Predicting short-term market moves is never easy and has become even more difficult as the long running bull market cycle ages. Pitcairn’s emphasis is always on the long term and we see little benefit in reacting to short-term market events. Nonetheless, we think our clients benefit from our forthright assessments of current circumstances, as well as our view on future market trends. We strive to make the best possible forecasts and there’s no question it feels good when we are right. It’s even truer that being right about good news feels better than being right about bad news. We’ve had both experiences since our last quarterly letter.
In July, we shared our view that Federal Reserve actions and the market’s acceptance of those actions were likely to influence global markets more than Greece’s debt problems or China’s economic slowing, which were hot button issues at the time. In mid-August, following the release of minutes from the Fed’s July Federal Open Market Committee meeting, markets took a serious tumble. While China’s economic weakness and our Fed’s position on employment and interest rates are related, we still believe Fed action (or non-action) will be the primary return driver for the near future.
In August, we wrote that we believed the market’s turmoil would be either a dramatic short-term sell-off or possibly the start of a two to three-month correction. We did not think it was an inflection point marking the end of the bull market. So far, it seems we were right about that as well. By mid-October, the S&P 500 stood at 2023.
The main takeaway from the third quarter is that the US stock market experienced its first real correction since 2011. Notably, the sharp sell-off and slow recovery scenario we have seen so far is remarkably reminiscent of that 2011 correction, which was followed by four additional years of market gains. We still fully believe equities — whether US or non-US, public or private – are the foundational component of investment portfolios. It doesn’t feel good when they go down, but it’s something we live with in order to enjoy the upswings.
Looking more closely at equity moves during the quarter, it appears that panicked selling by hedge funds and other short-term investors sparked the correction, while the strong hand of institutional investors steadily and quietly provided counter support, just as it has since 2009. What that means is that equities did not have the sharp and quick bounce-back they sometimes do, but that large investors, unfailingly looking to equities as a source of higher return, have slowly driven stock prices higher.
For three years now, we have been saying that one of three potential drivers will bring down the bull market – broad-based and speculative participation by retail investors, excessive equity valuations, or the onset of a recession. We see none of those catalysts at this time.
There has been no broad-based participation from retail investors, let alone speculation, and there is actually more fear than there was six months ago. Equity valuations remain reasonable and, on the heels of the August correction, are even cheaper than they had been. (We discuss valuations in more detail in the US Equities section.) As to global economics, a recession could happen in China, Europe, or the US, but we don’t think one is probable in any of these areas, based on current data.
The economic and market cycles are aging, but our view is that the cycles are in their mid to late stages. Others might say it’s later than that; I am more optimistic based on the presence of ample liquidity and the absence of speculation, overvaluation, and recessionary pressures. There are certainly risks on both “tails” of the market bell curve. On the left tail, there’s risk that slowing growth, a Fed policy misstep, or a geopolitical shock could push stocks lower. On the right tail, there are many reasons for stocks to move higher and not having appropriate equity exposure could definitely mean missing further upside. You certainly won’t be surprised to hear that we think a diversified portfolio is the best way to manage risks in both tails, exactly the strategy that has worked very well for us and for you over the last eight years.
The global economy is undoubtedly slowing, with most of the weakness concentrated in China. I recently returned from a great session with the Wigmore Association in London, where we focused on international economics. As you would expect, China factored prominently in our discussions. One presenter told us thousands of government officials in China have been taken away by secret police on corruption charges. Imagine the fear that breeds in other bureaucrats and corporate executives. The presenter’s point was to show why no deals – good or bad – are being made in China.
Some economists believe China could devalue its currency again, a move that contributed to the August market volatility and, if repeated, would make it even more difficult for the Fed to raise interest rates. However, we don’t expect another devaluation because China wants its currency added to the International Monetary Fund’s (IMF) Special Drawing Rights (SDRs) basket that currently includes the US dollar, euro, British pound, and Japanese yen. China has to meet complex criteria (which include stability) before the IMF’s executive board is scheduled to decide in November. Devaluing would likely be a mark against them.
