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Apr 06, 2017 / Investment Commentary
Global equities greeted the new year with the same degree of élan with which they closed 2016. Emerging-market stocks led the way with a double-digit return, followed closely by developed international and U.S. stocks (Vanguard FTSE Emerging Markets ETF up 11.2%, Vanguard FTSE Developed International ETF up 8%, and Vanguard 500 Index up 6%). While investor optimism seemed to leave no contingency for downside surprises—the VIX, the markets’ fear gauge, ended the quarter at historic lows—macroeconomic fundamentals were also broadly supportive.
Investors took the Federal Reserve’s widely anticipated 0.25% increase in the federal funds rate in stride, treating it as another indicator of the U.S. economy’s return to form. As Fed Chair Janet Yellen stated, “The simple message is the economy is doing well.” On Friday, the Bureau of Economic Analysis released a revised GDP figure of 2.1% for the fourth quarter of 2016 versus an earlier estimate of 1.9%.
In Europe, stock gains also seemed to reflect a combination of bullish investor sentiment and positive economic data, including rising corporate earnings. Upward revisions to corporate earnings forecasts, GDP growth that far outstrips that of developed economies, and valuations that are still cheap compared with developed-market stocks all helped drive the strong gains in emerging-market stocks.
Defensive assets turned in a solid performance during the first quarter. Treasurys rallied after the Fed’s March 15 announcement. The core bond index made up some ground in the latter half of March. That still wasn’t enough to outpace the flexible, actively managed bond funds we own. Our absolute-return-oriented and flexible bond funds delivered gains of 1%–3% versus the core bond fund’s 0.9% return (Vanguard Total Bond Market Index). Our floating-rate loan funds performed in line with the index.
Moves in Treasurys and the U.S. dollar were closely tied to investor perceptions the Fed might be poised to take a more hawkish stance on interest rates in anticipation of Trump’s legislative agenda boosting inflation. This view changed as the quarter drew to a close, with both the Fed and financial markets forecasting roughly two more rate hikes this year. The yield on the 10-year Treasury ended March at 2.4%, down from an intraquarter high of 2.6%. The dollar also fell, ending 2.8% lower against a basket of currencies. Traders attributed the fall to the Fed’s failure to raise its inflation expectations, which would signal a potential move to a more accelerated pace of interest rate increases.
It’s too soon to know how the second quarter will play out, but we remain alert to potentially policy-driven political risk in the United States. In Europe, the outcome of upcoming elections, and related developments in France (May) and Germany (September), may have unexpected impacts on markets. While to date investors have shown a remarkable degree of staying power, that does not mean they will continue to do so.
For the first time in a while, global economic growth is in sync and improving. A quick survey of the economic landscape suggests the environment should remain supportive of stocks and other risk assets, at least over the next six to 12 months or so. As we’ll discuss later, we continue to believe high current valuations will be a major headwind to U.S. stock market returns looking out longer term (i.e., the next five years). We also remain concerned about the unresolved risks stemming from the global debt build-up and unprecedented central bank policies. But for the time being at least, the global macroeconomic backdrop offers reason for optimism that many of the reflationary trends that have benefited our portfolios in recent quarters can continue.
Across a wide range of measures, the global economy is in its best shape in many years. Economic growth in most countries and industries is in sync and has been accelerating, albeit modestly. Leading economic indicators suggest this trend can continue, and many of the respected economic research firms we follow agree. Capital Economics expects world GDP growth to be at least 3% this year, up from 2.5% in 2016. In its March 16 cover article titled, “On the Up: The World Economy’s Surprising Rise,” The Economist noted that across the United States, Europe, Asia, and emerging markets, “all the burners are firing at once, for the first time since a brief rebound in 2010.”
While unexpected macro shocks can occur at any time, causing at least a short-term flight from risk assets, the likelihood of an incipient U.S. or global economic recession appears low. Without a recession, history suggests a bear market in stocks is unlikely.
To highlight a few of the positive global economic indicators:
Macroeconomic fundamentals appear reasonably solid and are improving from cyclically depressed levels in many regions outside the United States. But financial markets respond to new data, information, and events that differ from the consensus expectations already discounted in prices. In other words, markets react to surprises. The Citi Economic Surprise Indexes are meant to capture whether and to what extent new economic data points are exceeding or disappointing consensus expectations. As the chart "Economic Data is Exceeding Expectations Around the World" shows, these indexes have also rebounded sharply over the past year. In fact, the Surprise indexes for Europe and emerging markets both recently hit seven-year highs.
