Louis P. Abel, CFA, CAIA
Chief Investment Officer, First Foundation Advisors – Member, Investment Committee
The third quarter was a good one for investors, with nearly all financial markets posting solidly positive returns. Year-to-date, stocks, bonds, and real estate are all up nicely. The financial markets have shown remarkable resiliency, having bounced back from one worrisome issue after another. Whether it was the slowdown in China, the devaluation of the yuan, plummeting oil prices, concerns about an overly- aggressive Fed, or the surprise Brexit vote, the markets have recovered from a series of sharp sell-offs and gone on to post solid – and in some cases even strong – returns so far this year.
After a period of significant volatility late last year and earlier this year, we are at a point where there is very little volatility – at least until just recently. And yet, there are still countless issues of concern out there, including ongoing worries about the global economy, whether oil prices have stabilized and will continue to recover, how hawkish or dovish the Fed will be, what the long-term implications of negative interest rates are, worries about the European banks, concern over the rise of populist movements in both the U.S. and abroad, continued uncertainty over the U.S. presidential election (and other elections around the world), and concern about whether massive monetary easing by global central banks may have created asset bubbles.
With so many potential risks and uncertainties swirling around us, and yet such solid performance by nearly every asset class so far this year – with remarkably little volatility until just recently – we liken this situation to being in the eye of a hurricane. Like the pilots who fly directly into hurricanes to assess their strength, coping with severe turbulence before reaching the serenity of the eye – but knowing they have to eventually head right back through the turbulence again – here we sit, knowing that the calmness of the financial markets we are currently experiencing is likely transitory. We expect financial market turbulence to resume at some point. The hurricane analogy is not a perfect one, of course. Hurricanes can result in the loss of life and leave a path of major destruction in their wake, as was the case with Hurricane Matthew, which tragically left 1,000 people dead in Haiti and 44 people dead in the U.S. By comparison, financial market volatility is nowhere near as serious, but it can be trying to investors nonetheless.
In this edition of our Quarterly Update and Outlook, we explore why the financial markets have been so resilient, why we might be about to face a renewed period of volatility as we move from the eye of the hurricane back through the turbulence of the storm, and how we are positioning our clients’ portfolios for the possibility of such an environment. In particular, we will explore four key issues facing investors: Brexit, the U.S. presidential election, global central bank policy, and some key market distortions. But first, let’s do a brief review of the quarter.
The Third Quarter in Review
U.S. Large Cap Stocks
U.S. large cap stocks, as measured by the Vanguard 500 Index, rose by nearly 4% during a quarter that witnessed populism gain ground in Europe, the installation of a new government in the United Kingdom after the Brexit vote, an unsuccessful coup attempt in Turkey, and a U.S. presidential campaign that continued to unfold as the most unconventional in recent memory. Markets handled these uncertainties with aplomb; stock market volatility remained at extremely low levels through July and August. However, September seemed to usher in a slight change in tone. During the month, stock investors registered some anxiety, with stocks rising and falling in response to any oil-related headlines and any suggestion of interest rate hikes by the Fed. This may be an early signal that we are beginning to leave the eye of the hurricane.
During the quarter we witnessed a strong rotation into and out of sectors perceived to be “safe,” such as utilities, telecoms, and consumer staples. Financials continue to be pressured by low interest rates, a challenging regulatory environment, and negative investor sentiment – headlines surrounding Deutsche Bank and Wells Fargo have not helped. Overall, we continue to view the U.S. stock market as richly valued. However, with few viable alternatives, we think U.S. stocks can continue to post modestly positive returns over time. With no recession in sight, and a pickup in earnings growth, stocks can make further progress. But, with relatively high valuations and the possibility of global macro events causing a renewed bout of volatility, we remain cautious. We are focused on high-quality large cap stocks, but have avoided certain sectors – such as utilities and telecoms, which although may seem safe on the surface, we think are actually risky due to their high valuations.
Small Cap Stocks
Although they have done well this year, we continue to believe that small cap stocks in general are overvalued and thus we have largely avoided them. We remain on the lookout for opportunities to add exposure to this segment over time as valuations become more attractive.
