission infrastructure globally.
Stock selection in the communication services sector also had a positive influence, driven by the strong performance of Meta Platforms (META). Shares of the social media platform and leading digital advertiser surged following a blowout of its fourth-quarter earnings release. The company guided to its first quarter 2024 revenue far exceeding consensus expectations while simultaneously keeping operating expenses and capex spending intentions flat with prior expectations. The stronger revenue and margin results bolstered our investment case that Meta will continue to gain share, that TikTok is not an existential threat to the business and that the company is past the peak in its AI investment.
Stock selection in the health care sector was the largest detractor from relative performance, as several of our holdings came under idiosyncratic pressures. For example, biotechnology company Biogen (BIIB) reported lower than expected revenue growth for the fourth quarter due to weaker than expected sales from its multiple sclerosis medication Vumerity and spinal muscular atrophy drug Spinraza. Additionally, the company issued 2024 earnings guidance at the lower end of the market consensus range, primarily due to lower than anticipated contract manufacturing with flat product sales. We believe these issues are temporary and see room for improvement through its new product Skyclarys, management’s cost-cutting initiatives and the long-term prospects of its new Alzheimer’s drug Leqembi. Another detractor was UnitedHealth (UNH), a leading diversified health care company that offers health benefits through its UnitedHealthcare segment and health services through its Optum division. Rising competition within the Medicare Advantage market, as well as a potentially mounting pattern of managed care companies underestimating the recent increase in health care utilization, have spurred rising investor concerns.
Portfolio Positioning
We added a new position in United Utilities (OTCPK:UUGRY), in the utilities sector, which provides water and wastewater services in the U.K. We believe that the market underappreciates the inflection in growth from the need to upgrade regional water infrastructure. As a result, United Utilities stands to significantly accelerate its growth beyond historical levels as headwinds from inflation continue to abate, creating a compelling value opportunity within this defensive corner of the market.
We also exited our position in Eastman Chemical (EMN), in the materials sector, which produces a number of specialty chemicals and material compounds including hydrocarbon resins, fungicides, paint additives and cellulose acetate fibers for end use across a wide variety of industries. While we believed that Eastman’s earnings would inflect as destocking pressures subsided this year, we now see additional risk that the mid- to long-term supply growth for the industry is accelerating. As gasoline demand is peaking due to the transition to electric vehicles, big oil is increasingly focused on chemicals production to maintain growth. Despite Eastman’s efforts to build new revenue streams in plastics recycling, we remain concerned about oversupply in its base commodity business and elected to step aside until we can better gauge industry dynamics.
Outlook
The blistering pace of AI investment has dominated market sentiment over the past year, moving beyond a mere technology investment cycle to become a disruptive force across multiple industry and ESG dimensions. Most notable is the stress on the U.S. power markets caused by the explosion of data center builds across the country. While the transition to renewable sources and increased electric vehicle demand were already putting strain on the country’s power supply, potential shortages caused by incremental AI demand are causing the market to scramble for solutions to alleviate the shortfall. While the portfolio has meaningful exposure to this theme through our electrical equipment and power utility holdings, we continue to look for derivative beneficiaries that the market is not yet focused on.
On the opposite end of the spectrum, investor appetite for other energy transition areas have cooled meaningfully and present intriguing opportunities. One such example is electric vehicles, where consumer demand has disappointed and most incumbent original equipment manufacturers have missed production targets. We believe the main cause is the industry’s inability to bring down costs and price quickly enough to drive adoption up. However, given new developments around battery chemistry and production automation, these challenges can likely be overcome, and the longer-term growth opportunity remains unchanged. Valuations have corrected across much of the auto supply chain, offering attractive entry points.
Another area of dislocation is renewable energy and the associated grid modernization. Higher interest rates have slowed the pace of renewable growth due to increased funding costs. This slowdown should be temporary, however, as the increase in power prices has already restored the economics of these renewable projects. The average age of EU power grids is more than 40 years, while that of the U.S. is around 30. While the need for grid modernization is significant and pressing, a pro-cyclical market and interest sensitivity have caused stocks of major players in this space, many of them utility companies, to underperform. Given the essential role that renewables and grid modernization play in the energy transition, we believe such near-term concerns have created buying opportunities for these secular growth stories at value prices.