In our 2016 year-end commentary, we noted that on the heels of a fourth straight year of underperformance for foreign stocks versus U.S. stocks, the consensus view was for more of the same this year. The consensus was also for the U.S. dollar to appreciate, driven by divergent central bank policies—with the U.S. raising rates while other major central banks continued monetary stimulus—as well as President Trump’s expected fiscal and trade policies. Both these consensus views have been wrong so far this year. International and emerging-market stocks have beaten U.S. stocks, and the dollar has declined by about 3%, retracing much of its post-election gain. (The dollar still looks overvalued based on longer-term fundamentals.) These counter consensus reversals were helpful to our portfolios in the first quarter, given our modest overweight to non-U.S. stocks.
Over the longer term, our analysis continues to indicate the U.S. stock market is broadly overvalued. Specifically, our estimate of the expected annualized total return for U.S. stocks (including dividends) in our base case scenario is in the low single digits over the next five years. For U.S. stocks to be priced in what we consider to be a “fair value” range, that is, to at a minimum compensate investors for the risks they incur owning public equities, their expected return would be at least in the upper single digits. Since we are well below that hurdle rate in our base case scenario, we remain less than fully invested in U.S. stocks.
As the valuation chart to the right indicates, the U.S. stock market is as expensive as it has ever been in the past 50 years, with one exception: the dot-com stock market bubble of the late 1990s, from which the S&P 500 Index plunged nearly 50%. We don’t believe this time is different. We do believe valuation matters. When stock market valuations are high, the odds are your future market returns will be low. So we remain underweight to U.S. equities in favor of (1) foreign stocks with much better return prospects and (2) select alternative strategies we believe offer at least as attractive returns as U.S. stocks do, with much less risk.
Our portfolios have meaningful exposure to developed international markets, with a modest tactical position in European stocks. These positions added value to our portfolios in the first quarter, and we continue to be confident European stocks will outperform their U.S. counterparts over the next several years.
Primarily due to the onset of a regional debt crisis in 2011, European corporate earnings have barely grown since the 2008–2009 financial crisis. Fiscal and monetary policies have not been stimulative enough to offset this. Meanwhile, U.S. company earnings have grown strongly, exceeding prior cyclical highs due to historically high profit margins, stock buybacks, and low interest expenses. This divergence in earnings trends is the key reason we view European stocks as more attractive looking forward.
We estimate that over the next five years European companies will likely grow earnings at a much faster rate than their U.S. counterparts; this would lead to outperformance by European stocks. Simply stated, we believe European earnings are cyclically depressed, while U.S. earnings are near cyclical highs. Further, we do not believe this condition is adequately reflected in their respective valuations. We don’t know the precise timing or exactly what catalyst will lead investors to close the gap. This is especially true now, when political uncertainty in Europe is high. Yet, there are reasons for optimism the market will finally start to take notice.
Last year, for the first time since the 2008–2009 financial crisis, Europe’s economy grew faster than that of the United States. Improving economic growth is a good sign as it ultimately leads to better sales growth and gets consumers and corporations to borrow and spend, furthering the growth cycle. According to the Bank Credit Analyst, private sector credit growth in Europe is up at the fastest rate since the financial crisis.
Unsurprisingly, the European Central Bank is expressing greater confidence in its economic outlook, and has revised upward both its inflation and growth projections for 2017–2018. We are also finally seeing better earnings from European companies. Looking at the sector level, according to NDR, the most beaten down sectors, such as financials and energy, are seeing the fastest earnings growth year over year in local-currency terms. Europe has a relatively large exposure to these sectors and any improvement there will reflect positively in index-level earnings growth.
Last but not least, our active equity managers own many global business franchises that while domiciled in Europe are geared toward growth outside the continent. Even if Europe’s growth were to disappoint, these businesses would benefit from emerging markets’ growth and/or improvement in the United States’ economy.
Some examples: Fresenius Medical, a German company, generates 70% of its revenues from the United States and has a leading market share here. Valeo used to be primarily focused on France, its home base, but in the past several years it has transformed itself into a truly global auto-components company.
Our analysis continues to indicate that emerging-market stocks are attractive compared to U.S. stocks. Emerging-market company earnings are cyclically depressed relative to earnings of U.S. companies, yet investors are essentially pricing that in as a permanent condition. Using what we believe are very conservative normalized earnings estimates, our analysis indicates emerging-market stocks in aggregate are trading at a price-to-earnings multiple well below their historical averages. Using Robert Shiller’s valuation methodology—another way of normalizing earnings, or smoothing out their cycles—emerging-market stocks are trading at around half the multiple of their U.S. counterparts. As emerging-market earnings growth comes through, we expect investors to bid up their prices and valuations, generating low double-digit annualized returns.