International stocks haven’t kept pace with U.S. stocks so far this year. The MSCI World Ex-U.S.A. Index has gained 3.6%, less than half the year-to-date gain of 7.7% for the Vanguard 500 Index. However, our three international fund managers have all outperformed their benchmarks on a year-to-date basis.
European stocks outperformed U.S. stocks after the Brexit low and for the third quarter. But they still trail U.S. stocks for the year (both in dollar-denominated and local currency terms). We continue to believe European stocks are cheap relative to U.S. stocks, based on normalized earnings power, and offer attractive relative returns in our base-case scenario. While U.S. stocks are no longer over-earning as they were over the past few years, European stocks continue to significantly under-earn compared with their normalized earnings power. There are a number of catalysts that could result in an earnings recovery, most notably the European Central Bank’s continued efforts to keep borrowing costs down as a way to stimulate lending and investment spending. The ECB’s policies may also spur financial engineering, with companies using the proceeds from issuing debt to buy back their stock and boost earnings per share, as we have seen occur in the U.S. Either outcome would bode well for future profits and stock prices.
Although our base-case scenario calls for an earnings recovery in Europe, we remain cognizant of heightened risks. Brexit, along with the rise of many right-wing political parties, serves as a wake-up call to European authorities that they need to generate better growth in the economic bloc soon. As a result, they may become more open to loosening the fiscal purse strings to assist the ECB’s reflation efforts. It’s possible nothing much gets done on the fiscal stimulus front until major elections are completed over the next year. And the elections themselves represent uncertainty and, hence, risk. The problems faced by the European banks, especially Deutsche Bank and the Italian banks, represent further risks. In light of these developments, we will continue to reevaluate our position over time.
Emerging Market Stocks
Emerging market stock returns have been particularly strong, building upon their sharp rebound and outperformance versus other markets that began in late January. Emerging market stocks are now up 17% for the year (versus 7.7% for the Vanguard 500) and up 32% from their January low (versus 17% for the Vanguard 500). We exited emerging market stocks before the sharp downturn last year, which proved to be a good move, but we unfortunately missed the recovery so far this year. We are currently reassessing our scenarios for emerging market stocks to determine whether this is a sustainable recovery. As we build confidence that this is a sustainable recovery, we will look to once more add exposure to emerging market stocks, opportunistically over time.
The political and economic risks facing emerging markets, including the very rapid growth of debt in China in particular, are still a concern. These risks carry meaningful weight in our scenario analysis and overall assessment of emerging market stocks. In light of these issues, it makes sense to take a cautious approach.
Yields on U.S. 10-year Treasury bonds ended the quarter at 1.56%, up from 1.44% as of July 1, as investors braced for an interest rate hike by the Federal Reserve that didn’t come. However, those looking only at starting and ending levels would have missed the big mid-September move. Yields briefly backed up to 1.75% on worries over central bank policies. The Fed’s decision not to raise interest rates in September soothed markets, but a December hike is still on the table. Financial markets remain keenly attuned to this possibility. For now, flows into core bonds are strong, the buyer base is broad, and central banks across the developed world remain hesitant to either spook the markets or hinder a still-fragile economic recovery by doing more than just paying lip service to a move away from their easy monetary policies. Core bonds, as measured by the Vanguard Total Bond Index, gained just 0.4% for the quarter.
We continue to believe that many core bond categories, such as U.S. Treasury Bonds and Investment Grade Corporate Bonds, remain unattractive given their high prices and corresponding low yields. Instead, we have favored other bond categories, such as mortgage-backed securities, including residential mortgage-backed securities and commercial mortgage-backed securities, which we think offer a better risk-reward trade-off in today’s low interest rate environment. We have also favored credit-oriented bond categories such as floating rate notes, which have adjustable interest rates, thereby offering some protection in a rising-rate environment, and high yield bonds, which have recovered sharply after last year’s decline.
