By Rick Pitcairn, CFA®, Chief Investment Officer
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Be Careful What You Wish For!

In my letter last quarter, I bemoaned the lack of new developments in the investment markets, pointing out that many of the same issues (low oil prices, a strong US dollar, Ukraine, and the Middle East) that held investors’ attention at the end of 2014 were continuing to influence results in the new year. I worried about boring you with yet another rehash of possible market responses to possible Federal Reserve actions. I started that letter with the old adage, the more things change, the more they stay the same. Well, there’s another appropriate adage for this quarter’s comments – Be careful what you wish for!

After a fairly orderly April and May, markets certainly put the kibosh on boring as the quarter marched to its end. If investors were starting to feel complacent with the status quo, they got a sharp poke as the Greek debt crisis reared its ugly head, and the dragon followed suit with Chinese equity markets taking a tumble. In addition, Puerto Rico’s debt situation grew so bad that thousands abandoned the island for Miami. (See Puerto Rico Default, No Impact on Pitcairn Portfolios, August 4, 2015.) Meanwhile, the threat of a Fed misstep remained with us.

I’d like to draw your attention to another comment from my letter of last quarter, a statement that proved somewhat prophetic. In talking about the importance of diversified portfolios, I wrote: “We can be the smartest, most hardworking investor on the planet and we will still sometimes be surprised by some global event or some company’s good or bad decision-making.” Though I wouldn’t say that events in Greece or China were true surprises, I’m sure the timing caught some investors unprepared. But not Pitcairn clients. Every Pitcairn financial plan is constructed with an eye toward occurrences such as this. As a result, the situation required no major changes to long-term asset allocations, nor did we think there was enough clarity for us to employ any tactical strategies to capitalize on the uncertainty.

We have been monitoring Greece carefully for several years now. The country’s fiscal situation was closely intertwined with global market meltdown fears in 2011 and has subsequently been on the radar of most market watchers. Since then, Greek citizens have faced painful austerity measures that spurred them to elect a government with a more extreme socialist ideology. As the country sought to renegotiate its debt terms with European lenders, a proposal (which in our view gave Greece many of the concessions it desired) was put before the Greek people who rejected it. Suddenly, a Greek exit from the Eurozone seemed possible, even though polls show that most Greek citizens prefer to remain in the Union.
Earlier this year, we proposed three possible endings for the current chapter of Greece’s story:

  1. Greece stays in the European Union (EU) with major concessions;
  2. Greece exits the EU; or
  3. A compromise temporarily appeases both sides and postpones any final solution.

As of mid-July, it seemed Germany would take the hard line and usher Greece out of the alliance. Then, on July 15, the Greek parliament approved a bailout plan with terms even harsher than those in the failed public referendum. So after much political maneuvering, we are back to scenario number three, a result almost laughably predictable given the history of this political drama.

Throughout the unfolding Greek crisis, we have been in constant contact with our colleagues in the Wigmore Association. Our peers in Europe have been particularly insightful about various developments, with the German members offering a window into German political opinion. German opinion polls show that 55% of the population approves of President Merkel’s handling of the crisis, while only 30% favored a more draconian response, including Greece’s exit from the EU (Source: Forsa/Stern Poll, Openeurope.org, July 16, 2015).

We don’t think the recent compromise marks the end of Greece’s troubles as the country still has more debt than it can repay. The European Central Bank (ECB), desperate to keep the European alliance viable, refuses to accept reasonable write-downs of that debt because other countries would then ask for similar discounts, a scenario unacceptable to Germany and France. From the start, we have maintained that none of the possible outcomes described above poses a serious threat to global developed economies or their capital markets. Consequently, we do not think the outcome of this crisis will create a secular inflection point that ends the impressive bull market we have experienced since 2008.

Next on the global worry list is China. Chinese stocks rose tremendously over the last 10 months, fueled by a high level of speculation, significant margin debt, and “shadow” debt not sanctioned by the government. For the second quarter, Chinese equities were up 6%, but the market peaked in early June and the bubble began to burst. (See Chart A.) Between the peak on June 12, 2015 and July 8, 2015, Chinese equities fell over 32%.
2Q-2015-Chart-A-425px
Some bears suggest this decline will end 20 years of Chinese economic growth and usher in an era of global depression. Our more measured view acknowledges that China has always been a volatile market, but also recognizes that China’s government wields tremendous control over its economy. The People’s Bank of China (PBOC) has exponentially more control over the Chinese equity market than the Federal Reserve has over US markets. In recent weeks, the PBOC has frozen trades by insiders, eliminated short sells, and stated that selling stocks is unpatriotic. As a free market capitalist, I don’t like to see such controls over markets, but I do think these measures are likely to stem a real run in Chinese equities.

