Resilience was the watchword for the third quarter as capital markets overcame multiple fear episodes to deliver modest returns. Similarly, resilience has defined capital markets for the past 10 years. We began 2010 still bruised by the 2008 financial crisis. Economic recovery was tenuous, debt crises abounded, US unemployment was above 9%, and most analysts were forecasting low equity returns.
While preparing this letter, the last of the decade, I reviewed our letters of the past 10 years and I am pleased to say that our approach to the markets and our advice to you has been remarkably consistent. We favored equities for their growth prospects, we decried market timing, and we touted the value of disciplined, diversified portfolios. In 2010, we wrote:
“We believe the combination of negativity and fear has kept many investors in cash or moving towards bonds. Sadly, these investors missed a sizable recovery. If these investors remain on the sidelines, they may continue to miss out on the recovery in the equity markets.”
As fearful as investors were in 2010, even the most pessimistic probably didn’t anticipate the full magnitude of the hurdles capital markets would overcome this decade – from the European debt crisis and BP oil spill at the start of the decade; through Japan’s earthquake and nuclear disaster, Brexit, Ebola, and an unprecedented US presidential election; all the way through to current trade wars, Middle East upheaval, and an impeachment inquiry. Yet, US equities surmounted that cascade of bad news. The S&P 500 has returned over 12% annually, far exceeding the meager 4-6% forecasts – just as we thought it could.
Come January, we will welcome a new decade. I venture to say that the themes and principles that permeated our letters for the last 10 years will still be relevant and beneficial in the decade to come.
US Equities Maintain Leadership, Bonds Rise on Falling Rates
Despite multiple fear factors arising in the third quarter – mainly revolving around politics, global trade, and the US yield curve – global markets generally held their own. US equities delivered a small gain. International markets, with the exception of Japan, were flat or down, as were emerging markets, primarily due to the difficult trade environment.
Global bonds rose in the quarter and outperformed global equities as global central banks solidified their shift to easier monetary policy. As a consequence of the briefly inverted US yield curve and foreign investors’ appetite for yield, global bonds have had a substantial rally this year. These results validate our conviction that there is always a place for fixed income in diversified portfolios. Three years ago, bonds seemed like dead weight in a portfolio. Now the US fixed income complex is having an 8% year. Bond markets could give back some gains over the next few months, but our premise is that the delivery of risk control through a diversified portfolio is much superior to market timing. Bond performance over the last 18 months has borne that out.
Politics Rule the Day
This has certainly not been the best environment for macro forecasting of market outcomes. Macro forecasters like to look at hard data and the risk and return potential embedded in that data, and then make forecasts based on those findings. Though economic and market-related risks can be measured, uncertainty cannot and the factors now driving investment results are rooted much more in political uncertainty than in macroeconomics and corporate fundamentals. Markets have been less focused on S&P earnings than on drama between the Trump administration and the Federal Reserve, negotiations between US and China trade delegations, and the newest concern – impeachment.
And these are just a few bricks in the current wall of worry. The list goes on: softening investor confidence, declines in global manufacturing, spreading Middle East conflict, $16 trillion in negative yielding global debt, and so on. The good news is that bull markets scale walls of worry; they don’t end until people believe stocks can’t go anywhere but up.
At our recent Wigmore meeting in Canada, we talked much more about global politics and the unpredictability of current situations than about investment fundamentals or individual companies. I value these interactions with the CEOs and CIOs of the Wigmore Association because they help sharpen Pitcairn’s view of global conditions and opportunities. During our discussions, we generally agreed that the reign of global populism from both the right and the left is creating a high degree of uncertainty in global capital markets. Whether you live in the UK, Brazil, Mexico, or the US, politics is causing much angst.
US politics will certainly be foremost in investors’ minds as we wade through impeachment proceedings and the selection of a Democratic presidential candidate. The market has not yet priced in the possibility of Elizabeth Warren winning the presidency, which might trigger some weakness on fear of higher taxes and spending. The combination of a potential impeachment and a possible Warren presidency may alarm some investors, but I say, check yourselves on that. When both President Obama and President Trump took office, I preached the same message: don’t let your politics dictate your portfolio. For families who are working to build a 100-year wealth structure, equities are not going to zero, no matter who is president. It is good to remember that presidential politics are only rarely relevant to long-run market returns.
Looking beyond the US, our Wigmore colleagues in Europe shared their belief that there is significant value in the region due to downward pressure from trade issues. They acknowledged that policies of the last several years have begun to benefit American workers over Europe and other regions yet expressed optimism for a European recovery. That view is controversial, but supporting their optimism is the European Central Bank, which like most other global central banks, is expected to maintain its accommodative policies.
