Presented by: Thomson Reuters
June 5, 2013
New York, New York
Speaking: Leslie C. Voth, President & CEO
Topic:Family Office

June 4, 2013
Baltimore, Maryland
Speaker: Rebecca A. Meyer, Managing Director
Topic: Exploring the Multi-family Office Alternative

Presented by Family Firm Institute
October 15-18, 2013
San Diego, California
Sponsor: Pitcairn

Click here to download the pdf version.

I often say that change is a reality, not an option. It’s reflective of Pitcairn’s drive to innovate. We are constantly seeking ways to better serve our families. Five years ago, our commitment to providing objective advice and fee transparency led us to a groundbreaking decision to establish a 100% open architecture approach to investing. As we mark the anniversary of that critical transformation, its resounding success and the vision it represented are clear: 

• Pitcairn sits solidly on the same side of the table as our clients in all investment decisions.
• Our approach was tested and validated during one of history’s most turbulent investment periods.
• Our asset allocation discipline, customized for each client’s long-term goals and designed with the knowledge there will be booms and busts, enabled our clients to fully benefit from the robust market rebound following the financial crisis. 
• Our investment due diligence process resulted in the vast majority of our managers outperforming their benchmarks and their peers since the move to open architecture in 2008—outstanding results during a time when many active managers struggled. 

There are numerous people to thank for the success of this strategy—most particularly, our clients for their confidence in both our ability to counsel them and our commitment to putting their best interests first at all times. Of course, we couldn’t have done this without the unwavering support of our Board of Directors. Many firms would have put short-term profits ahead of doing the right thing for their clients.

Among the many individuals across the Pitcairn organization who contributed to this change, Chief Investment Officer Rick Pitcairn and his team also deserve special thanks. Rick and the entire Pitcairn staff had the discipline and courage to take the long view, maintaining client exposures to stocks at a time when other advisors fell into a classic fear trap. We understood that the realities of the investment marketplace this time were essentially no different than in the past. Economies and markets go through cycles and our investment strategies have been built with this certainty in mind.

At a recent meeting in New York, Rick shared his view of the current investment environment and explained how Pitcairn is positioning client portfolios for the future. We hope you enjoy this recap of his thoughts.

As always, your relationship manager is available to answer your questions about this or other important matters.

Warm regards,

Leslie Voth
President & CEO

Click here to download the pdf version of Leslie’s letter.

Click here to read Rick Pitcairn’s recap.

By Rick Pitcairn, CFA, Chief Investment Officer

Click here to download the pdf version.

Those of you who know me know that I spent many years as an avid sailboat racer. To succeed in that sport, you must be completely attuned to the environment around you. Any change in the wind or current can dramatically affect your position in the fleet. Now that I spend my time assessing the global investment environment, being aware of any change in this environment is every bit as critical. For a few months now, I have been speaking about a shift in market sentiment from a fear-based “risk on/risk off” environment to a more momentum-based “rally” mindset. That change is now fully apparent. And just like in my sailing days, being aware of a change and positioning yourself appropriately is vital to success.

First off, I think every investment plan should begin with fundamental disciplines that can guide you through all market environments. Here are the principles we use to build client portfolios:

• Stay long-term in thinking. Families win when they recognize that investing is a long-term game, position their assets for a long-term environment, and avoid potential traps.
• Don’t abandon a well-thought out plan. Once your core plan is set, stick with it. Adjust it with your advisor, as needed, but always keep the big picture in mind.
• Be wary of following the herd. You can achieve your investment goals without chasing every passing fad.

These principles are especially important to today’s investors as markets are continually buffeted by so many financial, political, and emotional factors. They form a framework through which we can develop strategic positioning. At Pitcairn, we are focusing on five key themes that we think are particularly relevant for this environment.

1. Stay Well-Positioned for Asset Inflation

Since October 2008, when Federal Reserve Chairman Ben Bernanke first said he would pump as much liquidity into the economy as necessary, by as many means as possible, we have warned against fighting the Fed. Now, it’s not just the Fed, but the European Central Bank, the Bank of England, the Bank of Japan et al. Global central banks clearly agree with Bernanke that abundant liquidity is the best strategy for stimulating global growth and putting a floor under asset prices.

Some say this sort of massive liquidity injection has to end in tears, a severe market dislocation. I’m not so sure. There are several ways markets could make it through without the disruption some people fear. However, there is no question that inflation and higher interest rates are in our future. We just don’t know when. Therefore, we are very cautious about core fixed income and cash. We are positioning portfolios to be overweight equities and underweight fixed income, which would likely bear the brunt should the Fed need to wield its inflation-fighting tools.

2. Go Global in All Asset Classes

Regardless of where you live, “going global” is now reality. Families increasingly understand the opportunities created by technological connectivity and global commerce. We firmly believe that having a solid plan is not enough. You must also have access to the best managers in the world executing that plan by choosing among excellent investment options from around the globe.