Though the financial press ranks Greece as the most important issue facing investors, followed by China, and finally US interest rate policy, we think this pecking order is exactly wrong. We see Fed policy and the market’s acceptance of that policy as the determining factor in the continuation of the global equity rally. (Fed policy is discussed in more detail later in this letter.) To our mind, the second most critical factor is the Chinese central bank’s ability to stabilize its market, with Greece third in the hierarchy of major market concerns.

Global Economy

It’s interesting to note that European economic data (excluding Greece) remained strong, further evidence that Greece’s difficulties are not spilling over into other countries. (See Chart B.) Since the 2008 financial crisis, there has been talk of “contagion,” the fear that fiscal problems in one of Europe’s peripheral countries (Portugal, Italy, Ireland, Greece, and Spain) would spread like an epidemic, eventually wreaking havoc on global financial markets. We are not seeing any signs of that. We do see some possibility of political contagion, if other peripheral nations elect more left-leaning governments in upcoming elections.
2Q-2015-Chart-B-425px
Aside from its peripheral countries, the larger European economies of the UK and Germany – though not France as of yet – are moving forward and in vastly better shape than they were four years ago. UK consumers are particularly strong and given the economy’s momentum, the Bank of England is accelerating its anticipated rate raise and may even beat the Fed to the punch. Conversely, the ECB has made clear that it will stay in an easy money mode to support nascent growth.

In our view, the real risk to the global economy is Asia, particularly China. We discussed China at length above, but it is worth noting that the strength or weakness of China’s economy will reverberate across the globe. China’s first quarter GDP growth came in at 7%, beating the 6.5% expectations. This growth rate may seem robust, particularly compared to US growth in the neighborhood of 2%, but for China, this is the lowest GDP growth since the first quarter of 2009. Slower growth in China directly affects its trading partners in Asia and also dampens worldwide energy and raw material demand, negatively affecting commodity-exporting countries.

Will China’s current challenge alter its long-term course? The second quarter saw a notable course change by Chinese policymakers who in recent years had been willing to take short-term pain to ensure long-term gain, including an expanding role on the global economy. Though the draconian trading restrictions described above raise questions about the commitment to free market forces, we believe such questions will be relatively short-lived. In the end, long-term thinking and China’s aspiration to be a dominant global economic force will win out. The road ahead may be rocky, but just as we discounted the overly optimistic outlook for China five years ago, we discount today’s stridently negative voices and look for longer-term economic growth trends to forge a stable future for China.

In Latin America, Brazil’s economy continues to deteriorate. Most recently, Standard & Poor’s indicated it was on the cusp of downgrading Brazil’s credit rating to junk status. The country has fallen into recession with unemployment rising and consumption languishing. Meanwhile, the government is raising interest rates to control runaway inflation. With government spending falling, a corruption investigation expanding and borrowing costs rising, the current economic outlook appears grim.

Brazil’s woes, combined with continued weak energy prices and a further strengthening US dollar, will likely deter near-term economic progress in Latin America. However, much like China, longer-term demographic and consumption trends are positive and still intact. It will just take some time for those positives to outweigh the region’s short-term negatives.

US Economy

The US economy is still sputtering along in a growth mode. First quarter US GDP growth was somewhat weaker than expected. Similar to the first quarter of last year, anomalies, mostly seasonal, curbed US economic activity. However, it seems likely that second quarter GDP growth will be more in line with the previous trend, somewhere in the 2%-2.5% range. I still think economic growth will end up somewhere around 1.5% for the first half of the year.

A stealth positive for the economy could be activity in the housing and mortgage markets, which may do well in anticipation of and after the Fed’s first interest rate increase. In the perpetual 0% interest rate environment we have been experiencing, there was no sense of urgency for mortgage holders to refinance or prospective homeowners to buy. If mortgage rates show signs of rising, we may see people suddenly motivated to take action, which would generally be good for the economy.