Of course, there are risks investing in emerging markets. Among the new worries investors have is Trump’s protectionist stance on international trade. There remains considerable uncertainty as to whether his stated policies on border taxes, import tariffs, etc., will actually be implemented in the manner he has proposed. There is a good chance they may not be. Even assuming they will be, while they would be a near-term negative for some emerging-market countries, we argue they may actually be worse for larger U.S. companies. That is because, among other things, Trump’s protectionist policies would likely disrupt global supply chains for U.S. multinationals. This ability to conduct sourcing on a global basis has driven down multinationals’ operating costs and has been important in pushing U.S. corporate margins higher for the past decade-plus.
Emerging markets are better positioned today to weather protectionism, higher U.S. interest rates, and a rising dollar than they were a few years ago. Many countries are implementing reforms and undergoing political change that could be positive longer term. For example, Michael Kass, portfolio manager of Baron Emerging Markets, cites the approval of a “national sales tax” in India that’s aimed at creating a single unified market and reducing bureaucracy there. In Latin America, Kass is optimistic recent political regime shifts and renewed fiscal constraint in Brazil and Argentina could increase foreign capital and investment, helping the region recover from its economic stagnation. In China, much needed supply-side reforms seem to be happening. For example, in a recent conversation with Thornburg portfolio manager Vin Walden, we learned China is shutting down low-return-on-capital fertilizer plants and helping affected workers by creating a social fund. (The reduction in supply is generating stock-specific opportunities in the fertilizer space for Walden.)
The above developments are not sufficient in and of themselves to drive growth and outperformance in emerging markets. But when we start to see such actions occur at a time when earnings are historically depressed and valuations are attractive, we think there are good reasons to be optimistic about investing in emerging markets.
For the quarter as a whole, all but one of our active fixed-income funds outperformed the core benchmark, continuing the trend from 2016. (FPA New Income was the sole exception.) Our fixed-income exposure encompasses what we believe is a prudent amount of credit risk and modest interest-rate risk (duration). It also offers a meaningful yield and expected-return advantage versus the core bond index. We continue to believe that over the next several years the most likely direction for U.S. interest rates is higher, although it will likely be a bumpy path. That would be consistent with the evidence of global economic reflation as discussed above. In such a scenario, core bond index annualized returns will be extremely low (and potentially negative over a 12-month period). In contrast, we believe our actively managed flexible bond funds and floating-rate loan funds can generate mid-single-digit-type annualized returns.
As with the asset classes profiled above, managed futures are an integral part of our global diversified portfolios. We remain strong believers in the long-term benefits of owning alternative strategies in our portfolios. Our expectations for our managed futures investments, in particular, are that they will enhance our balanced portfolios’ overall risk-adjusted returns over the long term, with low or no correlation with equity returns. Additionally, there is a very good chance they will perform well—in both relative and absolute terms—in an equity bear market. Below we describe the basis for our conviction.
Trend-following managed futures funds invest in dozens of markets across multiple asset classes, employing rules-based quantitative models to detect and invest in price trends and benefit from time-series momentum in financial markets. There are certainly no guarantees, but during periods of extended equity market losses, trend followers’ returns should be negatively correlated with equity returns. While their short-term performance can be volatile, and the sharp reversals in performance when trends stop and revert can be uncomfortable too, the funds we use actually show less volatility than stocks do when looking at long-term average levels. In fact, our position, which we initiated in July 2015, has already provided a textbook illustration of why diversification is so important. Our managed futures funds were able to offset overall portfolio risk, and showed significant profits, when equity markets declined precipitously both in early 2016 as well as during June’s post-Brexit market fluctuations.
Managed futures also show low correlation to bond returns. These valuable diversification benefits are incredibly powerful in a portfolio context. One way to think of our investment is as insurance against extended periods of poor stock and bond returns, but with an important distinction. Rather than paying an insurance premium, we receive a payout in the form of positive returns over the long term. The flipside is that investors can experience periods where most asset classes deliver strong returns while trend-followers are down. In order to maximize these diversification benefits while mitigating the risks of concentrating in any one style of implementation, we use several managers with varying approaches to investing. As a result, we are diversified across different trend lengths and asset class weightings. Over multiyear periods, the funds should perform roughly similarly when adjusting for their differing risk profiles. This won’t insulate us from disappointing performance over short-term stretches, but we are confident it will benefit our portfolios in the long run.
Despite a high level of volatility emanating from U.S. politics in recent months, U.S. stock market volatility has remained very low. That is unlikely to last. Our portfolios are prepared for more oscillations, particularly downside risk to U.S. stocks. We remain confident in our positioning and in our investment process, both of which allow us to look past periods of uncertainty and keep our focus where it should be: on prudently managing our diversified portfolios to achieve long-term, risk-adjusted returns.
—Litman Gregory Research Team (4/6/17)
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