Fixed income is an area where global options have been expanding. Previously, fixed income markets within emerging markets were almost non-existent, so companies could only go to banks or issue equity to raise capital. Over the last 15 years, fixed income markets in emerging countries have evolved significantly, so that we can now invest in debt of fast growing companies with excellent balance sheets and do it in a currency diversified way to manage interest rate risks.

There are a host of other investment ideas and methodologies like this that lend themselves to global thinking and can enrich families over the next 10 to 20 years.

3. Be Diverse

History tells us that diversification has a higher probability of success than market timing. Families that I have seen succeed typically set their goals, pick a mix of assets, and let that mix work for them over a long period of time. They don’t try to guess what asset class will be on top in any given year.

We are wary of strategies that take any core asset class to zero. Such strategies introduce timing and execution risks that lower your probability of long-term success. That’s why we position portfolios the way we do. For example, we believe interest rate risk is very real at this stage of the economic cycle, but we’re not excluding fixed income. Instead, we are finding fixed income strategies that are less interest rate sensitive. These include levered loans and convertible securities.

4. Keep Current on New Technology and Innovations 

Technology frequently provides opportunities to deliver asset classes in a new and better way. One example is Pitcairn’s proprietary tax optimization program, which we introduced in conjunction with our open architecture platform. This program looks across the US equity managers in a portfolio and executes the changes that managers are making in a tax efficient way in order to deliver tax savings along with performance. Results have been very robust—indeed, these tax savings have covered the majority of our fees.

Another example of innovation opening up opportunity is the impending “Vanguardization” of the hedge fund industry. In the 1970s, Vanguard significantly reduced the cost of equity market “beta” through indexing. We anticipate a similar development through which hedge fund return streams may become much more accessible and fee efficient for investors.

Our role as advisor is to anticipate and tap into new technologies that allow us to combine and deliver asset classes in a radically different way. Pitcairn portfolios look very different than they did just five years ago, but our fundamental principles haven’t changed. Nor should they.

5. Don’t Let Your Politics Dictate Your Portfolio Positioning

Last fall, my friends on the Right felt compelled to reposition their investments because they were sure the country was going down the tubes after the election. Subsequently, many missed the November/December rally. Then, in early 2013, my friends on the Left were upset by sequestration and thought austerity would kill the rally. So they took actions they thought appropriate. They, too, made the wrong call.

What is important to understand is that the political and investment cycles work on different timeframes. The typical investment cycle is much longer. Thus, allowing politics to overly affect decisions places investment portfolios at greater risk. Consider 2011, a period when political concerns seized the markets. Then look at 2012-13 when the markets largely shrugged off the election, as well as the fiscal cliff and sequestration. Our advice: Keep your eye on larger trends in the marketplace or you may do yourself a disservice.

The US has some important growth advantages at this time—a potential manufacturing boom, a positive sea-change in the US energy situation, and the growing interconnectedness of global commerce which benefits the best global capitalists, many right here in the US. I am optimistic about the ability of the US to dig itself out of its current structural challenges, but some people are so caught up in the possibility that fiscal problems will crush us, they are paralyzed and doing damage to their long-term plans in the interim.

Our view is that you can work toward your goals in a way that has a high probability of success and not be dragged around by the marketplace—if you take a different viewpoint. Have a sound long-term plan, vetted by someone who knows how to lead families to success, populate it with the best managers in the world, and then stick with it and let it work for you. We never know how things will turn out on a year-by-year basis, but we believe the simple themes highlighted here will position investors well for the coming years.

Click here to download the pdf version.

By Karen R. Wawrzaszek, CFP^®, CFTA, Managing Director

Click here to download the pdf version.

Most wealth creators have similar dreams for the future: A lasting legacy. Heirs who embrace their values and honor their life’s work. Enduring wealth consistently employed for the good of the family. Above all, they fervently seek to avoid the “shirtsleeves to shirtsleeves” paradigm.

What does it take to achieve such dreams? Consider these amazing examples from the animal kingdom: Male deer regenerate their antlers each year to compete with other males for mates and find food in the snow. Crayfish regenerate their claws, and when they are young, the claws grow back faster and stronger. Sharks continually replace lost teeth and may have over 20,000 in a lifetime. A family’s multi-generational survival depends on its own ability to re-grow its “antlers, claws and teeth.” What if you could give your heirs the skills to put them on a path to wealth regeneration rather than wealth depletion?  

Typically, wealth creators worry whether everyone will have enough money to be well cared for. The more critical questions are:

• “Have I shared my knowledge about growing wealth?”
• “Am I confident that my heirs can replicate the success I’ve had?”

In a perfect world, we would transfer our wealth, and our heirs would make the same decisions we did to create that wealth, leaving the next generation in an even better position. In reality, our heirs are living a different life at a different time, with different choices before them. However, an innovative approach called a “Family Bank” can provide a framework to pass on a wealth creator’s knowledge and values, while strengthening family bonds and facilitating wealth regeneration across multiple generations. Quite simply, a Family Bank can turn heirs into “makers” instead of “takers.”   

