August 1, 2016 – WOW! is perhaps the most fitting word to describe the second quarter, given the UK’s shocking decision to exit the European Union (EU) and the market’s dramatic reaction. At 2:30 a.m. on the day after the Brexit vote, I was in Miami on a conference call with the two European CIOs from the Wigmore Association. I can’t tell you how beneficial it is at a time like that to have access to the insight and perspectives of our Wigmore colleagues, especially when they are right at the center of the event.
As unexpected as the outcome of the UK referendum was, the equity market’s rapid recovery from the initial sell-off was an equal – and infinitely more pleasant – surprise. Equity markets, after an immediate and sharp negative response, quickly recovered and within two and a half weeks, the S&P 500 was at an all-time high after having traded in a range for about 14 months. (See Chart A.)
The Brexit event and the quick market snapback make me think about how investors have assessed risk over the course of this long market cycle, which began after the 2008 financial crisis. First, nearly everyone was convinced there would be a devastating double-dip recession after 2009. Next, there was fear of a destructive inflation spiral from the Fed’s stimulatory efforts. Then, we had the threat of spillover from the financial troubles of Europe’s peripheral countries, soon to be followed by the Japanese tsunami and nuclear disaster, China’s economic woes, and the menace of an overly aggressive Federal Reserve.
When in the last eight years have we not had something significant to shake confidence in our investment plans? Yet, in all of these instances, investors assigned a higher probability of that particular risk derailing the market than they should have. Our job is to evaluate the potential positive and negative outcomes and properly weight them. Many investors have a hard time doing this, which explains why $12 trillion in cash has remained on the sidelines during one of the longest bull markets in history.
Unfortunately, overamplifying risk keeps people out of the market due to fear, thus taking the biggest risk of all – that they will fail to achieve their long-term goals. Unless your goal is to never, ever lose a single dollar, it’s essential that you don’t lose sight of the forest for the trees. We are still in the midst of one of the strongest and longest bull markets in history.
Though global economic fundamentals are moderately better than they were a year ago, that story has taken a back seat to Brexit. Once the UK voted to exit the EU, questions began swirling. How long and what shape will the exit process take? What country could be the next domino to fall? Most importantly, how far will the economic impact reach? Though it is certainly possible other countries will consider leaving, remember that the EU is made up of countries that are net takers and countries that are net givers (just like US states, though we tend to be less bothered by this). In the end, the net takers have no reason to leave and the net givers will likely find that the negotiation process and the related anxiety are motivation enough to stay in the EU.
At this time, the Brexit story remains to be written and it could take a fair amount of time (and a fair amount of anxiety) before the political and economic results are clear. From an economic standpoint, Brexit involves the most risk for the UK and the EU. However, we really don’t know how the exit process will go. Negotiations may go well and this could end up being a non-event. Regardless, we believe that as you move away from the UK and EU, there should be less and less economic impact on the rest of the world. In particular, emerging markets, including China, should see little effect.
The global economy’s real story over the last year has been historically unprecedented negative interest rates. The German Bundesbank is the philosophical home of the European Monetary Authority and Germany has an anti-inflation bias in its DNA due to its experience with hyperinflation during World War II. If you buy German 10-year Bund now, in 10 years, you get back 0.17 percentage points less than you invested. On June 30, 74% of government bond yields were below 1% and 36% were negative. With returns to global bond investors at historically low rates, bond markets that offer positive returns, including the US, are being distorted by the global search for yield.
We have pointed many times to the conditions that we believe signal the end of a bull market – extreme valuations, extreme exuberance, and an inverted yield curve. We’ll talk about valuations and sentiment in the US equity section below. Let’s look at the yield curve. Since we noted these danger signs three years ago, the yield curve has flattened significantly, but it’s not inverted. Since the Fed controls rates at the short end of the yield curve, it would have to purposely invert the curve and I just don’t think that’s likely.
Regarding economic growth and the possibility of recession, the yield curve seems to be far less of a predictor of US economic health than 15-20 years ago. When 74% of government bonds are paying less than 1% and US government bonds are paying 2%-3%, foreign money is definitely going to come in and flatten our yield curve. However, that doesn’t tell us anything about our economy.
In fact, the US economy is on pretty strong footing, particularly consumers, who are responsible for about 68% of US GDP and have rarely been in a better position than today. (See Chart B.) Historic low interest rates mean consumers are refinancing homes which puts more cash in their pockets. Even after the recent rise in oil prices, consumers are not getting beat up at the pump. Employment is solid and delinquencies are at low levels. All of this bodes well for consumer spending and a positive effect on GDP growth.
