May 9, 2018 – Global investment markets encountered a number of formidable obstacles during the first quarter of 2018. And as is often the case, we saw both meaningful trends and distracting noise. To my mind, three key factors shaped the quarter’s results:
- A return to more normal equity volatility
- The Federal Reserve’s ongoing quest to normalize interest rates
- Delayed reaction to political uncertainty, triggered mainly by tariff rhetoric
Ideally, investors responding to a quarter like this would maintain a long-term perspective and an allegiance to process over emotion. However, that more accurately describes this quarter’s true champions, the Philadelphia Eagles and the challenges they overcame to finally win a Super Bowl for millions of loyal – and very patient – fans. After losing their starting quarterback to injury late in the season, the Eagles seemed poised for a downturn that would crush any hope of being Super Bowl Champions. But the players and coaches understood that success is almost never determined by one event – even one as seemingly consequential as losing your starting quarterback. Despite the adversity, they stayed the course. The Eagles’ success depended on strategies that are also essential to sound investing and very familiar to our Pitcairn clients.
For investors who fixated on the market’s daily tribulations, the first quarter felt much worse than the final score indicated. After falling as much as 10%, the S&P 500 Index ended the quarter down just 0.76%. Across US markets, growth stocks delivered positive results, while value stocks fell. Fixed income suffered small losses as rates rose and the yield curve flattened. Globally, developed markets were slightly lower, similar to the S&P, while emerging markets delivered a positive return.
Following a period as emotionally charged as this past quarter has been, it’s especially valuable to reflect on what actually happened and to carefully consider whether or not these developments might alter the course of the investment markets.
Three Key Themes
Normal Volatility Feels Bumpier in the Wake of a Calm of 2017
Before this quarter, volatility had been absent from the equity market for so long, many investors forgot what it feels like. US stock markets saw more 1% moves in February than in the whole prior two years. Volatility, as measured by the VIX (Volatility Index), averaged 17.3% in the first quarter, still below the long-term historical average, but above the range experienced throughout 2017. (See Chart A.) Not surprisingly, this shook market psychology.
We said in our January letter that volatility was likely to increase and that the market was primed for a short-term pullback. I believe that’s what we’re seeing. First quarter volatility moved the S&P 500 price-to-earnings multiple from 18.2 to 16.4, taking valuations back to levels last seen in the fall of 2015. Though valuations remain close to long-term averages on a forward basis, the sharp decrease in equity valuations alleviated concerns about excessive valuation that we saw in December 2017. In fact, when compared to bonds, equities remain quite cheap even given recent upticks in interest rates.
It may take markets a few months to find their footing, with ongoing volatility likely. However, most indicators suggest the synchronized global growth that has been with us since mid-2017 will continue. As far as corporate earnings go, the only criticism I have seen of the recent earnings season is that results are so excellent by historical standards, there is no way it can get better. That is hardly a clarion call for the bears. With robust growth and a healthy earnings outlook, it’s hard to see the recent pullback as the end of this bull cycle.
A Steady Hand on Interest Rates Is No Threat to Bull Market
During the first quarter, the Fed raised the federal funds rate by 0.25%. The action was expected as the Fed previously signaled its plan for three rate increases this year. The Fed has three primary objectives as it proceeds to normalize interest rates: prepare for the next recession, control inflation, and avoid severe disruption to the equity markets.
At the top of the Fed’s agenda is to be prepared whenever the next recession occurs; it doesn’t want to face an economic downturn with no room to cut rates. The Fed is comfortable raising rates because increased government spending provides fiscal support, the economy is sound, and inflationary spikes are absent. Clearly, the Fed doesn’t want a major market disruption, but is okay with markets slipping a bit if necessary.
There’s an adage that old age doesn’t kill bull markets, the Fed does. How the late stage bull market handles the rising rate environment is likely to be a key determinant of where markets will be a year from now. The bull market should tolerate higher rates as long as economic growth is solid and the Fed holds course with measured 0.25% increases, which I think it can do given the favorable backdrop. Possible threats to the scenario include a spike in inflation, poor GDP growth, or a Fed misstep. Right now, we don’t consider any of these likely.
Posturing vs. Policy: Markets Grapple with Chronic Uncertainty
President Trump’s communication style is an ongoing challenge for investment markets, which categorically despise uncertainty. What’s surprising to me is not that markets became a bit more volatile this quarter, but that volatility did not resurface sooner. Investors suppressed their response to significant uncertainty in 2017 as good economic and earnings news boosted sentiment. That pent-up emotion was a catalyst for first quarter volatility.
Much of this quarter’s political uncertainty centered on trade. Tariff rhetoric and fear of a global trade war caused most of the equity market’s down days. Yet two important points were disregarded. First, as we have seen in many cases under the Trump administration, the tariff bite is likely to be far milder than the bark of the rhetoric. Second, the threat to the economy may be far less than is widely believed. Our friends at Strategas measured the negative effects of proposed tariffs against the expected economic boost from last December’s tax reform and found that the tax cuts are far more positive than the tariffs are negative. (See Chart B.) Unfortunately, the market doesn’t always see beyond the sometimes-impulsive posturing of world leaders. In reality, there are just too many countries for whom a trade war is a bad thing.
As long as markets find it hard to distinguish between the President’s words and actual policy, volatility is likely to continue. Ultimately, markets like policies that promote GDP growth and that will drive results.
Will Robust Earnings Fire Up the Bull Market?
Following the first quarter market moves, we are left with the age-old question – How long is the bull market going to last? We have acknowledged for some time that this current equity cycle is in its later stages. To the general public, that may sound like the end is days, weeks, or months away. But even at this late stage, the end could still be years away.