While the rest of the world focuses on the near term, Chinese officials have a strategic long-term view of their country’s position in the global economy and are not afraid to take short-term hits to achieve it. Key to China’s long-term plan is a transition from being an export/manufacturing-driven economy to being consumption-driven. This transition is going through a dip just now, but China’s government has a myriad of tools and trillions of dollars in reserve to steer its economy and the markets through this rough patch. Officials have already cut interest rates and relaxed reserve requirements for banks. They may now turn to fiscal stimulus, which could certainly improve the trajectory of expectations for China. Our good friend Jason Trennert at Strategas has a number of economic regression models that suggest China’s economic growth won’t fall below 4% and will probably be closer to 6%. (See Chart A.)
If there’s no recession in China, that’s one macroeconomic risk taken off the table, but that doesn’t mean we’re out of the woods. Among the major global powers, Europe actually appears closest to a recession, based on GDP numbers. The region has experienced a measure of calm since the acceptance of Greece’s bailout package, but we all know that was a punt, not a resolution. Greece will likely raise its head again; the situation has just taken a back seat to growth concerns.
The potential impact of the European Central Bank’s (ECB) stimulus program is a positive force that many are underestimating. We think the ECB’s actions could have more impact than the Federal Reserve’s had in the US, where much of the liquidity was bottlenecked in banks that just weren’t lending. In Europe, the mechanism to get money into the economy is more effective. Yes, bigger European banks were restricted from lending and told to shed bad assets, but the region has an array of smaller banks that are required to lend out more of the money they get from the ECB. Furthermore, even big banks may be more willing to lend now that they have survived government stress tests. As a result, the ECB’s capacity to spur the economy is better. Coming off low expectations, Europe could surprise everyone with expanding economic activity. There has already been some improvement in consumer confidence (see Chart B), but even more noteworthy is an increase in actual consumer spending.
The main concern about Europe is that politics appear to be trumping economics in many market discussions. The region is facing discord on immigration issues and seeing greater extremism on both the right and left sides of the political spectrum. On top of that, Europeans are naturally more troubled by Putin’s aggressiveness in Europe than we are in the US. All in all, politics is flashing yellow rather than green on European investor sentiment and putting the brakes on markets.
Turning to Japan, we are modest fans of Prime Minister Abe’s economic program, “Abenomics.” We have witnessed the central bank’s successful efforts to stimulate Japan’s economy, but the administration’s broader desire is to make more lasting social changes that would support Japan’s long-term economic success in concrete ways. Skeptics say Japan can’t change, but the country is already seeing a spike in the number of women in the workforce, which will help alleviate an impending worker shortage. On the whole, we see more positive than negative in Japan’s economy.
With commodity prices still in a downslide, the commodity-driven emerging markets, including Latin America and particularly Brazil, will probably remain weak for at least two to three more quarters. Australia, in addition to commodity price pressures, is also struggling with currency weakness and political issues. Asian economies, other than China, are showing signs of economic strength, but commodity prices and China’s weakness are still a headwind for the region.
The US remains the strongest of the major global economies. In the second quarter, the US economy (GDP) grew 3.9% (annualized rate quarter over quarter). That is the highest growth rate in the last three quarters. However, our economy still faces obstacles.
We had expected the dollar to weaken a bit through summer and fall and for oil prices to rise. That would have been good for US corporations, making it more likely they would surpass previously lowered earnings forecasts. However, in the wake of China’s currency devaluation and slowing growth, the reverse happened, the dollar moved higher and oil prices fell further. (See Chart C.) As a result, US production slowed more than we would have thought in June. That doesn’t mean corporate earnings will fall short, but does mean we may see fewer positive earnings surprises this fall.
Our opinion is that Fed monetary policy has done just about all it can do to move the US economy and ignite inflation. Unfortunately, as the Fed waits and waits to raise interest rates, the chances of a policy error rise. Delaying also increases the chances that investment markets will react poorly to any Fed action. Typically, the Fed raises rates when S&P earnings are rising. With the Fed now contemplating a rate increase in the face of modestly decreasing S&P earnings, risk of recession increases. We still don’t think a recession is probable, but we believe the possibility has gone up slightly.
