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Jan 05, 2018 / Investment Commentary
The fourth quarter capped yet another stellar year for U.S. stocks. Larger-cap U.S. stocks (Vanguard 500 Index) gained 6.6% for the quarter and ended the year with a 21.7% total return. This was the ninth consecutive year of positive returns for the index—tying the historic 1990s bull market and capping a truly remarkable run from the depths of the 2008 financial crisis. The broad driver of the market’s rise for the year was rebounding corporate earnings growth, supported by solid economic data, synchronized global growth, still-quiescent inflation, and accommodative monetary policy. U.S. stocks got an additional catalyst in the fourth quarter with the passage of the Republican tax plan, presumably reflecting investors’ optimism about its potential to further boost corporate after-tax profits, at least over the shorter term.
We’re running out of superlatives to describe the U.S. stock market, but we’ll throw out a couple more factoids that reflect just how unprecedentedly steady its recent performance run has been. The market’s 1.1% gain in December crowned 2017 as the first year ever that stocks rose in each and every month. By year-end, the S&P 500 Index had rallied for more than 400 days without registering as little as a 3% decline. This is the longest such streak in 90 years of market history, according to Ned Davis Research.
Foreign stock returns were even stronger, with developed international markets gaining 26.4% (Vanguard FTSE Developed Markets ETF) and emerging markets up 31.5% for the year (Vanguard FTSE Emerging Markets ETF). In the fourth quarter, however, these markets couldn’t match the S&P 500, gaining 4%–6%.
Moving on to bonds, the core bond index fund (Vanguard Total Bond Market Index) gained 3.5% in 2017. This return was close to the index’s yield at the start of the year, as intermediate-term interest rates changed little during the year with the benchmark 10-year Treasury yield ending at 2.4%. Although the Federal Reserve raised short-term rates three times (75 basis points total), yields at the long end of the Treasury curve declined and the yield curve flattened. Corporate bonds across all credit qualities and maturities had positive returns. High-yield bonds gained 7.5% (ICE BofA Merrill Lynch U.S. High Yield Cash Pay Index) and floating-rate loans rose 4.1% for the year (S&P/LSTA Leveraged Loan Index). Investment-grade municipal bonds (Vanguard Intermediate-Term Tax-Exempt) rebounded from a flat 2016, returning 4.5%.
Our globally diversified balanced (stock/bond) portfolios generated strong returns for the year, consistent with the positive overall return environment for most financial markets and asset classes. Our portfolios benefited from meaningful exposure to emerging-market and European stocks, both of which had very strong absolute returns and also beat U.S. stocks for the year. Our decision earlier in the year to swap our half-position in a currency-hedged European stock index ETF into a fully unhedged position also added value, as the euro appreciated sharply versus the dollar for the year.
In the fixed-income portion of our portfolios, our long-held tactical positions in several flexible and absolute-return-oriented bond funds added value, outperforming core bonds by several percentage points. Our tactical floating-rate loan positions also beat core bonds, albeit by a more modest margin.
Our investments in liquid alternative strategies fulfilled their portfolio diversification roles while generating low- to mid-single-digit returns. After a rough first half, managed futures funds rebounded and ended with a gain for the year. Lower-risk arbitrage strategies generated absolute returns in the 4%–6% range. These funds beat core bonds but, not surprisingly, trailed the 20%-plus stock market returns. As with the past several years, it didn’t pay to be somewhat defensively positioned or to diversify away from U.S. stocks with these alternative strategies. We remain confident their relative-performance day will come and their “insurance” value within our portfolios will be realized.
On the whole, our portfolios benefited from our larger-cap U.S. equity managers. However, after a strong rebound in 2016, value stocks and many valuation-sensitive managers struggled to keep up with the surging market. Small-cap value stocks were the biggest laggards, gaining only 7.7% (iShares Russell 2000 Value ETF). The large-cap value index (iShares Russell 1000 Value ETF) was up 13.5% for the year. That’s certainly an attractive, above-average absolute return. But in relative performance terms, it trailed far behind momentum and growth stock indexes, which gained a whopping 38% and 31%, respectively (iShares Edge MSCI USA Momentum Factor ETF and iShares Russell 1000 Growth, respectively). We invest with concentrated, active managers across a range of investment approaches and “styles,” including growth-oriented managers—and both of our dedicated U.S. growth managers soundly beat the growth index in 2017. But overall, our U.S. active manager exposure has a value bias, and therefore, they (and we) have faced a relative-performance headwind versus the market index during most of the post-financial-crisis period. But that cycle too will turn, as it historically always has, and our confidence in our manager lineup remains strong.
