Pitcairn Update, December 2016
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In the midst of what feels like monumental global change, Pitcairn hosted its annual Family Wealth & Investment Forum on November 13-14, 2016. Central to the Forum’s content was an investment roundtable led by Chief Investment Officer Rick Pitcairn, featuring Greg Valliere, Chief Political Strategist of Horizon Investments, Karen Harris, Managing Director of the Macro Trends Group at Bain & Company, and Bob Doll, Chief Equity Strategist at Nuveen Asset Management.
Mr. Pitcairn opened the roundtable by acknowledging the uncertainty pervading markets, politics, and the global economy. “In periods of significant change, it’s appropriate to think about what is happening in the world and to what degree that should affect our investment thinking.” However, as people contemplate opportunities and risks going forward, Mr. Pitcairn advocated for levelheadedness. “When we get wound up in a particular set of potential outcomes, it helps to take a step back.” Mr. Pitcairn shared a quote relevant to the current environment:
“Learn the art of patience. Apply discipline to your thoughts when they become anxious over the outcome of a goal. Impatience breeds anxiety, fear, discouragement, and failure. Patience creates confidence, decisiveness, and a rational outlook, which eventually leads to success.”
- ~ Brian Adams, How to Succeed
“We can all be wary of the unknown ramifications of events like Brexit or the incoming Trump administration, but in response to anxiety, investors can sometimes overreact.” Mr. Pitcairn pointed to patience as a source of confidence, a way to forge through situations by focusing on probable outcomes rather than emotional drivers. As Chart A shows, emotions that have driven the current bull market include optimism, euphoria, fear, and depression. “Our goal,” explained Mr. Pitcairn, “is to capitalize on these emotions rather than be held captive by them.”
For the last eight years, markets have pivoted between fear and hope. Fear is a natural emotion to protect us, but sometimes it outruns its purpose. “There is $12.7 trillion in cash on the sidelines of the bull market,” said Mr. Pitcairn, “and that means fear is keeping many retail investors from participating in a great opportunity.”
“Most people would describe me as calm and optimistic,” stated Mr. Pitcairn. “Still, I can’t ignore the things that keep people from feeling good about the capital markets. What I can do is remind our client families that all great bull markets climb a wall of worry and a long-term strategic investment portfolio can succeed even in the face of a mountain of short-term uncertainty.”
November’s US election results unexpectedly upended the political landscape. “We do not have a firm basis to frame expectations for the incoming administration,” said Mr. Pitcairn. “However, we are mindful of actions that could affect market and economic cycles. For example, if the administration puts economic growth policies ahead of trade and social policies, we believe the market would take that better.” Mr. Pitcairn contended that the fundamental economic backdrop in the US is reasonably strong with the incoming administration inheriting a much stronger economic backdrop than we faced in 2008. “Consumers are in good shape going into what could be an extraordinarily robust holiday sales season and corporate earnings 2017 over 2016 could be solid as well.”
Mr. Pitcairn reminded the audience that five years ago he encouraged clients to embrace a series of five investment themes that are still relevant to long-term investors:
- Be prepared for asset inflation. Whether central bankers maintain their accommodative policies or the world returns to a more normal inflation environment, holding risk assets will be important.
- Go global in all asset classes. We believe successful long-term investors will have a global view within their investment portfolios.
- Stay up-to-date in technology. Just as Pitcairn harnessed technology for its tax overlay strategies, today, new technologies in the ETF market are changing how we deliver risk and return exposures. Effective use of new technology continues to improve long-term investment outcomes.
- Be diverse. Strategically diverse long-term portfolios have a much higher probability of success than those that rely on concentrated positioning or short-term trading.
- Don’t let politics overly influence portfolio positioning. We wrote in 2008 that we thought the economy would be resilient and it was. We warned in 2012 against letting politics overshadow fundamental economic strength and that was the right call. With politics again taking center stage, we encourage long-term investors to keep their eyes on a set of factors that transcends short-term drivers of the day.
“Pitcairn portfolios have reflected these themes for several years,” said Mr. Pitcairn, “and our clients have achieved better results because of it.”
Mr. Pitcairn then invited the distinguished roundtable participants to share their perspectives. The presentations and interactive discussion touched on a number of Pitcairn themes as speakers addressed topics related to global affairs, domestic prospects, and the state of the bull market.