Though it is still possible the Fed will raise rates in December, the consensus seems to be for early 2016. We have said in the past that the Fed delaying the rate raise into 2016 is a negative because it means the US doesn’t have the economic growth to support a shift in monetary policy. On the plus side, overall US economic conditions are relatively strong. Employment is improving and consumers are still in a reasonably good position, with cheap oil serving as a tailwind for spending. This could help the Fed rationalize a decision to normalize interest rate policy.
Non-US equities returned to the back seat in the third quarter as US equities were once again in the driver’s seat. This marked a significant reversal for global equity markets. Going into the third quarter, non-US stocks led by 2%, but trailed US markets by 1.3% as the fourth quarter began. Volatility in the international equity markets has provided opportunities for active managers to add value so far this year.
China’s equity market was by far the most volatile, not surprising given the currency devaluation and weakening growth expectations we discussed extensively in the Global Economy section above. By mid-July, China’s stock market declines had erased its year-to-date gains and stocks moved still lower, with the MSCI China Index returning -11.4% for 2015 through quarter end. Though we don’t anticipate Chinese equities roaring back, we think they are close to a bottom and could see some firming through the fall.
Though we often talk about the Chinese equity market as a whole, it’s important to differentiate between two distinct segments – the local Chinese (A-Share) market, which is highly influenced by retail investors, and the H-Share market, which is traded in Hong Kong and dominated by institutions. Pitcairn clients would mainly have exposure to the H-Share market, which was not immune to recent activity and, as a result, is now trading at attractive levels.
Core European equity markets were relatively strong in the third quarter. We think European markets should rebound sooner and more sharply than China due to better dynamics. European companies appear attractive based on their lower valuations, the lower euro, which boosts the region’s exports, and the tailwind of the ECB’s liquidity program. We see no evidence the ECB will waiver in support of capital markets. Furthermore, European companies benefit from lower oil prices as the region is a net importer of oil.
It will be interesting to see the impact of Germany’s recent auto scandal. Autos sales account for a large portion of German exports, which are a key contributor to Germany’s economy. Our sense is that this will blow over, so we are not expecting the scandal to change the economic dynamics in Germany or the broader eurozone.
Japan’s stock market had a pretty healthy quarter and could be a bright spot in Asia this fall. Unlike other Asian economies, Japan is not as hampered by the commodity cycle and is well past the “growing up” issues that China faces. Japan’s fiscal policies and central bank actions are also potential positive forces behind its equity market. The Bank of Japan is likely to announce additional monetary stimulus at its late October meeting, which would extend its support of Japan’s equities.
Rising global risk aversion hampered results in the emerging markets, which plummeted in the third quarter. Many emerging markets, like Brazil and particularly other Asian markets, are still commodity-dominated, so it will take some time for that cycle to play itself out.
US equities ended the third quarter down more than 7%, their worst quarter since 2011. Within the US market, large stocks outperformed small stocks as risk appetite deteriorated. Among large cap stocks, growth stocks led value stocks, but in the small cap universe the reverse was true with value stocks outperforming their growth peers.
US equities have been the place to be for some time and we don’t think third-quarter results represent an inflection point or an end to the seven-year bull market in US stocks. Based on multiple valuation measures (forward price-to-earnings, dividend yield, price-to-book, and price-to-cash flow), stocks are cheaper than their 25-year averages. (See Chart D.) That’s not the sign of market peak. Of course, stocks are one of the few assets that people don’t seem to want more of when they get cheaper. It’s a paradox that precludes many people from successful equity investing.
Nevertheless, there are just not many other options right now to achieve growth in a portfolio. Positives for US stocks include healthy corporate balance sheets and consumers who are not highly leveraged and may benefit from increased purchasing power due to lower energy prices. We believe the dollar’s strength and oil’s weakness will continue. Any macro event that causes those to revert – the dollar to weaken and oil prices to rise – would be positive for US stocks and for earnings. Conversely, if the dollar and oil continue to diverge, that would put pressure on US stocks.
An interesting aspect of the current market is the continual low drumbeat from activist investors – professional investors who take a position in a company and then seek to influence company decision-making, often through seats on the board of directors. In the past, corporations tried to fend off such efforts. What we’re now hearing from activist investors is that companies are more receptive to their suggestions. We take this as an indication that in this age of low returns, US corporations are getting into exceptionally good financial shape and management teams are actually using activists as pretext to take actions they wanted to take anyway.