As noted above, U.S. stocks were up 22% for the year, driven in part by expectations of a historic corporate tax cut, which the Republican-led Congress duly delivered. We suspect much of the benefit of tax decreases might be priced in based on consensus earnings estimates for the S&P 500. Regardless of what might be priced in, one question we are pondering is what do lower corporate tax rates mean for our long-term earnings assumptions for the United States? The answer is not straightforward as there are many variables to consider.
Politically, the tax cut has been sold as providing an incentive for companies to hire and spend more. This may be true to some extent, but one wonders why an additional incentive is required when companies are already generating record earnings, flush with cash, and pursuing share buybacks and mergers at a record pace? To us, it seems there is a higher likelihood these tax cuts could worsen the inequality between “capital owners” and “labor,” which we think is one of the key factors or forces behind the relatively high corporate margins we’ve witnessed over the past two decades or so.
We think some companies will increase hiring and boost pay as a token gesture but ultimately the pressure from shareholders—to pursue activities that generate higher profits and returns—will lead most companies to return much of the excess cash flow from tax savings to shareholders or capital owners, and this will probably come largely at the expense of labor. If we are right, it may mean that profit margins are slower in reverting to historical averages (until the societal pressure builds further and leads to changes). Our base case scenario already reflects this condition to a good degree as we have been using margin assumptions that are generous compared to their long-term historical averages.
As it relates to earnings, specifically, we are evaluating whether the boost in after-tax corporate earnings will be temporary or permanent. We agree that earnings will probably see a boost in the short term: consensus seems to be around 10% in aggregate, with less benefit for larger companies overall and possibly more for smaller companies given the former’s actual effective tax rates were already well below the 35% statutory federal rate. Over the long term, we’d expect the incremental margin benefit from lower taxes to be competed away (in most cases). In the new tax plan, there’s an additional tax incentive for companies to pursue capital expenditures, and that could increase economic activity, boosting overall profits. But this would come at a time when we are in the later stages of the business cycle, when the economy arguably is running close to full employment. This may create inflationary pressures and/or cause the Fed to raise rates faster, both of which may counteract the benefit from rising profits.
Politically, it was an eventful year for Europe. The uncertainties stemming from the 2016 surprise Brexit vote flowed into 2017. Markets then heaved a sigh of relief after French elections suggested that populist forces might be receding. However, investors were constantly reminded of prevalent political risks in Europe, with the general rise of eurosceptic parties and the more recent Catalan vote in which the pro-independence parties in favor of breaking away from Spain secured a renewed albeit narrow majority.
Political uncertainties notwithstanding, Europe continues its economic recovery within what appears to be a benign fiscal and monetary environment. Europe is matching the United States in terms of economic growth and, according to Capital Economics, is on track to generate its strongest growth since 2007. Earnings have rebounded strongly, with Ned Davis Research analysis showing continental Europe and U.K. local-currency earnings growing over 25% and 35%, respectively, over the past 12 months. (The United States has seen earnings growth of 14% over the same period, according to NDR.) While earnings were up strongly, investor sentiment was relatively depressed (especially during the fourth quarter), leading valuation multiples to compress. In U.S. dollar terms, Europe generated strong performance in 2017, up 27%, and outperformed U.S. stocks, although this includes a hefty contribution from currency, with the euro appreciating about 11% versus the dollar.
Emerging-market stocks had a strong year, up 31.5% in U.S. dollar terms (including around a 6% boost from currency appreciation). Like European stocks, emerging-market stocks posted strong earnings growth of nearly 20%. After this recent run-up, we still expect emerging-market stocks to generate mid- to upper-single-digit annualized returns over the next five years in our base case scenario. While not attractive in absolute terms (given equities’ downside risk), these returns are still better than what we expect from U.S. stocks.
We believe the key risk to emerging-market stocks continues to be China. If there is a financial crisis in China, it would negatively impact Chinese demand for emerging-market exports. The resulting drop in commodity prices would compound the problem for some key emerging-market countries. Increasing risk aversion could also lead to capital outflows, exposing countries like Turkey and South Africa that have relatively large current-account deficits. Broadly speaking, though, most emerging-market countries have reduced their current-account deficits and are relatively less beholden to foreign capital. This is also the reason why we think emerging markets can handle a slow or managed rate increase by the Fed, as they did in 2017.
Given this risk, it’s worth reiterating that we have deliberately incorporated a discount associated with a “slowing China” into our base case return scenario for emerging-market stocks. Our optimistic case meanwhile assumes China continues to march along at a decent clip, without a crisis or “hard landing.” This scenario would be supportive for emerging markets more broadly. There are indications that China is implementing some supply-side reforms, such as eliminating excess, uneconomic manufacturing capacity. If China is successful in these and other policy efforts, we could get a much better return outcome than what our base case suggests.