Green metal, particularly copper, is also an important part of the energy transition story currently underappreciated by the market. Continued production challenges and geopolitical conflict across major copper producers have created a noticeable decrease in supply. Meanwhile electrification demand continues to grow unabated, setting up a shortage situation for the foreseeable future. Sentiment around copper has remained low due to pessimism around China, though very recently we have begun to see prices beginning to lift.
Lastly, as the U.S. election cycle picks up steam, we anticipate increased volatility in areas such as energy policy, infrastructure spend, immigration, tariffs/trade and the Inflation Reduction Act to name a few. We hope to be opportunistic should the political rhetoric cause extreme swings in investor sentiment.
Portfolio Highlights
The ClearBridge Global Value Improvers Strategy outperformed its MSCI World Value Index benchmark during the first quarter. On an absolute basis, the Strategy had gains across eight of the 10 sectors in which it was invested (out of 11 sectors total). The industrials and financials sectors were the main contributors, while the utilities sector was the main detractor.
On a relative basis, overall stock selection benefited performance. Specifically, stock selection in the industrials, communication services, materials, IT and financials sectors, a lack of exposure to the real estate sector and an overweight to the industrials sector positively contributed. Conversely, stock selection in the health care, utilities and consumer staples sectors and a utilities overweight weighed on performance.
From a regional standpoint, stock selection in North America, Europe Ex U.K. and Japan were the greatest contributors to relative performance. Our U.S. holdings performed stronger than the broader market, helped by Vertiv, Meta Platforms and Uber Technologies. Conversely, stock selection in Asia Ex Japan detracted from performance, largely due to underperformance from Hong Kong headquartered AIA Group, the largest independent pan-Asian life insurance company, on concerns of lackluster investment returns and the risk of slowing new business in China and Hong Kong. Overweights to Europe Ex. U.K. and the U.K., and an underweight to North America, also weighed on performance.
On an individual stock basis, Vertiv, Hitachi, Meta Platforms, Banco Bilbao Vizcaya Argentaria (BBVA) and Fiserv (FI) were the leading contributors to absolute returns during the quarter. The largest detractors were Fluence Energy (FLNC), AIA, Biogen, Brookfield Renewable (BEPC) and AES.
ESG Highlights: AI Sustainability Opportunities and Risks
Artificial intelligence (‘AI’) is transforming the investment landscape, and while its rapid development sparks some valid social and environmental caution, it also brings with it enormous potential for helping sustainability goals, with better data to improve energy efficiency, optimize renewable energy, make agriculture more sustainable and improve human health. ClearBridge is closely watching these opportunities even while we observe AI’s energy intensity and social dimensions as the phenomenon plays out in our portfolio companies across sectors.
On the regulatory front, the world’s first comprehensive AI law, the EU’s AI Act (AIA), will come into force later in 2024. The AIA classifies AI systems according to the risk they pose to users: there is unacceptable risk (such as emotion recognition in schools and workplaces), high risk (such as critical infrastructure and medical devices), limited risk (such as chatbots, which carry the risk of manipulation or deceit) and minimal risk (such as spam filters). Each level of risk is subject to different requirements, and there are heavy fines at the company level for noncompliance. President Biden also issued an executive order on safe, secure and trustworthy AI in October 2023, aimed at establishing standards for AI safety and security, protecting privacy, equity and civil rights, and supporting consumers and workers.
On the labor front, AI can boost productivity, but automation has always threatened labor disruption, potentially deepening global inequalities as AI growth may favor advanced economies with sufficient infrastructure and skilled workforces (Exhibit 1). Hiring algorithms may also rely on and perpetuate race and gender biases. Almost 40% of global employment is exposed to AI.1
Exhibit 1: Employment Shares by AI Exposure and Complementarity
| Source: “AI Will Transform the Global Economy. Let’s Make Sure It Benefits Humanity,” Kristalina Georgieva, IMF Blog. Img.org. Jan. 14, 2024. For illustration purposes only. Complementarity implies AI leads to gains in productivity and higher income. |
With looming questions of misinformation and digital safety, cybersecurity, and even human capital management, as hiring for AI ethics jobs is picking up2, it is clear that as AI develops and hits multiple inflection points over the next few years, companies across ClearBridge portfolios will need to negotiate a variety of sustainability-related AI opportunities and risks.