As much as we have been a fan of the US equity market and remain a proponent of this market, we don’t see any notable catalysts that are likely to push it upward in double-digit fashion. Along with most of my Wigmore colleagues, I still believe that of the major asset classes, equities, and particularly US equities, are the best ones to hold. However, it’s pretty clear that absolute return numbers won’t be as robust as the last five years until some global and domestic issues resolve.
All eyes remained on the Federal Reserve at the end of the third quarter. After the Fed declined to raise interest rates, citing weak growth and minimal inflation pressures, the 10-year Treasury yield dropped back near 2%. This suggests that the market does not anticipate a steep increase even if a change in the Fed funds rate were to occur.
Fixed income markets generally benefited from a flight-to-safety trade as investors sought to escape volatility in riskier asset classes. This aided our clients given that we maintain fixed income exposure as an important component of diversified portfolios.
The same quest for safety that boosted US Treasuries had the opposite effect on investment-grade and below investment-grade corporate bonds. High-yield bonds issued by US energy companies came under particular stress amid worry that low oil prices would lead to more defaults in the sector.
We still believe core fixed income is the asset class with the most current risk. We are waiting for US interest rates to move higher and we believe they will. Though we don’t see significant economic cycle risk for fixed income markets right now, we are concerned about liquidity, particularly within high-yield. On August 18th, when we saw wild swings in US equities, exchange-traded funds (ETFs) diverged from their underlying securities. There are substantial high-yield bond assets in the hands of retail investors via ETFs, which could negatively affect liquidity in that segment. We are now focused on making sure fixed income investments held by Pitcairn clients are not overly exposed to that liquidity risk.
Commodities were clearly a victim of the global sell-off. Managers chosen by Pitcairn outperformed their indexes, but there was no escaping the poor performance. Commodities right now embody the adage that “your portfolio isn’t truly diversified unless there’s something in there you really don’t like.”
Pitcairn’s global infrastructure exposure remains positive on a year-to-date basis and held up very well during the summer dip. Meanwhile, master limited partnerships (MLPs) were negatively affected by weakness in the energy segment and declined for the quarter. Like Pitcairn’s commodity holdings, our MLPs performed well relative to their index. With pocketed pressure on the absolute returns from a number of real assets, we reiterate the importance of having managers who outperform their indexes, adding alpha that will enhance results when these markets return to positive territory.
As another quarter passed without an interest rate increase, many hedge fund strategies remained under pressure. The global macro style was a bright spot, benefiting from the ability to capitalize on geopolitical events. Equity long/short, on the other hand, is a little more tied to global equity markets; as we would expect, that segment was hampered by the equity market sell-off.
Despite widespread dissatisfaction with hedge fund returns, we believe that like fixed income, hedge funds have a role to play in diversified portfolios. In the current difficult environment, hedge funds have all been painted with the same brush, but the dispersion of returns among hedge fund managers is striking. Individual results have been very dependent on the investment style deployed. Managers who are able to pick out and profit from positive or negative trends have performed well, while other managers floundered. Such disparity of results calls out for investors to evaluate both their hedge fund diversification and their risk in vehicles with high fee structures. We have long believed that Pitcairn is well positioned to guide investors in areas such as this where there are measurable diversification benefits and significant return potential, but also substantial risk.
For the remainder of this year, and perhaps into 2016, global economic growth, geopolitics, and the Fed’s actions will be the issues topmost on investors’ minds. We think the Fed’s moves will have the most significant influence over market returns, but we are well aware that China’s situation will be a factor in the Fed’s decision-making process. In Europe, politics will overshadow economic data and in emerging markets, commodity weakness and global risk sentiment will likely drive results. We remain convinced that global equities will be the highest performing asset class even as we acknowledge that absolute returns may be lower than what we have enjoyed these past few years.
The third quarter provided a very powerful validation for our commitment to diversification across all asset classes, regardless of short-term market conditions. As we have said time and time again, we firmly believe that equities, whether US or global, public or private, are a foundational component for every portfolio. We also believe that regardless of recent performance, current risk or economic conditions, a diverse mix of assets including equities, fixed income, hedge funds, and real assets, is instrumental in achieving long-term investment success.