High Yield Bonds
When high yield bonds experienced a decline last year in the wake of plummeting oil prices, we took the position that with a recession unlikely, the decline was temporary; we maintained our position, expecting a recovery. That proved to be the case. As oil prices stabilized and it became apparent to investors that a recession was not in the cards (and China avoided a hard landing and a further sharp currency devaluation), high yield bonds recovered, just as we had expected. The BofA Merrill Lynch U.S. High Yield Index, for example, gained 5.5% for the quarter. It has risen 15.3% year-to-date, making it one of the best-performing bond indices. At this point, with such a strong recovery this year, we think high yield bonds are beginning to become expensive. However, with few alternatives to achieve meaningful yield in today’s low interest rate environment, high yield bonds could continue to produce good relative returns. Nevertheless, we think some caution is warranted, and thus we are starting to reduce our exposure to the category.
Tax-Exempt Bonds declined slightly during the quarter, as measured by the Vanguard Intermediate-Term Tax-Exempt Bond Fund, which was down 0.3%. However, the fund remains up 3.5% year-to-date. Municipal bonds remain a staple of our fixed income portfolios and the core fixed income component of our balanced portfolios for taxable accounts given their tax-exempt status, generally high quality, low volatility, and low historical default rate. However, in such a low interest rate environment, they don’t offer particularly attractive yields at the moment, and thus we have chosen to remain underweight in this category. As interest rates rise – which we think will occur gradually over time – and municipal bonds become more attractive, we expect to increase our exposure to this area.
Real Estate Investment Trusts (REITs), as measured by the Vanguard REIT Index Fund, declined 1.5% for the quarter as investors grappled with the possibility of the Fed raising interest rates. However, REITs have posted a strong gain of 11.7% year-to-date. We have exposure to only three publicly-traded REITs, which we think are undervalued for company-specific reasons. All three have outperformed the REIT Index significantly this year. This has been one of the best-performing asset classes in our portfolio this year. As these positions have risen in value, we are looking to reduce our exposure. We have trimmed one of the positions already, and are looking to reduce and exit our other positions over time as they hit our price targets. Overall, we think REITs are expensive, and we have limited our exposure to only these selected positions.
Let’s turn now to some of the issues that we think are central to the outlook for investment markets and that could cause a renewed bout of turbulence going forward.
The Brexit Vote
In the run-up to the vote, polls suggested the outcome could be close but would most likely result in the United Kingdom remaining in the European Union. Financial markets were clearly surprised by the opposite result. Global stocks sold off in the two days following the vote. The Vanguard 500 dropped 5.3%, emerging market stocks fell 6.7%, and European stocks plunged 13.6%. In contrast, the core bond index gained more than 1%.
In the vote’s immediate aftermath, and after careful consideration, we decided not to make any changes to our portfolios. We were actively inactive. We believed the vote increased the nearer-term risk of recession in the U.K. and Europe, and potentially globally. We also acknowledged the potential for increased shorter-term downside risk in our tactical position in European stocks in particular. But, in our assessment, Brexit did not materially impact our longer-term (five-year) outlook and assumptions for European corporate earnings growth and valuations. Therefore, we held our positions at a time when many investors were fleeing to traditional safe-haven assets. That decision proved beneficial for our portfolios’ performances in the third quarter, as European stocks rebounded 14% from their Brexit low while core bonds gained just 0.5% over the same period.
We continue to monitor the Brexit process. We remain cognizant that as the Brexit process continues to unfold, it might cause some renewed financial market volatility. Witness the recent “flash crash” of the British pound as one such example. Again, this may be an early sign that we are moving out of the eye of the hurricane.
The U.S. Presidential Election
Each time a U.S. presidential election approaches, we get questions from clients about our view and the impact on our investment outlook and portfolio positioning. We are being asked about the election even more than usual this year. Here is a quick review of how we think about elections in general within the context of our overall investment approach.
While the specific circumstances of any given election are unique, our approach remains essentially the same. First, to the extent a particular result is widely expected, current asset prices will reflect the market consensus. In order for us to believe there is a tactical investment opportunity stemming from a particular election outcome, we would need to believe (1) we have an edge in assessing the outcome more accurately than the market does and (2) our view is materially different from the consensus.