On the other hand, there is still quite a deficit in business investment. Companies are not spending – either because they don’t see end demand or because they are deterred by increased regulation. Corporations are not sure they’ll get the return on their outlay. We could see a turning point in this situation as I would think that no matter which way the election goes, either administration is likely to be perceived as more pro-business than the current administration. That just might spur corporations to spend.
GDP growth depends on this push and pull between the positive consumer effect and the dampening effect of low corporate spending. Given the current scenario, I think GDP growth might be better than 2%, but probably not better than 3%.
I think slowly improving US economic conditions have played a role in the recent rally. Manufacturing remains solidly in expansionary territory, while housing and consumer confidence measures are trending upward.
Meanwhile, the Federal Reserve is enjoying a bit of a Goldilocks scenario – the economy is not so hot that members feel compelled to raise rates, nor so weak that they need to revert to their easy money ways. Instead, they can wait for the right time. This Fed has been consistent in its reluctance to raise rates and though some economists believe it is waiting too long, events since last year’s rate increase have somewhat validated the caution. The Fed left policy rates unchanged in June and I think it’s unlikely the Fed will raise rates before the election to avoid being seen as political. That means there is a chance that additional rate hikes may be off the table for 2016.
Non-US developed equities sold off on Brexit fears and have not yet come back completely as the US did. And, for the second quarter in a row, emerging markets outperformed developed markets. Emerging markets were up 0.7% up for the quarter, while the MSCI EAFE was down 1.5%. Year-to-date, emerging markets are up 6.4% and EAFE is down 4.4%. That’s quite a spread, but it makes sense when you consider that most EAFE countries are within Europe and most emerging market countries are more removed from the Brexit impact.
Another driver behind emerging market performance is a waning of the China meltdown scenario. Overall and in a modest way, emerging market economies are gradually improving, though it’s always important to remember that emerging markets don’t move in unison. There are still immense challenges in Brazil, even as Asian economies other than China are recovering and, as we noted above, are the least affected by the EU’s political circus.
The search for yield was very dramatic in the second quarter in both global and US markets. With global and US bond yields so low and tons of cash on the sideline, it’s no surprise that utilities (and other income-generating equities) are being aggressively bought for their yields.
Valuations, even in core Europe, are relatively cheap and though these economies are certainly shakier than the US, the probability is they won’t fall into recession. For some time now, the US dollar has worked against non-US and emerging market equities, but the majority of the dollar’s move has now been made, so currency could be either a non-factor or a tailwind for non-US and emerging market equities. We haven’t seen non-US outperformance for the last few years, but valuations and the economic backdrop currently appear favorable.
The US dollar may be less of a factor, but currencies are likely to play a pretty big role for global equities going forward (See Chart C.) Somewhat surprisingly, the UK performed well in local currency, up almost 7%, but down 0.7% in dollar terms. Then there is the currency rally in Brazil, which supported stock prices this past quarter, but is essentially a junk rally, fueled by hedge funds rather than internal investment. As we noted above, Brazil still has enormous challenges, which will all be on display during the upcoming Olympics.
In my view, one of the reasons the Brexit-related equity sell-off reversed itself so quickly is that for the most part, stocks are still held by institutions, which tend to keep a steadier hand on the trigger. Retail investors react differently to short-term issues, like Brexit. Since there is still not a lot of individual investors in the equity market, there was no huge emotional bailout.
Once again, the second quarter was a story of US equities. The S&P 500 was up 2.5% for the quarter and the US market approached a new high. There is still $12 trillion in cash on the sidelines and an incredible hunt for dividend stocks underway. We noted the global market’s preference for utilities above – in the US, utilities were up 7% for the quarter. A result that, in our mind, is just not sustainable.
To summarize US equity results for the quarter, value stocks performed better than growth stocks, small cap performed better than large cap (perhaps because small caps have less foreign exposure and were, therefore, less vulnerable to Brexit) and defensive sectors (consumer staples, health care, and utilities) generally outperformed cyclical, or higher growth sectors (technology, consumer discretionary, and financials). One major exception was the 11% rise in energy due to the rise in crude oil prices.
Looking once again at our often iterated threats to the bull market, we can confirm that valuations are high, but are still not extreme. The current forward price/earnings multiple for the S&P 500 is 16.6x, narrowly above the 25-year average of 15.9x. And once again, we can point out the absence of irrational exuberance in equities. Just look at second quarter results. Investors aren’t in love with equities, they’re just estranged from bonds. There’s no yield available in the bond market and hedge funds are still having a hard time, so as our friend Jason Trennert from Strategas has said before, “There Is No Alternative” to equities.
