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Each quarter, we address questions from clients and advisors about our investment views, long-term strategy, and current positioning. Below, we discuss some of the key topics coming out of the first quarter: tariffs and trade wars, portfolio positioning, investing new client money in a volatile market, and more.
Do you have current thoughts on the tariff talk and how a potential trade war might impact your view on international stocks?
There are many viewpoints on this topic out there. For what it’s worth, our view is that the most likely scenario is one in which the United States and China negotiate and prevent an all-out trade war because it’s not in either country’s best interest. China, through its initial retaliation, has shown to Trump it can hurt his political base with its tariff measures. Meanwhile, China is in a relatively weak position in that it’s managing a transition from an investment-led economy to one more consumer-driven, while making sure the imbalances from its previous credit binge do not derail its economy. So, it cannot afford a major slowdown in its economy. (The major slowdown due to the credit binge is still a risk scenario—it’s a difficult task they have at hand.)
We assume both parties know this and will come to an agreement. It might mean China gives Trump a “win” so he can go back to his base and declare victory and feel good about the midterm elections. Whilst China will know that they can still largely adhere to their strategic vision of gaining a competitive advantage in key industries they have highlighted, perhaps if not by 2025 then a bit later—in the overall scheme of things even a decade does not matter much.
However, there is a risk that negotiations fail and we enter into a trade war. In that case, in the short term we’d expect all risk assets to suffer, including international. But looking out longer term, we’d venture to say it would be more of a negative for the United States because, in our view, its companies have benefited the most from globalization by expanding their complex network of global supply chains (this has contributed to the United States’ relatively high profit margins) and will end up hurting more as they are forced to unwind it.
The underlying reality is that China is fast becoming a major competitor in some key industries, such as solar, and aims to become one in other high-tech industries. In his April 10 Financial Times op-ed, “US-China rivalry will shape the 21st century,” Martin Wolf states that in 2017, China’s GDP was 119%, measured in PPP terms, and their R&D spending as a percentage of GDP is similar to the United States (a gap of less than 1%). This alone suggests to us that China will continue to make progress on its “Made in China 2025” vision. The developed world will have to adjust to this reality, but also rightly sees this as a threat and wants to see greater trade interdependence from China. As Wolf points out, and we agree, trade tensions will be with us for a while. It’s very likely in the long run to turn out fine, but it will be even more important for investors in this world to think globally rather than locally.
What is Litman Gregory’s case for a higher weighting to Europe, in particular, more than developed international in general?
Europe is about two-thirds of the developed international universe, so our tactical allocation to Europe gives us the majority of exposure to developed international markets. The other remaining country with a material weighting in a typical developed international index is Japan. Japan has gone through a long cycle of deflation since the early 1990s, and when we modeled it, we concluded the range of scenarios was so wide that we could not gain a high level of confidence overweighting it, whereas in Europe we could reach the level of confidence we needed to make a tactical investment. The case for overweighting Europe is their depressed earnings relative to their normalized level, which we don’t think is reflected in valuations.
Does your optimistic scenario for U.S. stocks consider consistent above-trend earnings growth?
Yes, our optimistic scenario considers earnings can grow 20% above trend, or the normalized level. And recently, we added some benefit of corporate tax cuts and raised our optimistic earnings number. History has shown that earnings don’t stay above trend for long and revert to their normalized level, mostly because margins ultimately revert due to competitive pressures and wage pressures (when economies come close to full employment). As such, over the long term, corporate profits grow in line with the nominal growth rate of the economy (around 6% in the case of the United States). In the past several decades, more of the share of economy-wide profits have gone to corporations than labor, elevating margins. But we are starting to see wage pressures come through and interest rates rise. Even the recent threat of protectionism, if it comes to fruition, will be a mean-reverting force for margins and therefore slow earnings growth. We don’t know what earnings will do in the short term, but they could continue to grow above trend due to a number of factors, which we capture in our optimistic scenario.
Can the team provide the rationale behind your approximate 11% allocation to alternatives? Why not more?
As always, our allocation to alternatives or any actively managed investment is a function of (1) our manager due diligence—identifying managers that we have a high degree of confidence can achieve their alternative strategy risk and return objectives; and (2) the role of these strategies within our portfolios’ overall risk/return objectives. Having identified alternative funds in which we do have conviction, it is then a portfolio construction and portfolio management process of weighing their expected returns, risks, and diversification/correlation characteristics in absolute terms and relative to the other available investment options and opportunities in our portfolios.
Our current 7% allocation to managed futures is meaningful, and we are not looking to increase that exposure. The 4% in arbitrage funds is a function of their more modest risk, return, and diversification profile. They are not exactly table-pounders in terms of expected returns, but we like what they bring to our balanced portfolios in terms of their diversification benefits, downside risk, and risk-adjusted return potential, particularly given our outlook for very low five-year expected returns for the stock market and high short-term downside equity risk. But there are also several other investments in our portfolio with somewhat similar risk, return, and diversification characteristics in which we have a lot of confidence, such as our absolute-return-oriented bond funds. So we believe our allocations to the lower-risk alternative strategies are appropriate as well.
Now, if expected stock market returns drop to the point where we want to further reduce our equity exposure, we might increase our tactical allocation to these lower-risk alternative strategies. We are also open to increasing our overall alternatives exposure if and when we find other compelling liquid alternative strategies that are run by managers in which we have confidence.
Finally, we’d note that most of our private client portfolios have meaningful exposure to private alternatives funds, in the form of private real estate (at a 10% target allocation) and some exposure to private equity and hedge funds as well. These are investments that we obviously can’t utilize in our public portfolios.