In his opening comments, Mr. Pitcairn noted that global concerns are one of the largest bricks in the current wall of worry. These concerns encompass politics, monetary, and fiscal policies. “One of the primary factors affecting the investment and economic outlook is that central bankers have achieved all they can by wielding monetary policy. Bankers now have to pass the baton of economic growth to world governments and fiscal policies. If that handoff can be done elegantly, global equity markets should continue to rise, but how world governments handle the responsibility for nurturing growth remains to be seen.”
Sharing his broad global view, Greg Valliere raised the possibility that geopolitical events could be a wild card for the coming year. “It’s likely some world leader will test the new US president to see whether he overreacts or is indecisive.” Mr. Pitcairn concurred, stating how hard it is to predict how President Elect Trump will react to global stressors. The three panelists highlighted several areas of concern globally, including Vladimir Putin’s actions, increased strain in US/China relations, Middle East conflict, movement toward a possible restructuring of the European Monetary Union, and perennial menace North Korea.
The roundtable discussion elicited several drivers that will help determine global growth and what countries are winners and losers in the future economy. Karen Harris noted that a shift from a supply-constrained environment to a demand-constrained environment and increased antipathy toward globalization were already affecting global trade. All three speakers concurred that a reshaping of the energy landscape is likely to influence the balance of economic and political power. The future of the European Union was another consideration.
Ms. Harris went into some detail about the change in the supply/demand balance. “World War II obliterated the world’s supply capabilities except in the US, so in the post-war decades, demand far outstripped supply.” She explained that after Europe rebuilt and China became a manufacturing powerhouse, the situation reversed. “In the 1980s, there was not enough supply and too much demand. Today, there are not enough consumers to buy everything being manufactured globally. That makes consumers the most important commodity,” said Ms. Harris. “From a structural perspective, having high domestic demand is beneficial in the world today and that is a positive for the US and for Europe.”
Ms. Harris pointed to China as a loser in this situation. Through much of the past decade, China was the main driver of global economic growth, but the shift in the supply/demand balance will temper China’s growth. China is working to create domestic demand, but a number of obstacles stand in the way: not manufacturing products its citizens want, no tradition of consumption, and concentration of wealth. Ms. Harris expressed doubt that if China succeeds in creating domestic demand it would welcome other countries to help satisfy that demand.
Though Europe’s economic activity has been slow, Ms. Harris noted that it is the world’s second wealthiest region and even with low or no growth, Europe is still an important consumer. However, Germany is at risk because it makes more than it can consume and 80% of its exports go to Europe, mainly the UK – which is leaving the European Union – and France.
Turning to the impact of energy, Bob Doll pointed to lower oil prices as a positive for the US. “In the US, we have far fewer producers than consumers, so falling prices should be a tailwind for economic growth, but because the oil fell too fast, the negative impact on producers overwhelmed the positive effect on consumers.” However, because Mr. Doll thinks oil could hover in the $30-60 dollars range for five years, the low price could still be a tailwind for the US.
Mr. Valliere pointed out that the new presidential administration is expected to strongly favor drilling for fossil fuels, which could further boost US production. According to Ms. Harris, decreasing dependence on oil and increased US production have a major impact on winners and losers in the global economy and power structure. She added, increased US production would be particularly bad for Saudi Arabia and could add to instability in the Middle East. “The possible upside is that the region will be less important [due to reduced global dependence on its energy resources].”
Reflecting on the future of the European Union, Mr. Doll noted that “the structural problems in Europe are real. When the euro was created, academics called it an accident waiting to happen due to the strain of having a region with one currency and monetary policy, but separate fiscal policies for individual countries. Ms. Harris believes this strain will lead to a breakup of the Eurozone and a reconfiguration in some different form within the next 10 years. “If you expect a major restructuring, there are two possibilities for the UK. The first is that the UK is in a good position because it will negotiate its own terms ahead of other members. The second outcome is that the EU has no incentive to negotiate a treaty with the UK and under the World Trade Organization, Europe can still export to the UK, but the UK’s export of its ‘services’ is prohibited.” Ms. Harris believes the reality will be somewhere in between. “The UK has a very unique trust architecture in financial services that is not portable and very hard to replicate. I see Brexit as a sideshow to a future dissolution and reconfiguration that should lead to a better outlook for all individual European countries except Germany.”