Given this enhanced initiative is still in the early stages, most of our EFI company asks are currently categorized as early stage or in-process (Exhibit 3). Examples of company asks focused on reducing emissions, improving labor relations, expanding electric vehicles (EVs), improving board effectiveness and implementing total shareholder return (TSR) metrics convey the spirit and overall benefits of the initiative.
AI and Power Demand Implications
AI is energy intensive, with data centers running the large language models requiring significant electricity and complicating the already complex power supply and demand picture of the energy transition. Overall estimates for data-center-driven U.S. power demand growth vary, but they generally forecast the electric load to roughly double by the end of this decade (from the current 3%–4% to ~8% by 2030).
On the surface, this kind of demand growth should cause generation shortages on the grid, especially in places where the data centers have been expanding rapidly such as Virginia and California.
Factors that could mitigate projected power shortages in the future would be:
- Continued improvement in technologies/efficiency of the data centers
- Expansion of the data center locations toward less congested grids
- An increase in utilization of the existent gas generation capacity and even delays in the scheduled coal plant retirements, which would increase the emissions intensity from AI
Another important mitigating factor over the next five years will be faster development of renewable power sources, as many data center hyperscalers have public commitments to carbon free energy. The renewable projects’ shorter development/construction timeline and locational flexibility to satisfy the data center demand should push demand for renewables higher and improve the renewable projects’ returns. Renewable developers such as portfolio holdings NextEra Energy (NEE) and AES should be beneficiaries of these trends. As highlighted at NextEra’s recent renewable-focused investor day, current forecasts call for renewable capacity to reach between 375 GW and 450 GW over the next seven years (2024-2030). This implies a 13% compound annual growth rate through the end of this decade and suggests a rapid acceleration in renewable development (235 GW of renewables were added over the last 30 years). According to the company, this anticipated power demand acceleration is expected to be driven by consumption growth from data centers (+108%), oil and gas industry (+56%) and chemicals (+14%) between 2025 and 2030.
Over the long term, data center power consumption growth and companies’ green targets should advance the development and utilization of more effective power storage and carbon capture and storage technologies as well as green baseload power solutions, such as green hydrogen and small modular nuclear reactors.
From the regulated utilities’ perspective, the ultimate impact of the data center demand growth will vary by region, but the overall implications for the sector should be positive. Data center additions to regional grids will not only drive incremental investments into the local transmission and distribution systems, but in some cases result in incremental generation needs. In the near-term, utilities located in the territories with planned data center expansions, such as Dominion Energy (D), Southern Company (SO), Sempra (SRE) and CenterPoint Energy (CNP), should benefit from higher required investments into the grid to accommodate additional demand.
AI Impact on Labor Conditions
Prior waves of technology dating back to the 19th century have changed the fabric of the global workforce. AI is similar but potentially more impactful in that it might affect white collar jobs just as much as it does blue collar labor. The power of generative AI (Gen AI) over prior AI advances is its ability to generate creative output. However, most companies are using Gen AI to augment their employees’ capabilities, rather than seeking to replace them. In ClearBridge engagements with technology companies using newly released code generation tools, we find they generally use them to speed up the first draft of a software engineer’s code output. This frees up the engineer to focus on larger problems such as user experience and system design. The risk of AI causing mass unemployment is therefore overstated, while the need to upskill and reskill today’s workforce is likely understated. By 2030, management consulting firm McKinsey estimates that as many as 375 million workers or roughly 14% of the global workforce might need to switch occupational categories and acquire new skills.3 Just as prior waves of innovation did, the AI wave promises to create demand for new skills around model training, prompt engineering and data science.