Our return expectations for core bonds remain muted looking out over the next five years, in the range of 2.5% to 3.2% (from a current yield of 2.7%). Since the financial crisis, government policy and direct issuance of Treasury securities has not only suppressed yields but has also lengthened duration. Today, we’re faced with taking on elevated levels of interest-rate risk for low yield. The yield per unit of duration is near its all-time low. For context, a 50-basis-point yield increase in the Bloomberg Barclays U.S. Aggregate Bond Index would wipe out more than a year of income. This explains our meaningful positioning away from core bonds in favor of flexible credit strategies, which we believe will outperform core bonds in a period of flat or rising rates. That said, we still maintain core bond exposure in our balanced portfolios to serve as ballast in the event of a risk-off environment.
A generally healthy economic backdrop in the form of rising GDP, low unemployment, and rising home values should support municipal debt. However, low current yields will make it hard for muni bond returns to match their 2017 gain. We expect a low-single-digit return. We would also emphasize the importance of credit selection in this environment of richer valuations and the potential for interest rate volatility.
As noted above, high-yield bonds and floating-rate loans had solid absolute returns in 2017, driven by signs of a firming macroeconomic backdrop (domestic and abroad), the Fed’s measured and largely anticipated rate hikes, low stock market and interest rate volatility, relatively attractive yields, and overall healthy fundamentals. The fundamental backdrop includes a benign maturity calendar (i.e., issuers of high-yield bonds and floating-rate loans have very little debt maturing over the next two years), EBITDA margins hitting their second-highest level on record, and leverage ratios that have declined for five sequential quarters. As a result, default rates remained at historically low levels for both high-yield bonds and loans.
Looking ahead, we continue to prefer floating-rate loans over high-yield bonds. We acknowledge that low global rates, accommodative monetary policies, and healthy overall fundamentals could keep bond spreads historically narrow, at least in the near term. However, we think that higher interest rates in general, but particularly short-term rates, will result in a headwind for high-yield bonds but will benefit loans, as their coupons are tied to short-term rates. One factor that caused loans to lag high-yield bonds in 2017 was the meaningful amount of loans being called by issuers to reprice/refinance them at a lower cost. This resulted in lower coupons for investors, which offset some of the benefit from higher three-month LIBOR rates. We expect this repricing trend to abate and loan coupons to increase, narrowing the gap relative to bonds. However, we also see limited room for loan price appreciation. Our 2018 base case return estimate for floating-rate loans is in the range of 4.5%. When considering a meaningfully bearish outcome (e.g., equities decline 25%), we think floating-rate loans could be flat to mildly negative over a 12-month period.
It was an interesting year for trend-following managed futures funds. Most funds experienced a difficult first half of the year, culminating in a very negative June. Fixed-income was the real story; after the European Central Bank and other central banks came out with hawkish statements in late June, yields spiked globally and long trends in bonds got crushed. That changed year-to-date performance from basically flat to significantly negative. The second half of the year was significantly better, with the SG Trend Index benchmark clawing its way back into the black. Net long exposure in equities globally has been a positive contributor throughout the year, with mixed performance from other asset classes (commodities, currencies, and bonds/rates).
There are no “fundamentals” to guide expected returns in trend following over a given period, so predicting returns is even more of a fool’s errand than it is in asset classes that are (theoretically, at least) driven by earnings, cash flows, and starting yields. There have been questions about the performance prospects in a flattening yield curve environment. According to data assembled by Campbell & Company, there is essentially no correlation between the steepness of the U.S. yield curve and subsequent 12-month forward returns on the Barclay CTA Index, going back to 1980. The one prediction we can again confidently make, however, is that the greatest diversification benefits from a managed futures allocation are highly likely to emerge during an extended equity bear market. We don’t think we (or anyone else) can consistently predict the timing of bear markets, so maintaining a strategic allocation to diversifying alternative strategies that have long-term positive expected returns makes sense, even more so given the elevated valuations in almost all traditional asset classes and U.S. stocks in particular.
Arbitrage strategies generally experienced positive conditions last year. The merger-arbitrage universe experienced relatively few deal failures. That said, there have been damaging, high-profile developments in a few situations, most recently in the Time Warner-AT&T deal, which is being challenged in court by the Department of Justice. Spreads have been fairly range bound most of the year, but they widened in the third quarter on fears of protectionism hampering cross-border transactions. Announced deal activity is below its peak level of two years ago but remains above the long-term average. With borrowing costs still low, but short rates significantly above zero, conditions are supportive for reasonable expected returns. Convertible arbitrage has benefited from a general uptrend in prices, supported by strong equity market returns and largely benign credit conditions. Net issuance turned positive in 2017, which bodes well for the opportunity set going forward. Additional new issuance may be spurred by further increases in interest rates, as corporations turn to convertible bonds to reduce cash borrowing costs relative to issuing straight debt. Funds that invest in SPACs saw an added boost last year given the significant issuance and strong market performance of a number of deals.