For the past 24 months, passive equity managers have performed better, while more active management styles have been hurt. That trend has caught our attention, but we know that any market trend can change very quickly. Every Pitcairn portfolio has an element of active and passive because markets don’t move in straight lines and leadership will eventually rotate between active and passive strategies. We favor maintaining exposure to each and constantly striving for the best balance. This is similar to our approach with individual asset classes. Even as many investors pulled back completely from fixed income in response to the threat of rising rates, we kept a significant percentage in fixed income, which has been an admittedly unexpected bright spot for our clients.
Stock buybacks have supported US equities, but only at the margins and mainly due to the lack of corporate spending we noted above. If businesses don’t want to spend and they have excess earnings, they can either buy back stock or pay out dividends. Buybacks put upward pressure on stock prices and appreciation is a more tax friendly way to return money to shareholders. Of course, this means we’re not getting the good GDP growth potential that comes from building factories and other corporate spending that expands economic activity.
Overall, our outlook for US equities is a story of many overlooked positives. The dollar is no longer a headwind, oil prices have risen (and may have more upside), and corporate earnings are solid. Given the fact that stocks have not gained much over the last 18 months, I think a case can be made that US equities are beginning to decisively break out from that tight range.
The bond markets performed surprisingly well – again! Rates remain at extreme lows and the UK’s Brexit vote spurred a further flight to safety that pushed yields even lower. The Barclays US Aggregate Index, which includes both government and US investment grade bonds, returned 2.2% for the quarter. So far this year, the index has returned 5.3%, which beats the 3.6% return of the Russell 3000® Index. Municipal bonds enjoyed another strong quarter, returning 2.6%, as measured by the Barclays Municipal Index. The dynamic of high demand and limited supply again provided a tailwind for municipal bonds and, interestingly, foreign demand for municipals has risen significantly. (See Chart D.) Some other bond niches, like high-yield, have provided the best returns in the marketplace.
With the 10-year Treasury yield at a record low, we can’t help but question when does this change. There must eventually be an inflection point given a scenario of implicit inflationary factors that have not yet been awakened. “Fire” economists envision a big inflation tiger in a bamboo cage and we’re tempting him with a bamboo stick. When he wakes up, inflation is going to eat everything. And at this point, it won’t take much of a reaction from the inflation tiger to entirely change the dynamics of the bond market. We still see that coming, but it’s not here yet.
Real assets have been big beneficiaries of the hunt for yield. REITs, global infrastructure, MLPs, and gold all performed well for the quarter and are strong year-to-date. Additionally, commodities turned last year’s dynamic on its head. Since hitting a low in January, oil prices have almost doubled.
Higher oil prices led to an amazing quarter for MLPs, up 20%. Like other yield plays, REITs, particularly US REITs, were also favored during the quarter. For the year so far, REITs have had a high single/low double-digit return. Meanwhile, global infrastructure was up about 5% in the quarter.
Gold advanced as well. As we have explained in previous letters, there are two potential drivers for gold. One, which we saw in 2009 and which I reject, is the fear monger, apocalypse trade. However, there is also the idea that gold is a prudent hedge against central bank activity and I think that explains why gold has done well this year.
It’s still hard to find good news in the hedge fund universe. Hedge funds muddled through the second quarter with the HFRI Index returning 0.75%. We maintain that hedge funds will deliver better performance when interest rates rise, but a lot of market watchers are wondering what the industry looks like when that happens. We have confidence in the hedge fund traders and strategies we hold. Our responsibility now is to monitor them and evolve as the hedge fund landscape changes.
We are now sitting in the midst of surprising snapback rally off the Brexit sell-off. The S&P 500 Index gained over 7.7% in just 10 sessions from June 28 through July 13. The ones who benefited from that are the long-term investors who had a plan and stuck with it. Believe me, traders were not going into the market on Friday, June 24 or Monday, June 27. They were running the other way and only now do we see how wrong that move was. At the time, I heard a pundit saying this was a bubble. Well, let me tell you, every strong upward move since May of 2009, has been met by a pundit shrieking, “Bubble.” Our knowledge of history at Pitcairn tells us the question is not if the Dow will reach 20,000 and the S&P 500 2200, but when.
Of course, our firm belief in the market’s long-term, upward trend doesn’t mean we overlook real risks in the current environment. Slow US economic growth means there is not a lot of room for execution errors and there is a chance we could see one from the Fed. Brexit showed us that social and political issues can bring a lot of volatility into the market and with the US election season underway, there could be a political shock. Regardless, this is not a time to shun equities or any other asset class.
It is a time to be sure you are comfortable with your investment policy and understand where you are on the path to your goals. We need to acknowledge that yes, there is risk in global events and in the markets, but there is an even greater risk in staying out of equities and missing a meaningful upward move. For the traders who were out of the market during the 10 sessions when the S&P 500 rose 7.7%, that gain is gone forever. But our clients got it. This is a lesson in how to succeed in difficult times and it’s the same lesson we’ve always instilled in our clients.