Those who know me have probably heard me loosely refer to agreements as “wrappers.” I do so because a wrapper can contain a collection of your intentions in one document without bogging you down in legal associations that can be difficult for non-experts to interpret. For example, if you are establishing a legal entity to benefit your children and grandchildren as they pursue educational and career goals, the wrapper is commonly known as a Trust. When you open the wrapper, you find all your intentions spelled out, along with specific people you want to benefit from these intentions. A Family Bank is a kind of wrapper that may involve a number of different legal structures, depending on a family’s situation and goals. Our focus in this article is not the legalities, but the potential benefits to the family and the family dynamics that make a Family Bank successful.

A Family Bank is not a formal bank in the way we normally think of one. Rather, it’s a collection of family members brought together to carry out investments, entrepreneurism, and/or philanthropy. A Family Bank is a vehicle that family members own jointly and where decisions are made collectively, with accountability to the broader group. It gives all family members a seat at the table and a voice in the discussion. Most importantly, it is not a structure for distributing wealth to family members. It’s meant for investing and growing wealth to serve a family for generations to come.

One Family’s Success

I have worked with a number of different families in establishing Family Banks and I have seen some achieve great success and others strive valiantly without quite pulling it together. The greatest success I’ve seen came from a seventh generation family who achieved excellent results over several decades. (Family members still enjoy holidays together!) From their experience, I have identified several critical “best practices” for any Family Bank.

•  A Clear Family Vision. This family stated its mission and family “brand” before setting up its Family Bank. They knew how they wanted to be perceived by the community and extended family and were explicit in what they wished to accomplish.
• A Well-Defined Participation Process. Though all family members could be equity stakeholders, not all would actively manage the Family Bank. The selection process was quite diligent, like a well-run corporation. Family members who wanted to participate went through an application and interview process that required them to meet minimum age standards and demonstrate applicable education and/or skills. 
• Evolving Leadership. The family set term limits that rotated members in and out of family council positions. This ensured accountability, minimized risk of tunnel vision from entrenched leadership, encouraged fresh thinking, and allowed younger family members to become involved, thus extending the success into future generations.
• Formal Communications. Passive family members were never in the dark. The family’s reporting structure was much like sharing corporate board minutes. Those managing the Family Bank met periodically as needed, but did not work in a vacuum. All activities were transparent to all family members, who could then provide feedback to more active participants. 
• A Fluid Structure. Their Family Bank was flexible enough to evolve over time as family council members identified needs and investigated opportunities.   

In short, the family I came to admire did an exceptional job of organizing its Family Bank and family council by being inclusive, open-minded, and thorough. For those who may be unfamiliar with the concept, a family council is composed of individual family members elected by the full family to meet regularly and provide governance and guidance for the family. Many families benefit from a family council even if they have not gotten to the point of establishing a Family Bank.

Ideally, a Family Bank and family council are established while the wealth creator is still alive so families can benefit from real life experience and knowledge. The family in this example established its Family Bank and family council in the early generations after the wealth creator’s death, but still achieved great success. Younger family members were excited to participate so they could learn to make sound decisions that affected the entire family, and their input was valued. In this particular family, decisions ranged from program- and mission-related investment initiatives to traditional investment approaches.

Barbara Hauser, an industry expert in family governance (www.brhauser.com), agrees that broad participation and accountability are keys to success. This family achieved both. The result: The family effectively altered the natural inclination of heirs from being “takers” to being wealth regenerators, something that should ensure this family’s well-being long into the future.  

Learning from Missteps

Several families I have worked with did not fare so well, but their efforts also provide valuable insight. A few critical missteps stand out among these families.

1. The wealth creator holds the reins too tight. You won’t have true buy-in if family members see the Family Bank as a guise for wealth creators to push their own agendas and keep the next generation in line. 
2. Failure to include multiple generations. Younger family members will ultimately be responsible for the family legacy and should be brought in sooner rather than later.  
3. Dismissal of some viewpoints and an unwillingness to consider unorthodox thinking. Diverse viewpoints and a breadth of ideas will only strengthen a Family Bank.

Avoiding these missteps will better ensure the ultimate success of your Family Bank.

Testing the Waters 

While you may not be ready to establish a Family Bank, there are ways to test the waters and even reap some of the benefits of a Family Bank. Start by getting the next generation involved in some aspect of your family’s legacy. Consider setting aside a slice of the family wealth and bring the younger generation into a discussion about how to manage it. For one family I recently worked with, we took a segment of the family’s net worth and opened a family discussion about how it should be invested. In this particular case, the family considered a mix of charitable causes because the wealth creator wanted to remove self-interest from the adolescents’ mindset. The family began by creating a mission statement and describing expected outcomes. Through this process, younger family members were able to see what various opportunities looked like and how to evaluate them. They saw wealth creation through a unique lens!