What will shifting global conditions mean for the world’s capital markets? Mr. Doll noted that US stock and bond markets have beaten the non-US markets by a wide margin – almost non-stop for seven years. “US economic and earnings growth have been mediocre, but it’s been even worse in the rest of the world,” said Mr. Doll. He cited commodities and US dollar strength as additional drivers of US outperformance. “For the US to pass the investment baton to the rest of the world, one of these factors must change” and though Mr. Doll believes the world is getting closer to that point, in his view, we’re not there yet.
Along with the wide ranging discussion of global issues, roundtable participants addressed a host of matters on the US home front. Mr. Valliere talked about likely developments as the new Republican White House and Congress take office. He believes much of the Trump agenda will be enacted through the combined efforts of Vice President Pence, Chief of Staff Preibus, and House Speaker Ryan. Among the policy matters most relevant to investors, speakers cited taxes, deficits, infrastructure spending, and immigration.
“Timing is everything,” Mr. Valliere noted, “and it remains to be seen how quickly action can be taken. Even with the Republicans controlling all the levers of power, things take time. It’s unlikely there will be an infrastructure bill before Memorial Day and any change to tax code might not be effective until the fourth quarter or even next year.”
“I do believe there will be generous, very pro-growth tax cuts, though I’m not sure they will reach the $4 trillion level Mr. Trump originally proposed,” said Mr. Valliere. Mr. Doll pointed to corporate tax reform as an important issue for the stock market. “The US has the highest marginal tax rate for corporations and is the only country that does not allow companies to bring cash back into the country without inordinate penalties.” Mr. Valliere believes an overhaul of taxation on overseas earnings is probably the easiest objective to achieve near term. US multi-nationals bringing back money stashed in foreign banks would provide tremendous capital for new plants and equipment, mergers and acquisitions, and dividend payments. He added that tax penalties on that money already have politicians salivating because much of it could be earmarked for infrastructure projects. However, Mr. Doll cautioned that political squabbling about the tax rate on repatriated assets is a potential obstacle.
While Mr. Valliere thinks Congress may also succeed in lowering the top business rate in the US, he added, “There’s little consensus on modifications to individual tax code and countless minute details could bog down legislators.”
Progress on immigration regulation is likely to be slow despite many diverse constituencies wanting reform. Mr. Valliere thinks there will likely be a stronger border presence and deportations, but that meaningful reform will be a challenge. All three speakers stressed the economic value of immigration. Ms. Harris pointed out that “the thriving countries over the last 100 years – the UK, US, and Australia – are those that embrace immigration.” Mr. Doll noted empirically-based studies showing that about half of the US economy’s growth over the last two decades has come from immigration and Mr. Valliere said that “deporting 11 million people or even two million would put contractionary pressure on the economy because we would see the unskilled labor market tighten.”
There seems to be no question that the Trump administration will raise spending in many areas, including infrastructure. Though the US deficit had come down dramatically over the past three or four years because of good receipts and restrained spending, Mr. Valliere explained that the trend had already begun to reverse in the last fiscal year. Though it doesn’t appear imminent, the deficit could make a sharp jump. “At some point,” said Mr. Valliere, “the bond market will get grouchy.” Mr. Doll thinks the deficit will remain on the back burner as long as the debt/GDP ratio is falling.
A key question, according to Mr. Pitcairn, is will the stimulative policies of the new administration boost US GDP growth? Mr. Doll is hopeful the US economy can grow more than 2%, largely due to reasonable probabilities for corporate tax and regulation reform. Ms. Harris expressed a positive outlook for the US economy longer term, suggesting that Mr. Trump might prolong the current period of overheating for a few years, followed by a mild recession. “A 2019 recession could precede a decade of strong US growth, with the US as anchor and the rest of the world weakening.” Ms. Harris pointed to several reasons the US economy could prosper in the coming decade. First, negative sentiment toward globalization puts the US in a privileged position. “We have consumers, fuel, food, innovation and productive capacity that is unparalleled. She also noted that demographics favor the US. “As the rest of the world ages, the US is an exception because our millennial generation is larger than our baby boomer generation.”