There is too much uncertainty and there are too many non-election variables that impact investment outcomes for us to likely see any value in positioning our portfolio for a particular result. Even if we had a higher degree of certainty as to both the outcome and the policies that would be implemented, the ultimate economic effects and outcomes would still be highly uncertain. Macroeconomics is far from a hard science, and there are a multitude of other factors and variables that impact economic and financial market outcomes beyond U.S. fiscal and monetary policy.
In sum, (1) we are not willing to bet on a particular election result relative to the odds already embedded in current market prices, (2) there is a wide range of potential macro outcomes around either result, and (3) there are a multitude of other variables and factors unrelated to the election results and outside of U.S. politicians’ control that are likely to have at least as meaningful an impact on the course of the global economy and financial markets over the next five years.
Instead of betting on election results, we stick to our longer-term analytical framework, in which we consider and weigh multiple macro scenarios, and assess the potential risks and returns for numerous asset classes and investments in each scenario. As investors, we expect to experience market price volatility and shorter-term downside risk at times – the degree of which will depend on the client’s investment objective, risk tolerance, and the corresponding risk exposure of the portfolio. Stock market history makes this clear. Volatility comes with the territory in stocks and other risk assets.
With that said, our research into the impact of the presidential election on the stock market has resulted in some interesting conclusions. Presidential election years can be among the most volatile for the stock market. Since 1900, the S&P 500 has fallen on average 1.2% in year eight of an administration. That clearly doesn’t apply to this year, with the stock market up nearly 8%. But we are bracing for potential volatility surrounding the election nonetheless. The market appears to be betting that Hillary Clinton will be victorious in November. Clinton is viewed by investors as the candidate of continuity (for better or worse, depending on your political perspective), and thus with Clinton, investors have less uncertainty with regard to future policies. What the market dislikes most is uncertainty. A Trump victory, should it occur, would likely come as a surprise and thus could cause a pullback in financial markets as investors assess the uncertainty associated with Trump. But we think such a pullback would likely be temporary.
The average compound annual growth rate of the S&P 500 since 1945 has been better under Democrat administrations, at 9.7%, than under Republican administrations, at 6.7%. However, the highest growth rate of 18.6% occurred under a Republican administration (Gerald Ford). The second-highest growth rate of 14.3% occurred under Bill Clinton. We conclude from this that there are too many factors, other than simply the party in the White House, that influence the growth rate of the stock market.
Which party prevails in an election does seem to impact individual sectors of the economy. Historically, Democratic administrations have tended to be good for health care, education, and alternative energy (although, in this case, a Clinton presidency could pose a serious challenge for the health care industry). Republican administrations have tended to be good for energy, financials, and defense. However, whichever party is in the White House, whether the president is able to accomplish his or her agenda will depend to a large extent on whether their party also controls Congress – and, right now, that question is up in the air. In any case, at the moment, we aren’t making any changes to our portfolio positioning based on the presidential election.
Central Bank Policy and Market Distortions
Global central banks have been a driver of significant market distortion in recent years. Along with the U.S. presidential election, their policies, particularly the Fed’s, remain a key near-term wild card for financial markets. At its last meeting on September 21, the Fed remained on hold but signaled it is on course to raise the federal funds rate later this year, likely at the December meeting. The Fed also lowered its longer-term forecast of interest rate hikes yet again, bringing it in line with the financial markets assessment. It now forecasts just two rate hikes in 2017, down from the three hikes forecast at the June meeting and the four hikes forecast at the March meeting. Bond and stock markets responded positively.
The distorting effects of these extraordinary central bank policies can be seen as investors are effectively being forced out of low-risk, but extremely low-yielding, core bonds and into riskier assets that offer higher current yields (though still quite low compared to historical levels). For instance, the traditionally “defensive” yield-oriented sectors of the stock market, such as utilities, telecoms, consumer staples, and REITs, are areas where many investors appear to be “reaching for yield” as well as perceived safety, but where we and many of our active fund managers actually see significant risk. As bond yields have been depressed, money has flooded into these sectors and related “low volatility” Exchange Traded Funds (ETFs). As a result, their valuations have soared. Strong short-term performance has attracted more money, perpetuating the cycle. Ironically, the perception that these are low-risk investments and appropriate “bondlike” substitutes for true fixed-income exposure has made them much riskier due to their high valuations and what looks a lot like speculative short-term money flows rushing into these stocks and ETFs.