Household net worth numbers are improving due to rising home values, which is generally a catalyst for consumer spending. On the other hand, the latest consumer confidence reading was weak, with US consumers undoubtedly feeling the uncertainty that has gripped capital markets over the past weeks. Overall, the economic picture is mixed, with mild positives only slightly outweighing the negatives.

Of course, the Fed’s view of this data is the only thing that really matters at this point. With a 5.2% unemployment rate in the seventh year of economic expansion, can the Fed justify a 0% interest rate? We don’t think so, making it likely that the US will be the first, or most definitely among the first, major power to raise interest rates. There is a measure of risk that comes with any shift in Fed monetary policy. If economic data is sketchy and the Fed raises rates anyway for political or ideological reasons, we may see an unfavorable outcome. The bond market could reject the Fed’s actions and lower long-term interest rates, causing a flat or inverted yield curve.

On the other hand, if the Fed raises rates and the bond market is confident that the increase reflects forward economic momentum, rates at the long end of the yield curve will continue to rise, the yield curve will be steep, the chance of recession will be small, and investment markets should be just fine. That seems the more likely scenario given that the yield curve has already begun to steepen, suggesting bond market confidence in the recovery. (See Chart C.)
2Q-2015-Chart-C-425px
Labor market dynamics, including wages and employment numbers, provide some validation for those who believe the Fed is behind the curve in raising rates. If wages and employment rates continue in line with Fed forecasts, then the Fed’s inflation projection appears too low. Nonetheless, this is a picture we have seen for six or more quarters now, and we still don’t have much actual inflation.

Global Equities

Recent turmoil in the equity markets – Greece, China, etc. – generally surfaced at the very end of the second quarter or beginning of the third quarter, and was not a major factor in second quarter equity returns. Most global equity markets were flat or down for the quarter, with the exception of international small cap stocks, which were a notable highlight. Foreign stocks as a whole (excluding US) were up about 0.5%, based on the return of MSCI ACWI ex USA Index. We will probably see some continued pressure on European stocks because even though economic fundamentals in Europe are good, the shadow of Greece still hovers over results.

We view the emerging markets not as a cohesive asset class, but as a collection of national markets. Though many of these markets are driven by idiosyncratic factors, we are seeing China dominate discussions surrounding emerging market equity performance. On a year-to-date basis, Asian equity markets are still showing positive numbers, but these markets returned 3.4% for the second quarter, as measured by the MSCI AC Asia Pacific ex Japan Index, and generally declined in the first few weeks of the third quarter, moving in sympathy with Chinese equities. The early third quarter weakness may also reflect concerns about how a slowing China will affect regional economies.

US Equity

US equity results were similar to those of developed international equity markets, with a return of 0.3% for the S&P 500 Index compared to 0.6% for the MSCI EAFE Index. US equities had been up about 3%-4% in the second quarter before the Greek and Chinese issues surfaced, causing US markets to give back a meaningful amount at quarter end. I would not be surprised to see US equities bounce back quickly as geopolitical issues subside.

Growth outperformed value across all US market capitalizations during the quarter and we saw a snapback in small cap growth performance. Last quarter, we talked about the US dollar perhaps being stronger than it should be compared to other currencies. We also noted that oil might be priced lower than it should be. The effect of low oil prices has had a dramatic negative impact on S&P earnings. First quarter S&P 500 earnings were down 4%-5% compared to the first quarter of last year, but if energy companies are excluded, earnings were actually up 8.6%. (See Chart D.) The strong dollar also dampened S&P earnings. We think the majority of those moves are behind us and if that’s the case, earnings estimates seem to have gone too far down. Given already lowered expectations, there’s a good chance earnings results will be positive going into the second half of 2015. By and large, the earnings released early in the third quarter were pretty good.
2Q-2015-Chart-D-850px
With a 0.25% increase by the Federal Reserve looking ever more likely for the fall, many people are wondering what the impact will be. Well, I can promise you that the day after the increase, the sun will definitely rise in the east, people will go to work, and there will be traffic jams. Furthermore, there is a good chance that once fear is replaced by an actual rate increase – assuming the US economy is still delivering good numbers – we could see a fall US equity rally. In my view, it’s likely that US equities have already hit their low for the year.

