November 3, 2016 – Fall is definitely upon us with colorful leaves and pumpkins in abundance. In our last letter, we characterized the second quarter with the one word, “wow.” Perhaps it’s fitting that this quarter, surrounded by all the trappings of Halloween – skeletons, ghosts, and ghouls –– the word we use to describe current market sentiment is “EEK!”
All bull markets scale a wall of worry. Our current bull has climbed (and continues to climb) an enormous one. Bricks in the current wall of worry include the unprecedented tenor of the US election, the bull market’s advancing age, Russian saber rattling, war-mongering around the world, continued FBI investigations. and negative interest rates in multiple countries. While the reasons for worry seem to garner all the attention, there are actually many positives. These positives may be hard for individuals and even professional investors to see, but anyone who knows me knows that I can only be described as an optimist, so you can be sure I will shine a bright light on every silver lining.
Just recently, I returned from a very illuminating trip to India with my colleagues from the Wigmore Association. The firsthand knowledge I gathered in India reinforced many of the auspicious conclusions reached during our trip to China last year. China and India have 1.2 and 1.3 billion people, respectively. Combined, that’s about eight times the US population. Both India and China have resolved that their countries will be meaningful participants in global capitalism. That participation will unquestionably change the way successful global investment portfolios are structured over the next 20 years, regardless of the short-term ups and downs of each country’s stock market. As you know, the goal of Wigmore is to bring good performing assets from around the world to our client portfolios. Once again, our collaboration with these colleagues – eight leading family offices from around the globe – has given us a valuable opportunity to engage and build relationships with market participants and investment managers that will allow us to capitalize as these key global markets move forward.
You wouldn’t know it from the evening news, but compared to January, the global economy is in much better shape, even if we can’t yet call it robust.
After the UK’s unexpected June vote to exit the European Union (EU), fallout in the capital markets was swift. Before the vote, the consensus had been that any country pulling out from the EU would suffer more from isolation than from its participation. However, by August, it appeared the UK might suffer no penalty for its decision. The UK’s economic indicators were strong, while indicators in Germany and core Europe were weak. The British pound had taken a bit of a hit, but the UK equity market was up. The lack of negative impact on the UK’s action may even have bolstered emerging populist movements around the world, even here in the US. (See Chart A.)
More recently, potential downsides to the UK decision have resurfaced. The British pound weakened on fears that the actual Brexit withdrawal process may work against the UK. It’s still too soon to be sure how Brexit will play out as negotiations are likely to be complex and prolonged.
Overall, global economic indicators in the UK and emerging markets (as well as the US) are decent or improving, but remain somewhat weak in core Europe. A few economic data points, including export and import figures, which came out of China just after the end of the third quarter, have been weaker than expected, something we hadn’t seen in China since January. One of the potential risks we outlined last quarter was the possibility of further slowing in China’s economy (along with the risk of a Federal Reserve misstep and uncertainty created by a Trump resurgence). However, China’s government has strengthened its economy by spending. Given that the outlook for China and Asia is much better now than at the start of 2016, as evidenced by the recent 6.7% GDP growth rate for the third quarter, we discount even more strongly the risk of China leading the global economy into a worldwide recession.
Overall, we think the global economy is ever so slowly improving and that central banks may have to reel in the accommodative policies that have pushed interest rates into negative territory.
The US economy’s strength is currently a key determinant for global equity markets. In order for global equities to advance, the US economy must grow. Conversely, a weaker US economy would affect both global and US stocks. Fortunately, US economic data seems to be improving. The unemployment rate is hovering near full employment at 5%, the housing market looks favorable, and US consumer confidence remains at elevated levels.
The US dollar has had a few short-term highs this year, but we still think the dollar’s major move is behind us. We also believe the major downward move in oil is behind us. This quarter brought further reversion to the mean on both the dollar and oil. (See Chart B.)