Establishing a Family Bank

Once you decide to establish an actual Family Bank, the process becomes a bit more formal. You will clearly need expert advice to establish the legal structures once you get to that stage. However, you may benefit from outside guidance even earlier in the process. For example, early steps in creating a Family Bank include:

• Writing the family’s mission statement 
• Setting up a family council if one does not already exist 
• Articulating desired outcomes 
• Establishing governance procedures  

A facilitator from outside the family can be an objective voice through each step, helping all family members to be heard and preventing the wealth creator from overwhelming the discussion. An outside facilitator can also function as a liaison between the family’s wishes and the legal structure. This person should have knowledge of family governance, but doesn’t necessarily have to be an expert on the underlying legal structures. Your choice could be someone who previously sat on family boards or someone who has a broad background working with families of wealth, such as through a family office.

Ensuring the Legacy

The ultimate goal of a Family Bank is to ensure the family’s continued prosperity by putting together a family team that learns to exercise good judgment and make decisions that express the family’s shared values. A Family Bank aims to inspire all family members to add to the family’s success by contributing their input, their abilities, and their knowledge. Not every family member may want to be directly involved in a family’s core operating business. That doesn’t mean they can’t be part of the family’s legacy. A Family Bank gives all family members the opportunity to be “makers,” rather than simply benefiting from the hard work of those who came before them.

Click here to download the pdf version.

___________________________________________________________

Karen R. Wawrzaszek, CFP^®, CFTA is Managing Director at Pitcairn. Karen leads Pitcairn’s DC metro area relationship management team, advising multi-generational families. She is responsible for developing, implementing, and monitoring long-term financial plans, focused on asset allocation, portfolio management, and tax planning, that meet clients’ short-term and long-term objectives.

Rick Pitcairn: The Wigmore Group met with the ECB in March. I came away from that meeting with the view that the ECB was committed to following the Fed model by being as accommodative as politically possible. Was that your view? Do you believe ECB policy is sustainable within the current political environment?

HQ Trust: I think the key restraint the ECB is facing is not so much politics as its mandate. Unlike the Fed, the ECB does not have the task to balance growth and financial stability, but a single focus on inflation. Thus, the ECB has to observe markets and the economy and can then act to combat risks of deflation or to ensure the transmission of monetary policy. The ECB cannot design or implement policies aimed to combat unemployment or stimulate growth directly.

Secondly, to address the underlying problems of fiscal irresponsibility, governments are called upon to act, not the ECB. Governor Draghi has been very clear about that. The Eurozone’s problems cannot be solved by abandoning the path to fiscal sustainability. Markets will substantially  calm down only when short-term spending to boost growth is balanced out by structural reform and a clear framework allowing for a path towards the ultimate goal of fiscal sustainability. The challenge for politicians is of course that structural reforms are contractionary in the near-term, and in most cases provide economic benefits only beyond the timeframe of the next election. It is near impossible for any politician seeking reelection to engage in such behavior.

Thirdly, the ECB has not only cut its benchmark rate, as of May 1, it is actively engaged in searching for and proposing additional solutions to the Eurozone’s most pressing problems. Besides the possibility of lowering the deposit rate to below zero, the ECB, for example, is looking into securitizing SME loans and thereby creating an entirely new mechanism for financial intermediation in Europe. Unfortunately, they are still in the early stages of that process (working together with the European Investment Bank), but if something can be delivered, it may completely change the currently dismal dynamics of the European lending market, and it could provide an exciting new asset class for investors at the same time.

To sum up, yes the ECB is behaving in a way that is sustainable, because the ECB has stayed, and will stay, within its mandate throughout its course of actions.

RP: German Chancellor Angela Merkel comes up for re-election in the fall. If Merkel is not re-elected how will this impact Europe?

HQ Trust: It depends very much on who wins the elections instead of Merkel and which party, or which coalition of parties, will end up forming a government. The policies proposed by the social democrats would maybe not impact Germany’s behavior as it pertains to the interaction with other Eurozone members that much; a socialist-green coalition would be worse, as some of the proposed tax increases and labor market regulations would significantly weaken the private sector. If however, as seems most likely at this point, a grand coalition is what will follow September’s election, we believe Germany may well end up playing a more constructive role in Europe than it has during the last couple of years.

RP: What is your opinion on investing in Europe? Do you see opportunity for investors in this environment?

SandAire: Europe is suffering from a recession, the onset of deflation, and a central bank that is a reluctant provider of liquidity. The cause of the problem is the single currency and the lack of any pan-euro fiscal transfers. Therefore, European economies have to gain competitive advantage by reducing their unit labour costs. Even Germany is now getting caught-up in the deflationary spiral as global markets are not compensating for the loss of European demand. The largest international European companies will survive and their stock prices are internationally competitive. The rest of the European capital markets are dysfunctional. There is potential in the corporate bond and loan markets, especially in distressed assets, but there is a paucity of deal flow as banks and financial institutions are reluctant to mark assets to a market clearing level. We hold no zeros, have no bank deposits in euro area banks, and have only blue chip companies. Something will have to change and then there will be plenty of investment opportunities, but timing is down to politics and not economics.

RP: You shifted from “risk-off” to “risk-on” in client allocations. Do you plan to maintain that position now that global economic data has moderated?