Wigmore is traveling to Brazil in February to get a closer look at the political and economic dynamics in South America. The third quarter was tough on Brazil’s capital markets, but year-to-date performance is solid. Meanwhile, a significant relocation for Argentina’s stock, bond, and currency markets played a role in poor results from the emerging markets. Argentina faltered on changing expectations for its presidential election and the outlook for the country’s inflation rate. Our visit should provide greater insight into opportunities and risks in the region.
Positives Ahead for US Equities
It’s always important to consider what is likely to go right, not just what could go wrong. For US equities, there is cause for optimism. The US economy may be frayed around the edges but is still by far the best global bet. A key positive for US stocks is that America is working. Unemployment has fallen to 3.5%, which translates into healthy consumers and continued consumer spending. US consumer data cannot be interpreted as anything but strong, despite some softness in September and October.
Trade has been a major pain point for manufacturing, but some pundits say global manufacturing is in the process of bottoming. Any improvement in the trade situation could quickly spark a manufacturing reversal. A US/China trade deal would likely have a halo effect on other thorny trade issues and once trade is normalized, economic numbers should pick up, reducing the risk of US recession.
Hope for a US-China deal remains high as the Trump administration is certainly aware that presidents do not get re-elected in bad economies. This is a substantial incentive for both a trade deal and other policy actions that favor growth. That said, we may not get the full ripple effects of a US-China trade deal if businesses worry the Trump administration will use tariffs against other countries. And a recovery in business confidence and corporate capital spending is critical to global growth.
Less dependence on exports has kept the US economy somewhat sheltered from recent trade disruptions, but many individual US companies garner a large portion of their earnings overseas and are not immune to trade issues. If trade improves and multi-national US companies gain the confidence to begin spending, it could drive the US economy back to a high 2% GDP from its current 1.8%.
Turning from the potential positives to current equity trends, we see that US equities are in a period of pretty extreme outperformance of growth stocks over value stocks, which is consistent with the mid to late cycle indicators we are seeing. For a brief period in September, value stocks outperformed growth, but the reversal was dramatic, and we are monitoring the trend to see if it extends into next year. (See Chart A: Growth Maintains Lead Over Value.) At Pitcairn, we have been including more late cycle, defensive investment managers in portfolios. Our strategy is to change the tenor of the actual managers to prepare for a narrowing in this huge gap between growth and value.
Inversion, Valuation, Exuberance: What Our Markers Say Today
If you have read Pitcairn letters over the years, you know we have repeatedly pointed to three markers that would signal the bull market’s end: an inverted US yield curve, excessive valuations, and excessive investor exuberance. Today, these markers call for vigilance but no swift end to GDP growth or equity gains.
An inversion of the 2- to 10-year segment of the US Treasury yield curve occurred in July, but it may be less predictive than in past cycles for three reasons: the quick reversion to normal, a less US-centric global market, and downward pressure on US yields from foreign demand (Given $16 trillion in negative-yielding foreign debt, the US looks pretty attractive!). We don’t deny that an inverted yield curve is a bad sign. But even if it is prophetic, equity declines typically occur 12-18 months and recessions 18-24 months following an inversion. This timeline could be extended even further given the slow-evolving nature of the post-2008 market.
US equity valuations ended the quarter at about 16.8x earnings. I don’t see how that can be deemed excessive; the 25-year average is 16.2x. With interest rates so low, price-to-earnings multiples should be in the low 20s, but trade and political concerns have held them down. I would call US equities fairly valued.
Investors can barely muster any appetite for stocks, let alone exuberance. Two unsuccessful public offerings this past quarter – Peloton and WeWork – showed just how far from euphoria we are. In other cycles, public markets would have run those stocks even higher than private markets. Instead, we saw rationality in the public market. That’s a good thing because bull markets don’t end with lack of euphoria. (See Chart B: WeWork Valuation Faces Investor Skepticism.)
Even as the bull market plods on, equity growth appears somewhat limited until equity markets get a boost from changes in the political environment (i.e. a trade deal or fiscal policy support). However, as most other major asset classes are rather fully valued, it still seems that equities offer the best reward potential. Central banks are likely to maintain their easy money stances despite a diminishing ability to spur growth, because abandoning those policies might put the brakes on global growth. As a result, there really is no alternative to equities. Pitcairn portfolios are positioned for this scenario, with the majority of growth coming from the equity side.
In this last letter of the decade, my message is nearly identical to our letters in 2010.
- Markets rarely do what everyone expects them to do.
- It’s better to focus more on what will probably go right than what could possibly go wrong and construct diversified portfolios to succeed in those environments.
- Periods of fear and uncertainty create the most incentive to take action, but are, in fact, the time when discipline and adherence to your plan are most critical.
Through this entire decade, we believed in the power of global capitalism, the resilience of the US economy and the potential of US equities. I look to our client families and I am proud that our advice has achieved very good outcomes for you. We remain
resolute in our belief that the core asset classes that created and sustained wealth in the past, will continue to do so in the future.