Recent news surrounding the Federal Reserve shows the Fed moving toward a December rate increase despite its reflexive dovishness. We had thought the Fed’s apparent inclination to keep rates low would bring into question whether there would be any rate increase at all this year. As of now, our view is that a December increase to the Fed Funds Rate is already priced into the market. Economic data justify an increase; however, if any weak data surface, the Fed could again stand pat in December. I don’t believe Fed Chair Janet Yellen sees any need to get out ahead of inflation, but instead considers caution to be the prudent approach. Of the past three Fed Chairs, Yellen seems more like Alan Greenspan in her willingness to keep her options open and let data guide her actions. This differs from Ben Bernanke whose tendency to telegraph his intentions helped smooth some of the impact on the markets, but may also have limited his options.
Two possible positive drivers of US economic growth are holiday and infrastructure spending. Solid retail numbers were released early in the fourth quarter, with the holiday season just around the corner. Once the election is over, our national mood may improve, interest rates remain historically low, and consumers have power to spend, so it might be an especially good holiday spending season. Looking even further ahead, both presidential candidates have talked about increased infrastructure spending, so we could be looking at fiscal spending as another tailwind for economic momentum.
The most influential consideration for the US economy at this time, even though it’s only tangentially related, is the US election. At the time of writing this letter, it appears the Republicans will retain control of the House of Representatives and the Democrats will retain the White House, while Senate control remains uncertain. This likely outcome suggests a continuation of the government gridlock we (and the capital markets) have become accustomed to. Though the specter of more gridlock may sound discouraging, the markets actually prefer gridlock to uncertainty.
Regardless of the election’s outcome, I strongly urge you (as I did four years ago) not to let your politics dictate your portfolio positioning. Investors who try to play short-term trends like politics, do so at their own peril. If you are concerned about the factors that are most likely to influence your investment performance, I point you to economic growth, S&P 500 earnings, inflation, and the Fed’s reaction to these numbers. Together, these numbers could bode well for equities, which we will discuss in more detail below. (See Chart C.)
All in all, an objective view of the economy paints a very different story than what you hear when you turn on the TV. Dr. David Kelly, Chief Global Strategist at JP Morgan Asset Management conducts careful modeling to determine what consumer confidence should be. By his measure, current consumer confidence should be about 101; in actuality it is only 91. Dr. Kelly submits that the low confidence numbers are probably not due to economic reality, but to poisonous political rhetoric and lingering fear of a repeat of the 2007/2008 global financial upheaval. As prudent investors, we attempt to put fear and fearful rhetoric in context and focus instead on the real probability of both negative and positive factors affecting the capital markets.
A globally diverse portfolio of equities is performing in line with US equities in 2016, the first time this has happened in five to six years. Also for the first time in a long time, emerging markets outperformed the S&P 500 Index in the third quarter, while outperforming developed markets for the third consecutive quarter. Third quarter global equity results support the case we make to all our clients that global diversification is fundamental.
In recent years, diversity, which we believe is the intelligent way to invest, has improved risk profiles for our clients, but has not necessarily added to absolute returns. We see that changing as markets begin to favor international equities. Of course, the trend could reverse again, but history shows that trends like these tend to move in five to six year cycles, so a quick return to the dominance of US equities is less likely.
Having just returned from the Wigmore trip to India, it seems appropriate to discuss that market in a bit more depth. The Indian stock market has been one of best performing on both a short- and long-term basis. We sensed a great deal of optimism while we were there. Entrepreneurs were investing heavily in their own country. The current leadership of Prime Minister Narendra Modi is well regarded and recognized for its efforts to reduce bureaucratic red tape and streamline the process for doing business in India, which in the past was a meaningful hindrance.
Though we all came away believing the administration was making relevant and important changes that would bode well for the Indian economy and equities, we also recognized that global terrorism and India’s relationship with Pakistan are undeniable risks that must be considered. Additionally, India has an immense labor force, but the relationship between labor and capital is very different than in other parts of the globe, which means we must be very thoughtful in how we approach investment prospects, whether they be outsourcing, an area where India already excels, or opportunities that emerge as infrastructure improves and the country’s economy becomes more export-oriented. Pitcairn’s investment team will continue our due diligence on exciting opportunities like these and report our conclusions in the coming months.