While AI can often outperform human counterparts on a growing range of tasks, it lacks human intuition, context awareness and ethical judgment. Recognizing these limitations will help companies use AI more effectively and responsibly. When deploying AI to generate content, the primary ethical considerations are around protection of intellectual property rights and avoidance of unintended bias. Google’s (GOOG,GOOGL) missteps with Gemini are a recent lesson on how difficult it is to tune an AI system to account for biases and ambiguity. However, Alphabet, Meta and Amazon (AMZN) are also taking the challenge seriously and stepping up their investment in AI ethics and safety. Portfolio holding Meta currently has around 40,000 people working on safety and security, with more than $20 billion invested in teams and technology in this area since 2016. Google’s Vertex AI platform provides a suite of tools that cater to the entire AI lifecycle, from data preparation to model deployment and monitoring. By integrating robust security measures, promoting transparency through explainable AI and adhering to stringent ethical guidelines, Vertex AI empowers businesses of all sizes to develop and deploy AI solutions with confidence.
Misinformation and Social Manipulation
AI and Gen AI in particular make it much easier for bad actors to spread misinformation. We have already seen AI being used to impersonate individuals, including the two leading candidates for the U.S. presidential election in 2024. Meta and Google are working to thwart the misuse of AI-generated content on their respective platforms. In August 2023, Google debuted a watermark software for AI content, letting the user know that the content is AI generated. Meta meanwhile ensures its AI-generated content is labeled “imagined with AI” and is expanding this feature to include content created by third-party tools. The company is also focused on election transparency, namely serving over 500 million notifications on its apps since 2020 informing users how and when to vote, and building an industry-leading library of political ads that is publicly available and elucidates the entity funding each ad and who they are targeting. Given how quickly the tools are evolving, including high-quality AI-generated video in the near future, this remains an open area of both risk and opportunity for the world’s leading digital media platforms.
AI’s Potential in Health Care
The growth and increasing complexity of data in health care also makes AI potentially transformative in the sector. In drug discovery and development, for example, some companies are successfully using AI to create and optimize molecules to go into development, largely with applications in chemistry and protein engineering. Some companies are hoping to use AI to pick better targets for dugs, although we are skeptical about the near-term prospects, as the complexity of biology may pose a challenge for current AI models. Other companies are hoping to use AI and advanced computer models to better design clinical trials, although these attempts are in the very early stages.
There is also significant potential for AI in the field of diagnostics, both traditional testing and advanced genetic tests. For traditional methods of diagnosis, like blood/serum based tests and images such as X-rays, CTs and MRIs, AI should be useful for prescreening, enhancing or even replacing human reading of test results. AI models have already been used to develop tests looking for patterns of genes that indicate cancers or the prognosis for cancer.
Along these lines, Hologic (HOLX), a medical technology company focused on women’s health and the leading manufacturer of mammography machines, is incorporating AI in its breast imaging business to assist radiologists in locating possible breast cancer lesions. Siemens Healthineers (OTCPK:SEMHF), one of the leading manufacturers of CT and MRI machines, is also incorporating AI into its imaging platforms, which provide automatic post-processing of imaging datasets through AI-powered algorithms in order to reduce basic repetitive tasks and increase diagnostic precision when interpreting medical images. The company is the global leader in AI patent applications in health care.
Conclusion
The rapid ascension of large-language model AI in 2023 has made the technology central to companies’ futures in nearly every sector. It will be important for AI to be firmly tied to sustainable futures, and we will continue to monitor how ClearBridge portfolio companies and the market at large are navigating AI’s sustainability-related opportunities and risks.
Grace Su, Managing Director, Portfolio Manager
Jean Yu, CFA, PhD, Managing Director, Portfolio Manager
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Footnotes 1 “AI Will Transform the Global Economy. Let’s Make Sure It Benefits Humanity,” Kristalina Georgieva, IMF Blog. Img.org. Jan. 14, 2024. 2 Barclays Live – 2030 Thematic Roadmap: 150 Trends (Edition 5) – Managing AI’s blind spots (Investment Bank | Barclays). 3 “Retraining and Reskilling Workers in the Age of Automation,” Pablo Illanes, Susan Lund, Mona Mourshed, Scott Rutherford, and Magnus Tyreman, McKinsey. Mckinsey.com. Jan. 22, 2018. 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: Morgan Stanley Capital International. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance is preliminary and subject to change. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent. Further distribution is prohibited. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