But these trades can unwind quickly and the momentum can work in reverse. Market history is replete with examples of investors being burned by ignoring valuation, reaching for yield, and chasing recent performance. Because investors view these sectors as bond substitutes and a play on continued depressed bond yields, one clear catalyst for a reversal would be a rise in rates.
The performance of these sectors in August and early September show they may be riskier than they seem to be. While the overall stock market was flat in August, the utilities and telecoms sectors fell roughly 6% and low-volatility ETFs lost around 2%. Then, on September 9, when a previously dovish Fed governor shocked the markets by indicating he was inclined to raise rates at the next Federal Open Market Committee (FOMC) meeting, the Vanguard 500 dropped 2.5%, while utilities and REITs fell nearly 4%. Low-volatility stocks were anything but; they fell 3%. Core bonds dropped about 0.5% on the day.
It certainly seems that these “defensive” plays are vulnerable to any hint of interest rate increases (let alone actual rate hikes) and are potentially higher risk right now than even the broad stock market, not to mention bonds. As a result, our U.S. large cap equity portfolio management team and many of our active fund managers are avoiding these currently popular areas of the market.
While it is not clear that low-volatility and high-dividend-yield stocks (e.g., utilities and telecoms) are truly going to be lower risk going forward (e.g., if or when interest rates rise), to the extent the “buy ‘bondlike’ and high-dividend-yield stocks” theme remains in play, it will likely be a headwind for our actively managed U.S. stock portfolio and mutual funds overall. But when that trend reverses, our managers and portfolios should benefit. We saw that happen in the third quarter, as the yield on the 10-year Treasury bottomed at 1.37% on July 5 and closed the quarter at 1.56%.
While ultralow interest rates are supportive of financial asset prices (many would say distortive as well), we continue to view them as unsustainable and inconsistent with longer-term economic growth. Trying to anticipate the markets’ reactions to each Fed governor utterance or FOMC policy statement is a short-term guessing game that we simply won’t play with our investment portfolios.
Putting It All Together
Our decision-making is anchored in our long-term fundamental and valuation-driven approach. Given our approach, we and our clients need to be psychologically and financially prepared for periods of market stress and able to ride them out on the path to achieving our long-term investment and financial goals. Investors who can’t stomach a given level of volatility or downside risk should reallocate into a portfolio with a lower targeted risk level. And the time to do that is before a period of volatility strikes, not during or right after it, when they would be selling their riskier assets at lower prices and buying more defensive or safer assets at higher prices.
We structure our balanced portfolios across a well-diversified mix of investments, each with a distinct role to play within the overall portfolio (e.g., return generation, risk reduction, and hybrid/alternative). We expect our portfolios to be resilient and to perform at least reasonably well across a wide range of outcomes, balancing our objective of long-term capital appreciation with shorter-term downside risk management appropriate for each client’s risk tolerance.
Leaving the Eye of the Hurricane
While July and August were unusually calm months for the markets, volatility picked up in early September. This may be an indication that we are moving out of the “eye of the hurricane” and back into a period of financial market turbulence. There are many risks and uncertainties – from the Brexit process to the U.S. presidential election to an increased likelihood of rate hikes – that could cause a renewed bout of volatility. We are prepared for such a shift. In addition to our tactical positioning and portfolio tilts, based on our valuation framework, we remain diversified across multiple asset classes and strategies with diverse risk exposures and return drivers. This diversification should smooth out the overall portfolio ride over time. Finally, we remain alert to new risks that need to be managed, as well as new investment opportunities that will undoubtedly unfold.
As always, we appreciate your confidence and trust in us, and we thank you for your business. If you have any questions, we invite you to please contact your First Foundation Wealth Advisor.
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