How are your fixed-income managers positioning their portfolios in terms of duration and risk with the yield curve flattening and credit spreads being so narrow?
Across our line-up of managers, the mindset is that we’re later in the business and credit cycle, and risks are increasing. Our managers are more defensively positioned, and they’ve done this by upgrading credit quality, reducing duration, and being mindful of the credit risk they’re taking. One thing is clear, regardless of whether you take on more credit risk or duration risk, you’re only getting an incremental benefit while taking on a disproportionate level of risk. So a lot of the discussions we’re having with our managers focus on how they’re balancing absolute versus relative value.
Here is a brief update on each of our managers:
Guggenheim Macro Opportunities (GIOIX): The team has reduced their exposure to corporate credit over the past year or so as they have become increasingly concerned about downside. They are focused on getting sufficient yield for a perceived level of risk, which speaks to their more defensive posturing. They are looking at sectors where they view spreads as relatively wide compared to their credit quality and/or have the best total return potential in light of the macro environment. The highest fund weightings today are non-agency RMBS, CLOs, bank loans, and commercial ABS. Nearly the entire portfolio is in floating-rate securities, which should perform well if the yield curve continues to flatten as short-term rates continue to rise. Looking forward, they expect continued spread volatility and hope to take advantage of opportunities as they arise.
Guggenheim Total Return Bond (GIBIX): This is Guggenheim’s core portfolio, and as such it is managed more duration-neutral to the core bond index. The fund is positioned similarly to the Macro Opportunities fund in terms of sector weightings: 75% of the fund is in floating-rate securities. Any duration in the fund comes from the long end of the curve, where they expect interest rate volatility to be more subdued relative to the short and intermediate parts of the curve. Curve positioning will continue to be important as the curve is expected to flatten.
Loomis Sayles Bond (LSBDX): The combination of rich valuations and uncertain macro conditions have resulted in a conservative portfolio stance relative to the fund’s history. The team makes investment decisions on a fundamental, bottom-up basis, but the macro environment plays a role in determining the team’s assessment of relative and absolute valuation. The fund’s conservative stance is evident through its current duration and cash positions. Effective duration is down to just over three years, which is the lowest in the fund’s history. (For context, this duration is roughly half that of the core bond index.) And the fund’s liquid reserves have increased from just over 2% at year-end 2016 to over 20%. The team expects to put this “dry powder” to work when more attractive investment opportunities surface. But this doesn’t mean that the team sees an immediate cause for concern. The economy is in decent shape and valuations have been more expensive in the past. Despite the overall cautious positioning, the team has found select opportunities within higher-rated high-yield credit (BBs as opposed to B- and CCC-rated securities), where yields are relatively attractive and where technicals and fundamentals are still reasonably supportive.
Osterweis Strategic Income (OSTIX): This is a short-dated high-yield bond fund. As with our other fixed-income positions, the fund’s positioning has been increasingly conservative. And like Loomis, the Osterweis team remains patient in waiting for attractive opportunities. Cash in the portfolio is nearly 20%. The team is finding some opportunities, but the combination of portfolio holdings being called and investor inflows is keeping cash high. One area where the team has been opportunistic is in convertible bonds, which accounts for roughly 6% of the portfolio.
DoubleLine Total Return Bond (DBLTX): This mortgage-based fund currently has a duration shorter than the core bond index (as is typically the case), which will provide more protection against rising rates.
William Blair Bond (WBFIX): The fund is positioned as it has been for quite some time. At the short end of the curve, they are finding attractive mortgage securities, specifically low-loan balance pools, that have superior yield relative to securities with similar maturities. On the long end, they are focused on investment-grade corporate credits that have attractive yield premiums over similar-maturity securities in the index. We recently met with the team and they are continuing to upgrade the quality of the corporate credits when opportunities present themselves.
The volatility pendulum seems to be readjusting this year after a historically calm 2017. What’s the most prudent approach to putting new money to work in this type of environment for clients who are hesitant to jump in? Do you build up cash like some of your value managers, or do you just get invested immediately?
Our typical approach to a situation like this is a dollar cost averaging strategy for the cash earmarked for equity allocations and to immediately invest the rest of the cash that is earmarked for fixed-income and alternative strategies (as they are low volatility, so there is lower potential for client regret due to really bad luck/bad timing).
Investing (or not investing) based on one’s emotions is usually a bad idea. So in the current situation, you might have a reflective discussion with your client about the times in the past when they were very nervous about the markets or investing and things turned out fine over time or turned out very differently than they were expecting. We also find it’s helpful to tie the discussion back to their long-term time horizon and financial goals. Providing additional material, such as longer-term historical charts of stock market volatility, drawdowns, and recoveries, may also be helpful in building their frame of reference and getting them a bit less focused on the very short term and the recent volatility. It could prepare them for further market ups and downs. We included the following chart in our most recent client presentation to help educate clients about the actual experienced volatility when holding stocks.
In terms of the time period for dollar cost averaging new cash into equities, we usually suggest doing it over a six- to 12-month period. Beyond that, if the client is still nervous about investing incremental cash into the equity portion of their portfolio, it may indicate they are in a strategic portfolio allocation that has too high of a risk threshold for their risk profile and temperament.
A final point is, we would not recommend dollar cost averaging into our tactical overweights to European and emerging-market stocks. We would immediately and fully invest any new cash in those tactical positions.
—Litman Gregory Research Team (5/10/18)
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