In terms of the near-term macro outlook, the consensus view is that there is little risk of a U.S. or global economic recession in 2018. The market expects the in-sync global growth that we saw in 2017 to continue. Most of the investors and strategists we respect seem to share this view. And without a recession, a bear market in stocks is unlikely—although a run-of-the-mill 5% to 10% “correction” can happen at any time (the recent tranquil market notwithstanding!) and an unexpected macro/geopolitical shock could cause a larger drop.
Given this sanguine near-term macro backdrop, one might ask why we aren’t more heavily invested in U.S. stocks or stocks in general. The simplest answer is that we have little confidence in our (or anyone’s) ability to forecast the timing/onset of recessions. We also think most investors are overconfident in their ability to do so, believing they can successfully time the market and are able to “get out” before everyone else and before prices take a meaningful hit. Of course, that is logically impossible (just as everyone can’t be an above-average driver). Investors may also be underestimating the potential for a surprise negative shock, leading to a stampede for the exits.
Moreover, when an outlook becomes the strong consensus view, one should assume it is already discounted to a meaningful degree in current market prices. This is where our investment discipline comes in, because we do think we have expertise and an edge in assessing fundamentals, valuations, expected returns, and risks across different asset classes and over longer-term periods. Current market prices are a key input into that assessment: high valuations (high prices relative to underlying fundamentals) imply lower future returns. When the market is excessively bullish or optimistic, our analysis should reflect that in lower/low expected returns. That is where we find ourselves today with the U.S. stock market.
We fully expect to get the opportunity to add back to our U.S. stock exposure at prices that imply (much) better expected returns across our scenarios. One obvious trigger for that would be a meaningful drop in the market (i.e., a bear market). We believe one is likely sometime in the next five years (our tactical time horizon). Again, we can’t confidently predict exactly when, but one reasonable scenario would be triggered by ongoing Fed monetary policy tightening, which is already underway, followed by other central banks, such as the European Central Bank, Bank of Japan, and/or the People’s Bank of China. Economic and market history would argue for that eventual outcome.
This market cycle has the added “feature” of an unprecedented unwinding of unprecedented monetary policies put in place after the financial crisis: trillions in central bank asset purchases and negative interest rates that have yet to be normalized. Given the boost to asset prices from these policies, it is reasonable to expect some negative impact as they stop and then reverse course (i.e., “quantitative tightening”). So far so good, with the Fed’s gradualist and well-telegraphed steps. But there’s a lot of road to go. There will also be a new Fed chair and several new voting FOMC members in 2018, creating more potential for a market surprise. PIMCO put it this way in a recent commentary: “With markets having become used to and addicted to easy monetary policies [and only expecting two Fed rate hikes in 2018], this turn in the tide of global central bank policies poses significant risks to markets and economies, particularly as the new and still-evolving Fed leadership is untested.” At the very least, it raises the potential for increased market volatility (although, admittedly, that’s not saying much given how low it’s recently been).
On the other hand (there’s always an “other hand”), should U.S. stocks continue their very strong upward trajectory, we will further reduce our exposure to them. As noted below, there are multiple variables and moving parts that go into our determination of portfolio allocations. But, all else equal, one key trigger for U.S. stocks would be if even under our optimistic/bullish scenario, we are seeing low-single-digit five-year expected annualized returns. Currently, our optimistic scenario shows expected annualized returns of around 7%–8%.
Our portfolio construction and management are based on several factors:
Currently, our base case scenario implies very low expected returns for both the U.S. stock and core bond market indexes looking out the next five years. As such, in our tactical active models we remain defensively positioned in U.S. stocks and tilted toward European and emerging-market stocks, where, as noted above, our return expectations are materially higher than for U.S. stocks.
We believe the range of outcomes covered across our bear and optimistic scenarios adequately captures the recent U.S. corporate tax cut’s potential benefits for U.S. equities, and, therefore, we are not contemplating any portfolio-level changes. If we ultimately conclude that U.S. corporations’ normalized (i.e., longer-term) earnings have bumped up a step, we’d likely increase our five-year earnings number slightly across our base case and optimistic scenarios, and maybe even in our bear case. The magnitude of such a shift would not be material (e.g., a 10% increase in our normalized-earnings estimate) and would likely not lead us to increase our exposure to U.S. stocks because we think U.S. stocks are quite overvalued and our return expectations from them are sufficiently low.