SandAire: We seek to alter the risk of a client’s portfolio in accordance to market and financial conditions. Equity markets do best when liquidity is ample and economic activity is sluggish. During the euro crisis of 2011 and 2012, we were unsure whether the ECB would provide sufficient liquidity to prevent the banking and credit markets from becoming highly dysfunctional. Such a backdrop is very negative for equity markets and since our mandate is to first preserve then grow capital, we lowered portfolio risk. Since the second quarter of 2012, following clarification of the ECB’s liquidity plans, we have been increasing the risk of portfolios and have been at maximum risk since the end of 2012. The fact that global economic growth remains sluggish encourages us to maintain our investment stance providing liquidity is generously applied. We will reduce risk either when central banks start to raise interest rates or if global economic activity accelerates. Since neither is likely to occur this year, we are unlikely to be changing our strategy.

RP: Emerging markets have struggled recently, significantly lagging developed markets in the first quarter. What do you think is behind the recent underperformance in Brazil and in other emerging markets?

Turim: Global growth is lower and commodity prices are going down. Developed markets are showing little traction in economic activity and emerging markets are still somewhat linked to developed markets. China, the most important emerging market regarding growth dynamics, is transitioning to lower growth, is less focused in investment/credit expansion, and is also less intensive in commodities. In the case of Brazil, the lack of structural reforms and government interventions in the economy are depressing sentiment among investors and entrepreneurs. Productivity is lower, investment is declining, and the country is caught in a situation of less growth and higher inflation, a deadly combination for asset prices.

RP: In light of the weakness in emerging markets, what Latin American country do you think will be the first to pick up and why?

Turim: Brazil has a high potential for positive surprises for the reason that pessimism is widespread among international and local investors. The government is starting to realize that its strategy is not working and has shown signs of pragmatism. For example, a couple of weeks ago analysts were not expecting interest rates rising despite higher inflation because of previous signs of political meddling by the executive leaders and their desire to keep real rates low. But in fact, the Brazilian Central Bank started a tightening campaign in April and recently signaled it could increase the pace of hikes to fight inflation defending its commitment to inflation targeting. In the long run, let’s not forget that Brazil has a growing middle class that sustains a dynamic domestic market. If supply conditions improve, this will prove an important structural tailwind for sustainable growth in Brazil.

Click here to read the 1st Quarter 2013 Pitcairn Economic Market Commentary.

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Wigmore Association was formed in late 2011 and consists of seven family offices from around the world Pitcairn (US), SandAire (UK), The Myer Family Company (Australia), HQ Trust (Germany), Northwood Family Office (Canada), Progeny 3 (US), and Turim Family Office & Investment Management (Brazil). Its goal is to further each other’s understanding of issues that are important to the families they serve. The Wigmore Association will meet next September in Brazil.

By Harold F. “Rick” Pitcairn, II, CFA®, Chief Investment Officer

Click here to download the printable pdf version.

Click here for the Global Perspectives Interview with members of the Wigmore Association.

“The S&P 500 reached an all-time high today, though many analysts expect a substantial pullback from these levels.” That’s a quote I heard on television the afternoon of March 28, 2013. My first thought was that even after a four-year run with a 135% gain since the lows of March 2009, this continues to be the most disrespected rally in memory.

There’s no question that the S&P 500’s all-time high is a milestone, given that we are just five years past the beginning of the worst global financial crisis since the Great Depression. As the crisis unfolded, we heard all manner of apocalyptic statements and such doomsday predictions have plagued us throughout the last five years, making it extremely difficult for sensible investors to follow sound long-term investment strategies. And yes, it was tough. The global economy faltered and many governments still face fiscal hurdles, but for those who ignored the fear mongering and overcame their own doubts to stick with their plan, there was no calamity. Their future goals remain achievable and their plans secure.

I am pleased to report that Pitcairn’s investment approach – complete with a state-of-the-art asset allocation technique, intensive manager selection process, and forward-thinking portfolio management tools such as a tax-efficient overlay – successfully guided our clients through the unprecedented challenges of the past five years. During the initial crisis when others panicked, we did not. And, during the recovery period, when others were timid, we were not. We kept faith in our long-term philosophy, our sound investment strategies, and our carefully vetted managers. Our clients have recovered from the crisis and most have experienced annualized returns in the high teens for the four years ended December 31, 2012.

The early signs of a reversal in investor sentiment that we noted in last quarter’s letter have continued to positively affect the markets. The Global Index Performance chart shows first quarter equity returns were strong across the globe, particularly in the US and Japan. Global liquidity, fueled by central banks in the US, Europe, and Japan, supported the rally, as it has since the middle of 2012. To the surprise of many, the US dollar has strengthened against most major currencies, including the euro and the yen. The dollar’s strength spurred strong inflows into the US as global investors borrowed cheaply and bought US equities.