The State of the Bull
Mr. Doll, from his perspective as an equity strategist, offered an outlook for the current bull market, one of the strongest in recent history. He highlighted a number of positives that were in place before the presidential election and remained true afterward.
- The US earnings recession is over. Third quarter earnings were the first positive quarter in almost two years.
- Central banks continue to provide a strong tailwind for risk assets, particularly equities. Though the Fed may have to speed the pace of rate increases following the election, central banks elsewhere are tripping over each other to push rates even lower.
- US consumers are in good shape, which bodes well for increased spending, a key driver of GDP growth. Over the last five years, the US has added more new jobs than at any other time in our history. Average hourly earnings are up 2.8% over the last 12 months and with the debt paid down since 2008, consumer balance sheets are much improved.
- Possible fiscal stimulus is a developing positive. Every new president or congress wants to show action in the first 100 days, so there may be higher fiscal spending and perhaps, as discussed above, corporate tax relief.
- Absence of investor euphoria. “People still think it’s crazy to buy stocks,” says Mr. Doll. “Their reasons are varied: the economy stinks, the election, stocks are expensive. Yet, for eight consecutive years, the S&P 500 has killed cash.” We don’t know when or at what level the bull market will end, but Mr. Doll and Mr. Pitcairn believe it won’t happen when there’s so much cash on the sidelines (as shown in Figure B).
Mr. Doll cited some negatives as well.
- Growth has been the slowest in modern history, with GDP growth averaging just 2.1% since the end of the great recession.
- Deflationary forces are alive, particularly in a few areas like Japan and Europe.
- Implementation of the UK’s exit from the European Union has created uncertainty.
- Geopolitics remains a cloud over global capital markets, with an array of potential problems to nag at us.
Mr. Doll then turned to valuation. “People say they won’t buy stocks because they are expensive. In my mind, the only relevant valuation is comparing what you can buy today with something else you can buy today. And on that measure, I would argue that stocks are less expensive than bonds or cash.” Mr. Doll points out that more than half the stocks in the S&P 500 have a higher yield than the 10-Year Treasury. “Stocks would have to go down a lot to underperform the bond market. And if interest rates continue to rise, the bond market is going to feel it. I’m not saying to be zero in bonds, but there is reason for caution.”
From the perspective of a Washington insider, Mr. Valliere offered his take on how the bull market will respond to the new US administration. “There are definitely things on Mr. Trump’s agenda the market will like, such as significant increases in infrastructure and defense spending. Conversely, the market would be concerned about trade protectionism. On balance, though, I think the Trump story is a pro-growth story.”
In further support of the bull market continuing, Mr. Doll discussed a study by his firm. “We identified six conditions – the prospect of recession, accelerating inflation, high interest rates, a tight money supply, excessive wage inflation and investor euphoria – that accompany the end of a bull market. Usually three were present and sometimes four or five were.”
“Though we can never entirely discount recession, the risk appears low at the moment. Inflation is accelerating, but merely from very low to low levels. Interest rates can’t be labeled high and the money supply is far from tight. Wages are rising, but not excessively and we already talked about investors’ disdain for stocks. We can’t check the box on any of these six conditions, which is a good sign for the bull market.”
Courage Has Its Own Rewards
A fitting close to these roundtable highlights is a story Mr. Pitcairn told to support his case for capitalizing on market emotions, rather than being held captive by them. “Many of you know Pitcairn is a founding member of the Wigmore Association, eight multi-family offices from around the world who discuss business practices and positioning to ensure that we all deliver excellence to our clients. Last spring when I was in Mexico with the Wigmore Association, we heard from Fernando Chico Pardo, an early partner of telecomm billionaire Carlos Slim. Fernando told us the story of how he and Mr. Slim first built their fortune. They were floor brokers on the Mexican stock exchange and during a period of fear in Mexico, people and corporations would not invest. As a result, companies were hoarding cash. Ultimately, these companies traded at a deep discount to their cash. Mr. Pardo and Mr. Slim overcame the pervading fear and took a controlling position in Telefonica, a move that led to one of the world’s great fortunes. I could argue that the fears Mexico faced were far more dire than any we face today, but the point is not to debate degrees of fear, it is to remind ourselves how important it is to move past fear to benefit from rational long-term investment positioning.”