One of these pullbacks will be the last pullback, but that’s not where we are now. At every turn, this slow developing bull market has punished short-term reaction and rewarded patience. The best thing for investors in a market like this is to turn off the TV and put down The Wall Street Journal. There could still be significant upward potential ahead.
Consider the current backdrop. We have a normal shaped yield curve and robust, synchronized global economic growth. The inkling of investor euphoria we saw in the latter part of 2017 was quashed in the first quarter. Equity multiples are at 16.2x earnings and the outlook for earnings is extremely positive. Analysts we trust are forecasting 20% year-over-year S&P earnings growth. Yet forecasters have S&P price targets just 4%-6% above where it is now. The combination of reasonable valuations and super robust earnings could reignite the bull market.
Though our next strategic repositioning will likely be a risk reduction move, it may not be for some time. We do see US economic growth as a key forward-looking data point. In our view, the long-awaited increase in government spending must boost economic output. If the economy remains stuck at 1.9% growth after the fiscal stimulus provided by tax cuts and increased government spending, that would have negative implications for equities.
Non-US Stocks Poised to Benefit from Valuations, Strong Global Growth and Dollar Weakness
For US investors, international stock returns depend on both performance of local equity markets and the impact of currency exchange rates on their dollar-based returns. Local market returns appear promising, supported by attractive valuations and economic growth. At a price-to-earnings multiple of 13x, valuations on foreign stocks remain cheaper than US stocks. Meanwhile, global growth is strong and synchronized. Economic activity in core Europe remains healthy, though slowing slightly. China’s economy continues to expand and South American countries, which had been under pressure, are now performing well. In these emerging markets, demographics remain a key growth driver as emerging consumers gain purchasing power.
The current Goldilocks environment for non-US stocks is likely to continue as long as the US dollar stays flat or depreciates relative to other global currencies. We think the longer-term dollar trend is slightly, but not markedly, down as federal budget deficits supply downward pressure, offsetting the upward push of Fed rate increases.
Sector Trends: Regulatory Pressure Shifts to Tech and Away from Financials and Energy
During the Obama administration, financial and energy companies found themselves in the crosshairs of Federal regulators, while technology companies largely enjoyed a free pass. In our January letter, we noted that these positions appeared to be reversing. Since then, financials have benefited from the tailwind of relaxed regulation, while large and new tech companies have found few friends in the Trump administration. Additionally, growing concerns about data misuse may make legislators and regulators on both the right and the left more amenable to tighter regulation of tech giants.
Beyond any short-term stock price impact, the key issue for tech companies is how regulation will affect business models and long-term growth. On my recent trip to Shanghai for the Wigmore Association CIO meeting, it was clear that we in the west have a concept of privacy not shared in China. Population size and freedom from privacy concerns give China a leg up in the development of artificial intelligence (AI) tools that depend on massive data.
The promise of data monetization is already embedded in the valuations of US tech leaders like Facebook, Google, Amazon, and Apple, as well as Tencent in China. Whether the US regulates data in a smart way, which is not easy, will affect these valuations, but also potential US leadership of future AI innovation. We are keeping a close eye on regulatory developments and their potential impact on the technology sector.
Fixed Income Markets Follow Expected Path as Rates Rise
With Fed interest rate increases moving along at the expected pace, the fixed income market has begun to show signs of pressure. The broad US bond market had a negative return for the quarter, the first since the fourth quarter 2016. Yields are still historically low, hanging around 3%, but rising rates will continue to pressure bonds. The impact should be in line with expectations unless a sudden inflation spike forces the Fed to accelerate its rate hikes. As I indicated above, we don’t see that happening. The Fed’s three planned rate hikes are on course with the rest of the world as other central banks also tighten monetary policies. The US economy, is healthy, but not overheating, which should keep inflation in check.
We still prefer equities over fixed income because core US fixed income is more overvalued than both US and non-US equities. Fixed income always has a place in long-term portfolios, but right now, attention to risk is vital. As interest rates have risen, bond durations have lengthened, exposing investors to more risk than they may be aware of. We have already positioned Pitcairn portfolios against the risk of lengthening durations and more aggressive Fed action.
Active Management Extends Leadership
Another notable development of the first quarter is the continuing reassertion of active management. After underperforming passive index strategies for multiple years, active managers began to outperform in 2017 and delivered even more bang for the buck in the first quarter. As we anticipated, rising interest rates and the return of volatility created opportunities for active managers. Hedge fund managers, the most active of all managers, finally had access to the full set of tools for generating return and the results were evident. Among Pitcairn’s hedge fund managers, a number significantly outperformed their relevant index in the first quarter. The leadership of active and passive managers seems to move in five-year cycles, which suggests we are near the beginning of active leadership.
Patience and Process Deliver Long-term Results
During the past quarter, capital markets coped with some fundamental changes in the investment landscape, particularly the ongoing global move toward higher interest rates. There was also considerable fodder for the 24-hour cable news. The fodder won’t help us answer the important questions of where we are in the economic and market cycles or how we should position our investments for the intermediate term, but it can pull us off course. If the Eagles taught us anything through their unlikely Super Bowl victory, it’s to focus on what we can control, trust the process, and be patient.
This quarter, Pitcairn marked the 10-year anniversary of offering our clients an open architecture investment platform. Back then, we made an unequivocal commitment to align ourselves in all ways with our clients. Pitcairn’s results over the past decade have been highly favorable for our clients. We did not achieve these results by overreacting to short-term noise. Instead we focused on things I have preached for a long time: Keep a long-term perspective, diversify, focus on your goals, and follow your plan. That’s how you win in the Super Bowl and in the investment markets.