In terms of international markets, we were heartened to see our investment thesis of a European earnings rebound coming through strongly last year. However, we don’t believe our portfolios have been fully rewarded for this yet given European stocks lagged the U.S. market in local-currency terms. The longer actual European corporate earnings growth is not reflected in stock prices, the cheaper European equity valuations become on metrics such as trailing price-to-earnings, price-to-cash flow, etc., which most investors tend to look at, as opposed to our normalized forward-looking framework. Ultimately, we expect there to be a hand-off in terms of drivers of European stock market outperformance versus U.S. stocks—from earnings growth to valuations. As such, we’re maintaining our tactical overweight to Europe. We also remain comfortable overweighting emerging-market stocks slightly relative to U.S. stocks, although valuations are less compelling than they were a year ago.
In light of the particularly low expected returns for core bonds, along with the risk of rising interest rates (which correspond to lower core bond prices), we have meaningful exposure to flexible, actively managed bond funds; they account for roughly half of our total fixed-income exposure in our balanced portfolios. While our base case five-year expected returns for these funds are several percentage points above that of core bonds, they do carry more credit risk than core bonds. Therefore, we assume they have more downside in the event of a recession or other macro shock (providing it’s not an inflationary shock, which would be bad for core bonds). We factor this into our overall portfolio risk exposure, and it’s why we still maintain a meaningful allocation to core bonds in our more conservative risk-sensitive portfolios. Despite their poor longer-term return outlook, we expect core bonds to perform well in a traditional bear market/recession.
Lastly, most of our portfolios have full allocations to alternative strategies: liquid alternatives (such as managed futures and arbitrage funds). These strategies are “alternative” in that they have different drivers of return and risk than traditional stock and bond investments. We believe they have superior risk-adjusted return potential relative to the mix of stocks and bonds from which they are funded. Their relatively low correlation (or no correlation) to other investments in our portfolio is a valuable additional benefit.
The year 2017 was a very good one for most financial markets and particularly global stocks. But there was one small corner of the investment world that did a bit better than stocks: bitcoin gained 1,518%. We don’t own bitcoin (or any other crypto currency) in our portfolios. It doesn’t fit within our investment discipline or circle of competence. It’s a speculative game we simply don’t need to play to achieve our clients’ investment objectives.
However, the exponential rise of bitcoin and the questions, emotions, and behaviors it triggers in many investors offers us an opportunity to restate some of the core principles and practices that underlie our investment approach. First, the path to long-term investment success is simple to describe but not easy to achieve. (As Charlie Munger put it in his characteristically blunt way: “It’s not supposed to be easy. Anyone who finds it easy is stupid.”) Successful long-term investors are disciplined and patient. They are honest with themselves about what they know, what they don’t know, and what they can’t know (the unknowable). In making investment decisions they focus both on what’s knowable (within a reasonable degree of likelihood) and what’s important (in terms of portfolio impact). Yet, they are also cognizant of and try to manage their exposure to risks that are important, but unknowable or unpredictable (e.g., geopolitical shocks).
Successful investors have the humility to know not every decision will turn out to be right and that simply having conviction about something doesn’t mean it will actually happen. Their investment process is well defined and repeatable. It requires having a sound basis for each decision, so that if investors consistently implement the process over time they should be right more than wrong and the gains from their winners will more than outweigh their losers.
Successful investors are willing to challenge their own ideas and admit when they are wrong—whether due to new information and changing circumstances, or an error in their original thesis. They keep their eyes on their long-term financial objectives and on the underlying fundamentals that ultimately drive investment returns. They don’t get emotionally caught up in the day-to-day noise of the financial news channels or the zigs and zags of the markets. But when the short-term zigs and zags get meaningfully out of whack with the longer-term fundamentals, they use that price volatility to their advantage—buying lower and selling higher. If the market isn’t presenting them with compelling investment opportunities, they are content to hold their current positions; in other words, they don’t confuse activity with progress. (Munger calls it “sit on your ass investing.”)
Successful investors are self-aware about their own risk tolerance and investment temperament. As such, they are invested in a portfolio consistent with those personal attributes, managed by an investment manager aligned with them as well. This enables them to remain disciplined and patient—during the good times as well as the inevitable challenging periods—on the road to achieving their long-term success.
Thank you for your continued confidence and trust. All of us at Litman Gregory wish you and yours a very happy, healthy, peaceful, and prosperous New Year.
—Litman Gregory Research Team (1/5/18)
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