At Pitcairn, we believe in the power of diverse portfolios. Over the past few years, that power hasn’t been as obvious as any allocation away from equities, and especially, US equities have not added to absolute return. Heavy hands of the Fed and other central banks have made US equities the number one game in town. We think healthy markets are marked by ups and downs across asset classes, with low correlation that provides opportunities for active managers. So, even though Pitcairn portfolios have benefited greatly from the historic US equity bull market, we actually hope that US equities don’t vastly outperform everything else going forward. We are finally beginning to see active investment strategies outperform passive strategies in the US. We are also beginning to see more diversity come into a global market that has been characterized by low volatility, high correlation, and US equity dominance. We think those conditions are ripe for change, but we never know, it could be another US year thanks to undercurrents around the world.

Fixed Income

The dynamics of the fixed income markets changed very little over the course of the second quarter. I still believe bond markets are at the inflection point we have been awaiting for so long. We do not see the bottom falling out of bond markets, but we do see interest rate-sensitive sectors beginning to weaken as the market prices in one or a series of 0.25% increases in the Fed funds rate.

In contrast to US equities where we are seeing more divergent performance across sectors and individual stocks, we are seeing a more homogenous fixed income market. A year ago, there were more performance differences between sectors. Now, interest rate fears are weighing on the whole market. During the second quarter, the long end of the yield curve was beaten up pretty badly, with the 10-year Treasury down 8%. The middle part of the Treasury yield curve, plus municipal bonds and mortgage-backed securities, were about flat or down just a little. This is further evidence that the inflection point is upon us.

Real Assets

The pall that interest rate expectations have cast over the fixed income markets extended into interest rate-sensitive equity sectors, including US REITs (and utilities as well). REITs performed extraordinarily well over the past few years and are seen as fixed income proxies based on their ability to deliver high income. Global REITs were down 6.9% and US REITs fell 10.3% in the second quarter. Those results speak much more to the interest rate environment than to any weakness in the real estate market or fundamentals of specific real estate companies.

Global infrastructure gave back a modest 1.8% in the second quarter. We continue to have confidence in this investment opportunity, sourced with our Wigmore friends and an exceptional performer over the past months. The excellent infrastructure managers at Lazard Global Infrastructure have taken advantage of available opportunities and we remain confident in their ability to deliver in this asset class. However, we think it’s important to note that our industry sources tell us the super normal returns of recent years probably won’t be duplicated going forward.

Commodities as a whole performed a bit better in the second quarter, buoyed by a comeback in oil prices. Agriculture performed pretty well as poor weather affected key US growing areas, reducing crop projections and causing prices to rise. Energy, however, was the real story, rising 10.9% and pulling the whole commodity index up with it. After advancing through most of the second quarter, oil prices are again being pressured by a proposed Iranian nuclear deal that will put Iranian oil on the marketplace, adding to supply. Any quick rebound in oil prices back to previous highs is probably not going to happen.

If you juxtapose today’s Greek situation against the Greek crisis in 2010-11, a key difference is the impact on gold prices. In 2010-11, gold was the fear trade and prices rose sharply on Greek instability. The large amounts of physical and notional gold currently being sold in the commodities markets show that the fear trade is non-existent, evidence of the market’s low level of contagion fears.

Alternatives

As we have said before, we think the advent of a rising interest rate environment will be a positive for hedge funds. Equity long/short funds returned approximately 3.5% through midyear, ahead of the S&P 500 Index, which is a positive. We have always thought that a portfolio of hedge funds would be a nice place to get a moderate 6%-8% return when fixed income was trounced by interest rates. With the 10-year Treasury down 8% in the second quarter and a basket of hedge funds delivering a positive return in the low single digits, we are seeing these funds begin to fulfill the role we assigned to them.

Conclusion

As we begin the third quarter, global issues remain at the forefront of investors’ minds, namely, the ongoing saga of Greece’s finances, China’s economic slowing, government policy actions, and finally the Federal Reserve’s apparently imminent (but certainly not set in stone) increase in short-term interest rates.

There is, of course, much speculation on how the Fed brings its policy boat around. When former Fed Chair Alan Greenspan wanted to move rates, he set out on the course and dribbled out a series of 0.25% increases over a long span of quarters. I don’t see that happening this time. I think Chairperson Yellen will implement a 0.25% increase and then wait to see what happens. And I think the markets will ultimately react favorably. With little inflationary pressure in the US, I don’t anticipate a series of rate raises, which supports my assertion that the interest rate environment will not be detrimental to financial markets.

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