The improved investor sentiment creates a different environment than the one we had recently been experiencing. Unlike the “risk on/risk off” mindset that caused markets to abruptly and frequently reverse direction, the current market is supported by a steady, more fundamental level of buying. Take Europe’s latest worry over Cyprus, for example. Just as the Cyprus crisis was at its nadir in March, I arrived in Frankfurt for the Wigmore Association meeting. As the bad news amassed, I would look at US equity futures in the morning, well before US markets opened and futures would be down dramatically. At the opening, they’d still be down, but a steady stream of buyers would have taken the sharp edge off the negativity. Then throughout the day, markets steadily crept higher. Two years ago, news like Cyprus would have kept US equity markets going down, down, down all day. That’s the power of the very different mindset behind this market. Whether the buyers are US-based hedge funds or foreign-based institutions, it is clear to me that trading patterns have changed as a result of more positive sentiment.

Five years ago, Marc Faber wrote, “The future will be a total disaster with the end of capitalism as we know it.” Fortunately, things worked out a bit better than that. Events are usually not nearly as bad as the most dire forecasts, nor as good as the most effusive. Today’s changing marketplace once again reaffirms the value of judgment and moderation in times of market extremes. Whether the equity markets’ strong first quarter rally means that the lion’s share of 2013 gains has already been attained or another strong fall rally is in store for us, it seems clearer than ever that a solid strategic plan, populated by excellent investment managers and prudently implemented, offers the highest probability for investment success.

Global Economy

From a global economic standpoint, we’re still facing a low growth environment with massive liquidity, supplied in unison by the world’s central banks. Though US economic data has been choppy and the earnings season was, at least somewhat, disappointing, the US is currently the favored arena for global investors. That may say more about the poor short-term growth prospects for Europe and China than it does about economic conditions here.

Most central banks have looked at the Bernanke model in the US and, to the degree that their political and fiscal situations allow, have imitated it. While in Europe with the Wigmore Association, my interactions with European Central Bank (ECB) officials led me to believe that they want to follow the Bernanke model more closely. By the end of our talks, it became clear to me that the ECB thinks liquidity would solve Europe’s issues, but that they are hamstrung because injecting massive liquidity into the system would not be politically tenable.

It was also clear to me that the ECB would probably do just about anything to keep Europe together. This fits with the belief we’ve expressed for some time that the European situation would be very serious and would take years to resolve, but would not lead to a breakup of Europe or a meltdown of 2008 proportions. Others apparently took a bleaker view, given that a 2008-style meltdown was priced into the market until recently. Despite the serious economic conditions in the region, any objective analysis would show that the situation has improved. Now as the crisis grinds into its third year, we’ve been staring at it for so long and have analyzed it so thoroughly, we’re probably well past the point where the market will be completely surprised by a negative event. In my experience, market meltdowns are far more often caused by something we didn’t see coming.

Speaking of the Wigmore meeting, I just want to emphasize how beneficial this association is. The first weekend we were in Frankfurt, the Cyprus situation came to a head. The news came out that European officials were talking “bail in” instead of “bail out” and that money would be taken from Cyprus’s bank deposits, which of course, Cyprus was unhappy about. Just a few days later, on Thursday, we were talking person-to-person with leading European economists and bankers. There’s no question we got an insider’s perspective on Cyprus by being there. Cyprus might not be an event that radically changes financial history, but for us, the opportunity to see and understand first hand how European power players responded to this situation provides insight that will undoubtedly be valuable to us in the future. This is a key reason why we are part of the Wigmore Association. Global perspectives from select members of Wigmore can be found on page 7.

Turning to other parts of the globe, the Bank of Japan (BOJ) joined the ranks of its fellow central banks, easing the country’s monetary policy and driving down the value of the yen. In an extreme adaptation of the Federal Reserve’s model, the BOJ announced a commitment to a monthly $75 billion bond purchasing program, which will remain in place until the economy moves from deflation to a 2% inflation rate. With a new prime minister for the country and new leadership at its central bank, Japan appears to have changed course, now seeking to end deflation and spur greater growth. Some fear this will lead to a currency war. Only time will tell. As investors, it is important to focus on the key issue, which is that Japan has joined the legion of central banks pumping massive liquidity into the global marketplace; however, Japan has a ways to go to catch up with the rest of the world’s major central banks.

In China, weaker-than-expected industrial output, disappointing retail sales, and an attempt to cool an overheated housing market by curbing property market investment all weighed on the country’s economic growth. But news from China is not all negative. Exports beat expectations and manufacturing increased during the first quarter. Also, the new government’s early actions suggest greater enthusiasm for reform. Since the transition to power last year, the new regime opened the interbank bond market to foreign investors and appointed new securities regulators focused on implementing international standards.

For some time now, we have been stressing the theme: “Go global in all asset classes.” Recent economic weakness in Europe and the emerging market countries may seem to invalidate this theme. Far from it. Although short-term weakness has temporarily slowed equity markets of various countries, our longer-term advice is that an investment portfolio constructed from a global perspective will thrive in the coming decades as the trend toward the globalization of commerce continues.

US Economy

With the presidential election over and fiscal cliff fears behind us, many issues that dominated the headlines in 2012 receded into the background during the first quarter of 2013. Economically, both US consumer spending and the housing sector improved in the first quarter. The Home Prices chart shows home prices have been on the rise since bottoming out in early 2012. With consumers feeling better, optimism clearly won out over the threat of inept politicians. (This is the opposite of what happened in August 2011, more evidence of how potent positive investor sentiment can be.)

