Louis P. Abel, CFA, CAIA
Chief Investment Officer, First Foundation – Member, Investment Committee
It was a tale of two halves in the first quarter of the year for global financial markets. Stock markets plunged early on, falling 10% to 15% or more – in some cases nearly entering bear market territory – but then sharply reversed course, staging a furious rally into quarter-end. Emerging-markets stocks led the charge, finishing ahead 5.9% for the quarter after being down 10.9% in the first six weeks of the year. Largecap U.S. stocks also finished in the black, up 1.3%, though domestic small-cap stocks trailed, down 1.5%. Developed international stocks also failed to keep pace in the rally, ending with a 1.9% loss for the quarter. And while the 10-year Treasury yield rose some 15 basis points from its mid-quarter low, it was still 49basis points below where it started in 2016. Core bonds gained 3.1% in the quarter.
Broadly speaking, the stock market decline in the first half of the quarter centered on many of the same themes that caused the market sell-off in August 2015, including
- ongoing fears of a hard landing in the Chinese economy, possibly accompanied by a sharp and sudden devaluation of the renminbi;
- a continuing plunge in oil prices to below $30 per barrel, using the WTI benchmark, from $40 at the start of the year;
- some weaker-than-expected U.S. economic data and growing fears of a global recession, if not a U.S. recession;
- aloss of investor confidence in the ability of global central banks to stimulate real economic growth; and
- increased concern that current monetary policies (e.g., negative interest rates in Japan and Europe) are now causing more harm than good.
On the last point, the Bank of Japan (BOJ) surprised markets by joining the negative interest rate policy (NIRP)club at the end of January. The BOJ pushed its policy rate down tonegative 0.1%, joining the European Central Bank (ECB) in negative territory. (Swiss, Swedish, and Danish central banks currently have policy rates ranging from negative 0.5% to negative 0.75%.)However, rather than having the intended effect of weakening the yen, the BOJ move pushed the yen up, which helped trigger another leg down in global stocks and other risk assets.
Then, beginning on February 12, everything changed. Oil prices spiked higher. Stock markets started moving up. China’s renminbi stabilized, then started appreciating a bit. High-yield bond prices moved higher and credit spreads fell. The 10-year Treasury yield rose. These broad market trends continued through March, as shown in the table below.
As is often the case, there was no single obvious catalyst for the turnaround,other thanspeculation that major oil producers might be ready to cooperate to cut oil output. At the same time, the head of the Federal Reserve Bank of New York dismissed the idea that the Fed would need to adopt NIRP, citing the U.S. economy’s strength and momentum. Soon after, the head of the Chinese central bank said the bank saw no basis for further renminbi depreciation.
The market rally continued in March on the back of better economic news in the U.S. Markets also reacted positively to dovish ECB and Fed actions during the month, as well as additional monetary and fiscal stimuli in China. On March 10, the ECB went deeper into negative rates, cutting its policy rate to negative 0.4% – its third reduction since adopting NIRP in June 2014. The ECB also expandedquantitative easing by increasing its bond purchases by €20 billion per month (to €80 billion) and including investment-grade non-bank corporates in the program, thereby boosting prices for such bonds. Finally, it initiated a new program of targeted long-term refinancing operations, where it will lend money at zero or negative interest rates to banks that increase their lending to the private sector. This should mitigate some of NIRP’s negative effects on bank profits and address related investor concerns that have driven European bank stock prices sharply lower this year.
In the U.S., the Federal Open Market Committee (FOMC) held its mid-March meeting and did not raise the federal funds rate, noting that “global economic and financial developments continue to pose risks.” It also highlighted solid U.S. economic fundamentals. Importantly, the FOMC lowered its projection of the number of rate hikes for the rest of the year (from four to two), while also signaling both a slower pace and a lower trajectory of rate hikes over the longer term than it had projected in December. This was broadly consistent with the market’s views, as reflected in Treasury futures markets, which had already factored in a high likelihood of just one or two hikes this year.
Financial markets responded positively to the Fed announcement, with stocks and oil/commodities continuing to rally and the dollar falling. After peaking in late January on a rally driven in part by the anticipation of higher U.S. rates, the dollar ended the quarter down more than 4%.
