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Apr 05, 2018 / Investment Commentary
Volatility returned to the financial markets in the first quarter, for the first time in a while. Global equity investors had a particularly bumpy ride—an experience we’d suggest getting used to for the months and years ahead. Stocks surged out of the gates in January, with larger-cap U.S. stocks up nearly 8% at the market high on January 26 (Vanguard 500 Index). This was followed by a short but sharp market correction, which dropped the market 10% over the next nine trading days. The VIX volatility index had its biggest one-day move ever, spiking more than 100% on February 5. U.S. stocks then rebounded into mid-March, clawing back much of their losses, before dipping again into quarter-end, buffeted by fears of a potential trade war with China (and possibly some U.S. allies as well) and a Facebook data scandal. When the dust settled, large caps ended down 0.8% for the quarter.
Developed international stocks also got off to a strong start to the year, before suffering similar losses to U.S. stocks during the sharp correction in early February (Vanguard FTSE Developed Markets ETF). They made up ground relative to U.S. stocks in March and ended the quarter down 1%. Emerging-market stocks held true to their higher-volatility reputation, shooting up 11% to start the year, falling 12% during the mid-quarter correction, and then once again outgaining U.S. and international stocks to finish the quarter with a 2.5% return (Vanguard FTSE Emerging Markets ETF).
Core bonds didn’t play their typical “safe-haven” role in the first quarter. They posted losses during the sharp stock market correction in February and delivered a 1.5% loss for the quarter overall, as Treasury yields rose across the maturity curve (Vanguard Total Bond Market Index). Our absolute-return-oriented and actively managed fixed-income funds outperformed the core bond index for the period. Floating-rate loan funds performed best, gaining around 1.4% (S&P/LSTA Leveraged Loan Index).
Our clients know we don’t invest based on three-month time horizons or short-term expected outcomes. To the contrary, we strongly believe that a critical element of our investment process and “edge” is the ability to maintain a longer-term (multiyear) perspective while other market participants over-react to short-term performance swings, daily news flow, and other emotional/behavioral triggers—much to their longer-term financial detriment. Yet, many clients are also naturally curious to know “what worked and what didn’t” in any given period. So, with that in mind, we typically provide shorter-term updates on the key drivers of our portfolios’ performance.
Overall, our active U.S. equity managers in aggregate added value relative to the benchmark, led by our active growth managers (Touchstone Sands Capital Growth and Harbor Capital Appreciation), who crushed the large-cap growth index (yet again) by several percentage points. Foreign stock funds did not fare as well in the first quarter. Active developed international equity managers outperformed, but active global and emerging-market stock funds failed to match the returns of their strategic benchmarks during the first three months of the year.
Our tactical portfolios have a modest overweight to European and emerging-market stocks, and are underweight to U.S. stocks. The overweight to emerging markets added to returns as they outperformed U.S. stocks for the period. European stocks (unhedged) lost a bit more than 1% (Vanguard FTSE Europe ETF). This could be attributed to any number of macro factors, such as Brexit-related uncertainty, concerns about the Italian election, increased trade-tariff rhetoric, and/or excessively optimistic economic expectations ripe for a disappointment (e.g., the Citi Economic Surprise Index for Europe turned negative in February for the first time since September 2016). A more direct explanation comes from a bottom-up perspective: technology stocks were among the top-performing sectors, but the European stock index has only a 5% weighting versus the U.S. market’s 25% weighting. Whatever the causes of this recent performance, we put them collectively in the “short-term noise” basket—par for the course when owning a volatile asset class like equities. Our longer-term tactical asset allocation view is unchanged and we are maintaining our foreign equity positions.
As noted above, our actively managed fixed-income funds and floating-rate loan funds produced better returns than the core bond index. This has been the case over the trailing three- and five-year periods as well. We continue to expect these positions to outperform over the next several years, particularly if interest rates continue to rise. As such, we are maintaining our exposures here as well.