The strong market returns in the US supported another of my key themes from last quarter: “Don’t let politics dictate portfolio positioning.” In recent months – before and after the fiscal cliff deadline – we have heard all manner of negative predictions about potential drag on GDP, negative effects on the investment markets, etc. The last minute fiscal cliff compromise did create drag on GDP via new taxation and sequestration brought on inefficient spending cuts. Neither is a positive for this growth-challenged economy, but they are not a death knell either. Through it all, US equities delivered double-digit gains in the first quarter, confounding investors who were certain that US fiscal challenges would stifle any equity rally. Not surprisingly, people who rose above the political rhetoric and stuck to their investment strategies shared in the gains.

Back in January, when the Fed’s December minutes were released, the market had an interesting reaction. The Fed, indicating confidence in the economy, opened the door to a possible end to quantitative easing. The market had a negative response. Let me just say that as an investment manager, I want the Fed thinking about how to wind down the massive liquidity without blowing things up.

The real question for policy makers is at what point can they begin the process of tapering off quantitative easing without bringing on a marked economic slowdown. Clearly, the Fed minutes from earlier this year showed that many Fed governors thought we were close to that point. However, last week’s release of a lackluster 2.5% GDP growth rate for the first quarter put those thoughts on the backburner. The combination of fiscal cliff-related tax increases and the recent sequester have resulted in more economic weakness than was anticipated. My sense is that this is another “soft patch” rather than a more serious downturn. That would mean that our low growth, liquidity rich, equity friendly environment will continue for the foreseeable future. But make no mistake, sooner or later the wind down of quantitative easing must happen.

When the Fed does finally signal an end to the abundant liquidity, the bears will look for higher interest rates to halt the equity rally. Historically, however, the Fed’s first interest rate increase doesn’t usually hurt equities. Rather, the market will likely interpret the initial uptick in interest rates from their current low level as a sign of a healthy economic environment. What will get hurt if interest rates rise is the fixed income market. More on that later.

Global Equities

The global equity rally continued through the first quarter, with US equities hitting record highs and global equities within 1% of their 2007 peak. During the quarter, the market experienced a major rotation in regional leadership as seen in Regional Performance chart. US equities and frontier markets within the emerging market universe led performance in the first quarter after lagging in 2012. Conversely, Europe and the remainder of the emerging market universe went from performance leaders in last year’s rally to laggards in the first quarter of 2013.

Japan led all global equity markets, buoyed like most other markets, by abundant liquidity. After a long streak of relative underperformance, Japan returned 11.2% in the first quarter. The BOJ’s aggressive actions to weaken the yen and stimulate inflation drove the equity rebound. Investors rewarded the BOJ’s efforts to re-inflate the economy by flocking to Japanese equities, which reached a four-year high in March.

Emerging market equities were a disappointment in the first quarter, falling 1.6%. After finally taking the lead over US equities in the fourth quarter of 2012, emerging markets fell victim to falling commodity prices, currency weakness, strength in the US dollar, and even improving economic activity in developed markets, which all contributed to a capital shift away from the emerging markets.

US Equities

Extraordinary global liquidity and positive sentiment have started to get money flowing into equities. US stocks were a key beneficiary of the reawakened equity demand, receiving $34 billion in net inflows to advance sharply and outpace all global markets except Japan. The US rally was broad-based, with stocks across all market capitalizations delivering double-digit gains for the first quarter. The rally coincided with a sharp drop in volatility, as the VIX (Volatility Index) fell 29.5% in the first quarter, reaching its lowest level since February 2007. Calmer investment markets, signs of improving economic growth, and continued support from the Fed coaxed investors further out the risk spectrum, as evidenced by small caps outperforming large caps. Small cap stocks returned 12.4%, as measured by the Russell 2000® Index, while large caps returned 11.0%, as measured by the Russell 1000® Index. US equities were driven by consumer stocks, health care, and technology, which are all well above 2007 peaks, ranging from 18% above the peak for technology to 60% above the peak for consumer discretionary.

And, we are just beginning to see individual retail investors come back to equities as shown in the OE Retail Fund Flows chart. I’ve said for a long time that market records will be one of the things that draw them back, so perhaps the time is coming. I believe that after five years, investors are just tired of doing nothing. Since 2008, people have been almost exclusively focused on what would probably go wrong in the investment world, rather than what could possibly go right. It seems that now they are finally realizing that while they were worrying, many things did go right and it’s time to get their investments back on track. Sadly, that means they have missed a good deal of the market’s gains, but it also provides impetus for the rally to continue, benefiting those who have held to their strategic equity exposure.

US Fixed Income

The fixed income market posted a lackluster quarter in the absence of inflationary pressures and the continuation of stable, low interest rates. Core-taxable bonds, as represented by the Barclays Capital Aggregate Index, fell 0.1% in the first quarter. US Treasuries were largely unchanged with small rate increases at the very short and long ends of the spectrum. Municipals bonds, as represented by the Barclays Capital 1-10 Year Index, gained 0.5% for the quarter. Within the municipal market, lower credit quality continued to outperform as high-yield municipal bonds were the performance leader.