Elsewhere in the global markets, the improvement in commodity prices that began in the second quarter continued to drive better performance in commodity-related countries. Brazil, somewhat surprisingly, built on its strong results from the second quarter. Our Wigmore counterparts from Brazil have been far more positive over the past few months than they had been in the last five years. Canadian equities are also having a strong year and Australia was one of the top performing equity markets for the quarter. Rebounds in these previously underperforming countries further support our commitment to maintaining global diversity.
Following the Brexit-related upheaval in late June, US equity markets have moved forward in a steady, not particularly exciting way, but the market’s internal dynamics have certainly altered. In last quarter’s letter, we wrote that utilities were on an extended upward run, driven by investors’ desire for alternative income sources given extremely low yields in most fixed income instruments. We also noted that runaway multiples on dividend-oriented stocks such as utilities were a factor in active managers’ underperformance of their indexes.
Of course, there have been other periods when active managers have been at a disadvantage relative to index strategies. In 1999, unbridled growth and optimism (the mirror image of today’s gloom and doom), led people to pay extraordinary multiples for technology stocks like Yahoo and VeriSign. Active managers weren’t willing to pay those multiples. As valuations ran higher and higher, active managers just couldn’t keep up. In 2016, low growth, high-yield utilities stocks have been the market darlings, and, just as in 1999, professional managers will not buy that profile of stock at such historically high multiples. Consequently, their returns, relative to the index, suffered.
Since June 30th, that dynamic has shifted. In the third quarter, US markets favored traditional growth sectors, such as technology and telecommunications, and active managers turned in better relative performance. Chart D shows an increase in the spread between the price/earnings ratios of a low volatility basket of stocks and that of a high volatility basket of stocks. This increase suggests that the market’s shift away from high dividend paying, low volatility stocks into higher volatility, higher beta stocks may persist. It will be interesting to see how this plays out. We contend that people who have been buying US equities solely for yield, without looking at fundamentals, valuations or earnings growth, will be extremely vulnerable to interest rate hikes that could happen in the next few months.
As I said above, there are many positives in the current investment environment, including the dissipation of key risks to equity returns. China’s improved growth outlook has mitigated the threat of a China-led global recession. The dollar’s strength has moderated and the price of oil has risen, removing two obstacles to corporate earnings. Meanwhile, most high quality energy companies survived the low oil price environment without a significant increase in defaults that might have rippled through the economy.
S&P earnings could show double-digit growth in the coming year as US companies rebound from the oil hangover. Credit fundamentals have improved a bit, the cost of borrowing has come down, and inflation has risen due to higher oil prices and rising wages. All of this has muted fears that the Fed might be forced to keep interest rates low or risk tipping the US into recession. If, surprisingly, there is no December rate increase, we would most certainly see multiple interest rate hikes in 2017, despite the Fed’s dovish ideological bent. However, even with higher interest rates, conditions could turn favorable, given reasonable equity valuations, not much exuberance, a steepening yield curve (the opposite of a recessionary predictor), and a new administration with a new mindset and the possibility of help from fiscal policy for the first time in years. Considered as a whole, this is not a bearish backdrop.
It is still plausible we could have a double-digit return on the S&P 500 Index in 2016. There aren’t many believers in this outcome, but if post-election sentiment catches up with the better economic news, it is within reach.
The global search for yield in a low and now negative interest rate environment spurred third quarter demand for investment grade and high-yield corporate bonds of various maturities. In other bond sectors, asset-backed securities, mortgage-backed securities, and commercial mortgage-backed securities provided excess returns compared to US Treasuries. All in all, it was another quarter of solid returns for fixed income investments. The main risks now facing the bond market are the possibility that corporate earnings, economic growth, and inflation tick higher, which could put downward pressure on prices of bonds with longer maturities.
One of the questions I have been asked most frequently over the past six years is, “If interest rates are going to rise, why not take fixed income allocations to zero?” I think to myself, if we took fixed income to zero, what is our alternative – cash? Cash only wins during big market disruptions. Over medium to long time frames, any investment that returns less than the rate of inflation is just slowly making you poorer. It’s very telling that I have heard this question as far back as 2010 and since then, fixed income has deserved every allocation it has had in diversified portfolios.