Finally, the performance of our liquid alternative strategies was mixed. Our lower-risk arbitrage strategy funds were flat during the market correction and slightly positive for the entire quarter, beating both bonds and stocks. Our trend-following managed futures funds started the year with very strong returns but gave them back and then some during the February market correction. We expected these positions to be volatile when we bought them. So far, we’ve experienced it more on the downside, which is certainly not fun, but also not particularly surprising as the losses have been within our range of expectations. The bottom line is that based on our research, our confidence remains high that these disciplined trend-following strategies will be beneficial to our client portfolios over full market cycles. What’s more, the benefits will likely be greatest during equity bear markets, which we have yet to experience this cycle. We believe a bear market is highly likely within the next several years given we are late in the current cycle and U.S. stock valuations are excessive. (We discuss this more later.)
Maintaining investments even as they cause shorter-term pain or discomfort exemplifies our process and discipline. In fact, it’s often the psychological price that must be paid to achieve successful long-term investment results. Additionally, the discomfort is almost always greatest the closer one is to a cycle turning in one’s favor. The emotional pressure to “throw in the towel” is highest when trailing returns for any given asset class or investment strategy are at their lowest (and likewise, the pressure to buy what has already gone up). That is the nature of financial markets, and it is this type of investor herd behavior that causes cycles over time and creates great investment opportunities as well. We know these cycles will recur, but their precise timing is never certain. That’s why having a reasonably long time horizon, to allow for each full cycle to play out, is critical to our investment process.
In our 2017 year-end commentary, we noted that by some measures U.S. stock market volatility was the lowest it had ever been in 90 years of market history. Of course, most experienced investors knew that was unsustainable. We also knew the exact timing, magnitude, and catalyst of a market disruption couldn’t be predicted with any precision. We highlighted central bank policy tightening as a potential or likely trigger, along with the ever-popular and all-purpose “unexpected geopolitical shock.”
As it turned out, the catalyst was an economic data point in early February showing higher-than-expected U.S. wage inflation. It unnerved markets to think that overall inflation may be rising more rapidly, thereby suggesting the Federal Reserve would tighten policy (raise interest rates) more aggressively than the consensus had been expecting. Selling then begat more selling, as short-term traders (the speculative herd) rushed to unwind their misplaced bets that the very low market volatility regime would continue.
Although the 10% market correction proved to be very short-lived, it may still have provided a nice reality check for some investors in terms of testing their true risk tolerance as compared to a hypothetical risk scenario on a questionnaire or in an initial discussion with their financial advisor. To the extent you were paying attention to the markets and your portfolio during that nine-day period: how did it feel to see the value drop by that magnitude? If it was starting to cause heavy discomfort or stress, that’s probably a sign you are not in a portfolio with the right risk level. Stock market corrections of 10% or more in any given year are very normal. Historically, they’ve happened more than half the time. (A 5% decline has happened in more than 90% of years.) We think this is a reasonable expectation for the future as well. That is why stocks are called “risky assets.” In exchange for their higher long-term expected returns, you must be willing and able to ride through their inevitable periods of decline.
From our perspective, as the market correction unfolded we were starting to view it as potentially creating an opportunity to reallocate some capital back into stocks. But the selloff ultimately didn’t go nearly far enough (i.e., stocks didn’t get cheap enough) for us to see an expected benefit from making any portfolio changes, so we maintained our positions.
Another observation about the market correction in February is that it was caused not by indications of an economic slowdown or recession, but by fears the economy may be getting a bit too strong, with a tight labor market finally causing rising wage growth and broader inflationary pressures. Fundamentally, even after the correction, the U.S. economy and global economy still look solid. Global growth may no longer be accelerating, but it remains at above-trend levels and the likelihood of a recession over the next year or so still appears low (absent a macro/geopolitical shock). The global economic and corporate earnings growth outlook has not materially changed from what it was earlier in the year. The near-term macro backdrop is still supportive for riskier assets such as global stocks, even though the U.S. economic recovery is getting long in the tooth.
A positive near-term economic view doesn’t mean we are at all bullish on stocks looking out over our five-year tactical investment horizon. Our analysis remains the same as we outlined most recently in our year-end commentary, the key driver being that the valuation of the S&P 500 Index is well above our estimate of its fair-value range on a normalized (longer-term) basis. As the valuation multiple comes down, it will be a significant drag on the total return of the market index. We estimate a very low single-digit annualized five-year return for U.S. stocks in our base case scenario, which we think is the most likely outcome. But there is a wide range around that base case, incorporating bearish and bullish scenarios.