Across all segments of the fixed income market, we saw investors moving away from securities with higher interest rate risk, a sign of increasing diversification. Money flowed into securities that are less sensitive to interest rate changes, including Mortgage-Backed Securities (MBS) and Collateralized Loan Obligations (CLOs). In the emerging markets, fund flows favored local currency paper, which offers exposure to more normalized local interest rates.

Between the equity and bond markets, I see the real risk in fixed income, to which people have been moving, rather than the equity market, where they have not been. Consensus thinking and nearly every available data point indicate that inflation has to pick up and fixed income investments have to come down in value. But, will it be another seven months or another two to three years? We just don’t know. And that’s why I say: “Stay diverse.” We are wary of strategies that take any core asset class to zero. We believe such strategies introduce timing and execution risks that lower your probability of long-term success. That’s why we position portfolios the way we do. We believe interest rate risk is very real at this stage of the economic cycle, but we’re not going to shun fixed income. Instead, we are focusing on sources of income that are less interest rate sensitive, such as levered loans and convertible securities.

Alternatives

Hedge funds closed the first quarter with record performance, surpassing a high-water mark from April 2011. Many managers equaled their entire 2012 return in the first quarter. The HFRI Fund of Funds gained 3.36%, with event-driven and equity managers generating top performance.

During the quarter, we attended several conferences with prominent long/short hedge fund managers. We’ve been listening to them speak for four years now and it’s very enlightening to see their outlook evolve. I have noticed that they are now getting more comfortable with long equity positions. (And, I think that’s part of the support for the current market.) The story was different in 2011 when many long/short managers were reflecting the mood of retail investors and were afraid to go long. We’re seeing a new attitude now. That newer attitude combined with the markets’ healthy trend toward a lower level of asset correlation, should lead us to stronger returns in alternatives over the next few years.

Here we are, with equities up over 10% in the first quarter and 135% since the rally began March 9, 2009. A pullback or breather is certainly possible following such a sharp advance in a reasonably short period. However, we think there’s every bit as much chance that the dramatic shift in investor and consumer sentiment will drive multiples further and that this market could be in a higher place than it is right now, maybe even significantly higher.

That said, the market is not without risk. There’s always the chance for what I call the Freddy Krueger moment—the time in every horror movie when the protagonists think they’ve finally prevailed. They let their guard down and suddenly the menacing music plays and the supposedly vanquished monster strikes again. We could still have a Freddy Krueger event that puts investors and consumers back in the old doomsday mindset. That won’t necessarily end the bull market, but it will make things more challenging. On the other hand, without a geo-political event or natural disaster like the Japanese tsunami, there’s a very good chance we’ll have another strong year for stocks.

Five years ago, on the eve of the global financial meltdown, Pitcairn fine-tuned the investment services we offered clients, incorporating an asset allocation methodology, a tax overlay and a comprehensive manager selection process. Because we made these changes, Pitcairn clients had precisely the right tools and strategies in place to triumph in a remarkably challenging period. While other investors were making classic mistakes under the mistaken assumption that “this time is different,” Pitcairn clients were making money.

For the next few weeks, we will certainly hear a lot about weaker economic activity, which we have been seeing, both globally and here in the US. Some will predict that weaker-than-expected results mean the recent cycle of spring and summer weakness will recur in 2013. Maybe. Whether this is a short-term “soft patch” or a more serious recalibration of global growth, it, once again, puts near-term inflation on the back burner. Further, it leaves us in very much the same slow growth, liquidity-fueled macro environment we have been in for the last three years. Combine that equity-friendly environment with improving investor sentiment, and there may be reason to expect that this summer could be better for equities than the last three have been. Regardless, this market shows no signs of the rich valuations and over-heated sentiment that typically kills bull markets.

Click here to download the printable pdf version of the Pitcairn Economic & Market Commentary 1st Quarter 2013

Click here for the Global Perspectives Interview with members of the Wigmore Association.

(Bloomberg Radio’s The Hays Advantage, April 29, 2013) Rick Pitcairn, chief investment officer at Pitcairn in Philadelphia, discusses the investment outlook among family wealth managers around the world as he argues in favor of equities over bonds because of the inherent inflation risk in aggressive monetary stimulus from the Federal Reserve, European Central Bank, and Bank of Japan.  Pitcairn speaks with Bloomberg’s Kathleen Hays and Vonnie Quinn on Bloomberg Radio’s “The Hays Advantage.” (Source: Bloomberg)

CLICK “PLAY” TO LISTEN:

(Family Wealth Report, April 3, 2013) Wigmore Association, the collaborative group of multi-family offices, finished its latest meeting in Frankfurt feeling bullish about the outlook for the global economy.

The organization, which sees the chief investment officers of a group of family offices discuss political and economic global events, is currently chaired by Pitcairn CIO Rick Pitcairn. Continue reading.