About four years ago, I would have said there was a 75% to 80% chance that equity markets would perform well and a 25% chance that some event would derail, even temporarily, the upward trend. However, the probabilities are a lot more even now. Given modest US economic growth and uncertainties in the global environment, I would say there’s now a 55% chance of good performance and 45% chance of a disruption. We want fixed income securities as a shock absorber in our portfolios.
Though we stand firm in our intention to maintain fixed income exposure, the question remains, what will happen when rates do go up? Pitcairn portfolios have had short durations for a while and will likely stay short. We are also looking at fixed income alternatives that may provide desired income and correlation attributes with less vulnerability to interest rates.
So far this year, we have seen very nice performance from real assets, an investment category that has proved to be an effective diversifier in 2016. We consider Pitcairn’s allocations to real assets as inflation-keyed equity exposure. Should Fed actions lead to higher inflation, allocations to real assets could play an important role in portfolio performance.
In the third quarter, the MLP sector returned roughly 1%, as measured by the Alerian MLP Index. MLP results tracked the price of oil fairly closely, in keeping with a history of high correlation between the two assets. The MLP segment had lagged earlier this year and we defended it on the grounds of diversification. Our conviction has been validated.
For the past few years, infrastructure had been a tailwind for portfolios that incorporated the asset class. Global infrastructure rose 2.7% in the third quarter buoyed by low interest rates and yields above the global equity market. A prolonged recovery in the energy sector and higher global capital expenditures could provide additional support to global infrastructure going forward.
Commodities delivered mixed results, with industrial metals rising, precious metals flat, and energy and agriculture down for the quarter. In aggregate, commodities declined nearly 4% in the third quarter, as measured by the Bloomberg Commodity Index.
Global REITs were up 1.3% in the third quarter, as measured by the FTSE EPRA/NAREIT Developed Index, taking the REIT return over 10% for the year. US REITs were down a little less than 1% for the quarter, but are up 11.4% so far this year. Real estate investments have benefited from a balanced recovery in the real estate market and their appeal as bond surrogates for income-focused investors. Though susceptible to fears of higher interest rates, REITs could actually benefit if inflation were to rise in line with expectations, as rents could rise as well.
Pitcairn views hedge funds and private equity as vital portfolio components, both for their diversifying characteristics and their return potential. We have reinvigorated our private equity and hedge fund research teams and continue to conduct significant research in the hedge fund and private equity arena.
The hedge fund universe saw improved performance consistent with the broader outperformance of active managers in the third quarter. However, challenges remain, including some very high profile underperformance, negative headlines about specific hedge fund managers, and news of plan sponsors abandoning their hedge fund mandates. We anticipate that hedge funds will perform better when interest rates rise, and if they do, the industry should largely look as it does today, perhaps a bit smaller. However, if interest rates rise and hedge funds continue to struggle, we could see a major shakeup in the group.
Interest in private equity has been growing and we are evaluating a significant volume of deals. I recently read a detailed industry research report pointing to private equity as a reason for the IPO market’s current weakness. Apparently, small companies are shunning the IPO market because they can find higher multiples in private equity. Though we believe there are excellent opportunities in the private equity segment, we believe valuations always matter and when they are higher in the illiquid private market than they are in the liquid public market, one must proceed with caution and deep due diligence.
Private equity and hedge funds offer excellent return and diversification potential, but like real assets, these markets are complex and inefficient, which is why it is so important to pursue them with actively managed strategies implemented by a team, like Pitcairn’s, who closely monitors the markets and performs extensive due diligence.
Even though there is still a skull next to the candy corn in my home, it’s only indicative of the Halloween season, not my investment outlook. I renounce the “everything is scary and awful” mindset that permeates our political discussions and the evening news because it is just not rooted in reality. The doomsday rhetoric flies in the face of the data. That is why we believe it is folly to play election cycles and short-term economic trends in your portfolio. Instead, we stand by the advice we have always given our clients: A long-term plan that includes a mix of asset classes, guided by the best investment managers, combined with the fortitude to stick with that plan, is the best strategy for a successful investment outcome. You may be tired of hearing this, but we will never tire of repeating it.
I leave you with one final piece of good news. No matter how scary things may sometimes seem today, historically, Americans tend to feel more optimistic once an election is over. We can at least look forward to that.