Our base case five-year expected return estimates are meaningfully higher for European and emerging-market stocks—in the mid- to upper single digits, at least. We view these as relatively attractive returns compared to U.S. stocks but not table-pounding in an absolute-return sense given the downside risks inherent in owning equities. This leads us to small overweight positions in both Europe and emerging markets, a meaningful underweight to U.S. stocks, and therefore a moderate underweight to equities overall.
Focusing further on our equity market scenarios: We emphasize a five-year or longer time horizon as the basis for our expected-returns analysis because valuation (what you pay for an investment relative to its future cash flows) has been the strongest predictor of returns over longer-term periods. By contrast, over the shorter term, markets are driven by innumerable and often random factors that are impossible to consistently predict (although that doesn’t stop lots of people from trying).
Nevertheless, it can be a useful exercise to think about—and mentally, emotionally, and financially prepare for—some potential paths the economy and financial markets may take over the next few years that are consistent with our five-year scenarios. These paths can also highlight some of the shorter-term risks that we take into account—along with the longer-term expected returns—when we construct and stress-test our client portfolios.
From a U.S. macroeconomic perspective, a recession does not appear to be on the near horizon. However, the U.S. economy is getting late in its cycle. (If U.S. GDP growth continues another 15 months, this will be the longest U.S. expansion in post-war history and twice as long as the average upturn.) Our economy is now operating at or slightly above its potential, as measured by the low unemployment rate and actual GDP above CBO estimates of potential GDP. At the same time, the Trump tax cuts and new fiscal spending bill will stimulate more demand, in the short run at least. Given the economy is already at its potential, these deficit-financed measures are likely to be inflationary (demand outstripping supply).
As an aside, this fiscal stimulus and the attendant increase in our federal budget deficit is historically unprecedented, as shown by the following chart. Normally, at this stage in the economic cycle, deficits are coming down. It makes one wonder what will happen in the next recession if we are starting from much higher government deficit and overall debt levels (including corporate debt). To quote the ever-colorful Albert Edwards, global strategist at Société Générale: “This is probably the singularly most irresponsible macro-stimulus seen in U.S. history. To say it is ill-timed and ill-judged would be a massive understatement.”
Consistent with this phase of the economic cycle, the Fed has been tightening monetary policy—raising the federal funds policy rate and unwinding its balance sheet by selling bonds it purchased during quantitative easing. They have done this in a gradual, deliberate, and well-telegraphed manner so far. But given we are coming off a sustained period of unprecedented global central bank market intervention and monetary stimulus that have boosted asset prices, the risks of a policy mistake or market hiccup remain high.
The inflationary potential of the new fiscal stimulus further raises the risks. On the one hand, to prevent an inflationary spiral, the Fed might pre-emptively tighten more quickly than the market currently expects or than the economy can handle. Alternatively, the Fed could fall behind the inflationary curve by not tightening quickly enough and then have to take more aggressive measures later, causing a sharper eventual economic downturn.
Obviously, neither outcome would be good for the stock market, which is still betting on a Goldilocks economic scenario (not too hot, not too cold). Core bonds would also get hit (rising yields mean falling prices) at the same time stocks are dropping. Investors got a taste of this during the February market correction. This bodes poorly for a traditional “60/40” stock/bond balanced portfolio and underscores the important benefits of the much wider set of assets and strategies in which we invest.
There are, of course, myriad other risks besides central bank policy (there always are). The potential for a trade war between the United States and China rose to the fore at the end of March, with threats and counter-threats. Stock markets tumbled on the news and remained jittery into quarter-end. No one knows how it will all play out, but rational observers agree that a full-blown trade war would be highly damaging to all economies involved. As such, the hope is the actors involved won’t allow it to get to that point. One possible outcome is that some relatively minor, targeted tariffs and restrictions are imposed, which would impact individual industries and companies (perhaps meaningfully) but would not have a major impact on the overall U.S. and global economy. But one never knows. While still a minority, there is a strong nationalist/populist/anti-globalist base in the United States and elsewhere, and they are not known for their even-handed policy-making.
Putting a trade war to the side for the moment, we think it is likely that inflation continues to move higher in this economic cycle. The core PCE inflation rate is still below the Fed’s 2% target. But a big inflationary surge is not our base case. As such, we would expect the Fed to continue its path of gradual rate hikes and quantitative tightening over the next couple of years. But as we’ve said before, not even the Fed itself knows exactly what it will do.
Eventually, absent a major macro shock, we’d expect monetary policy and overall financial conditions to tighten to the point where economic activity and asset prices take a hit and the economy rolls over into a recession accompanied by a full-blown bear market in U.S. stocks. That bear market could easily see a 20% to 25%-plus decline, and we’d emphasize the “plus” given lofty current U.S. stock market valuations. This would be true to the typical historical pattern of Fed tightening and an equity bear market preceding—and having a strong hand in causing—most recessions.
Of course, central bankers are aware of this history. But they need to respond to signs of rising inflation to prevent excesses and imbalances that could lead to even worse economic damage. Ultimately, the Fed has an impossible job trying to fine-tune monetary policy to prevent recessions given the uncertainties and lags between Fed actions and their ultimate economic impacts, not to mention all the other variables that affect the economy that are beyond the Fed’s control. The business cycle is here to stay.
We don’t have a more precise recession expectation in our base case scenario than “sometime in the next five years.” A lot can happen between now and then that might change our view. More importantly, we don’t believe our investment process or long-term results will benefit from us trying to be more precise in guessing the timing of recessions. However, we’d note that at least two investment research firms whom we respect (BCA and Guggenheim) currently expect a U.S. recession to happen around the 2020 timeframe.
To repeat: our investment decisions are not based on any specific recession forecast. However, the BCA/Guggenheim timeframe is one we view as plausible and consistent with our broad base case macro scenario. So, we will use it here in an exercise to walk through some potential paths over which our expected five-year return outlook may play out.
If the BCA/Guggenheim recession forecast turns out to be accurate, stock markets will probably start falling several months in advance of the recession’s onset, if history is a guide. That would still leave one to two years of positive returns for stocks. Also, as interest rates continue to rise over this period, we’d expect poor returns for the core bond index and continued outperformance from our actively managed fixed-income and floating-rate loan funds.
Digging a bit deeper, assuming a period of continued global growth (whether it lasts one year, two years, three years, or longer), we’d expect international and emerging-market stocks to continue to outperform U.S. stocks, driven by their more attractive valuations relative to their earnings potential. If things play out this way—and depending how strongly—we will then be in position to unwind our tactical overweighting to these markets as their expected-return gap versus U.S. stocks will have meaningfully narrowed. In other words, at that point all equity markets could be overvalued.
Of course, it’s possible the return gap across these markets doesn’t narrow enough for us to unwind our positions prior to the onset of the next bear market. There are a couple of paths that would then branch from this point:
Suffice it to say, there are many potential shorter-term paths to reach our five-year base case scenario destination. There is also a wide range of reasonably likely five-year outcomes around our base case that we attempt to capture in our bullish and bearish cases. Simply put: markets and economies are not that predictable. This makes logical sense, given the vast number of ever-changing, interacting, nondeterministic variables that drive them (including human beings). A quick study of financial market history makes this clear as well.
We believe that acknowledging and internalizing the inherent uncertainty in this endeavor is extremely beneficial. It can help immunize investors from over-reacting to short-term events—particularly unpleasant ones—and restrain our natural human inclination to “do something” in response to pain and discomfort. In the real world this human inclination to action is beneficial—thanks to our ancestors it’s why we are all here (and weren’t eaten by lions). But when it comes to the investment world, it leads most investors to undisciplined performance-chasing and other detrimental portfolio moves. Numerous reputable studies have quantified this. As Vanguard founder Jack Bogle put it, “Investors are their own worst enemy.” Or as Walt Kelley’s Pogo more famously said: “We have met the enemy and he is us.”
The best defense against that enemy is a sound, fundamentally grounded investment process that an investor has confidence in and is therefore able to stick with for the long term—through the ups and downs of market cycles, economic cycles, political cycles, and daily news cycles.
As always, we thank you for your continued confidence and trust.
—Litman Gregory Research Team (4/5/18)
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