As discussed in our Year-End Review and Outlook for 2016, and our Market Action Update issued in early January, we felt investor concerns over what we call the “Big Three” – oil, China, and the Fed – were overblown. We made the case that we would avoid a bear market and would eventually see a recovery. That proved to be the case, with investors seeming to breathea collective sigh of relief that their worst fears did not materialize.
Looking ahead, however, with consumer price inflation and market inflation expectations rising somewhat, stock and credit markets and oil prices rebounding, and the dollar no longer appreciating,it’s possible the Fed may turn more hawkish again. In fact, just a few days after the March announcement, several Fed governorssuggested the Fed could raise rates at the April meeting. Such a move could reverse these recent reflationary trends.
More generally, we’d note that global monetary policy is moving deeper into uncharted and historically unprecedentedterritory, bringing with it unknown and unintended consequences. This continues to be akey uncertainty and risk to consider as we construct and manage investment portfolios for a range of potential outcomes. How and when will these current extreme monetary policies be “normalized”? How willtheyimpact the global economy and financial markets? No one knows. As Dorothy in the “Wizard of Oz”famously said, “We’re not in Kansas anymore.”
Our investment outlook – both in terms of potential return drivers and risks – has not materially changed over the past quarter. However, in the context of the market’s recent gyrations, we’d like to highlight reasons for optimism that recent performance trends may be sustained for a while, which should benefit our portfolios. In short, the post-financial crisis period has been dominated by a few very strong market trends. It is important to view these accurately – as cycles that will eventually turn and may already be in the process of turning. Our next section discusses the concept of cycles, as well as several very specific cycles we’ve experienced in recent years.
Cycles of Investor Behavior – The Investor Pendulum
We often talk about cycles when discussing our investment philosophy and tactical asset allocation approach. This is because the history of financial markets and economies is composed of a series of multiyear cycles that generally occur within a verylong-term (secular) growth trend. We believe these cyclesare largely driven by group or herd behavior. And since we don’t think human behavior is going to evolve much over the next few decades, we expect marketsto continue to behave cyclically.
The existence of market cycles creates significant risks for investors who ignore them – e.g., the “this time is different” syndrome – and great opportunities for disciplined long-term investors. But while “this time”in fact is rarely different when it comes to investing, economic history and market cycles do not repeat exactly in terms of timing, duration, or magnitude.
Howard Marks, co-founder of the hugely successful investment firm Oaktree Capital and the author of many insightful investment memos over the past 25 years, often emphasizes the importance of understanding cycles. He uses the metaphor of a pendulum to describe market behavior, as summarized in the following excerpt from his 2011 book, The Most Important Thing.
Investment markets follow a pendulum-like swing:
- between euphoria and depression [greed and fear],
- between celebrating positive events and obsessing over negatives, and thus
- between overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world.
Marks notes that this pricing oscillation is similar to the up-and-down fluctuation of economic and market cycles, also pointing out that while the pattern is extremely dependable, one never knows exactly how far the pendulum will swing, how long it will stay at one extreme or another, or what might cause it to reverse.
We acknowledge that it is impossible to consistently and accurately predict whena cycle will turn or when the pendulum will reverse. However, drawing on our longer-term analytical framework, forward-looking assessments grounded in market history, and our disciplined valuation-oriented approach, we believe we can position our portfolios to benefit from the cyclicalswings of the pendulum. This requires having a long-term perspective, the discipline to stick to your process, and consistentexecution over time, especially when the cycle and pendulum are at extremes.
Market Cycles and Portfolio Positioning
In recent years, our portfolios have been positioned for a turn in some market cycles that hasn’t yet occurred. Although we are overweight U.S. stocks relative to our strategic asset allocation targets, we have maintained significant exposure to international developed-market stocks. We are underweight Treasury bonds (and investment-grade bonds) and overweight credit-oriented bonds (including high-yield and distressed debt).While this tactical positioning has impacted our short-term performance, we remain confident the current market cyclewill turn. In fact, at least in some cases, it looks like the turn might already be starting.
U.S. Versus International Stocks
Our portfolios are positioned based on our view that over our five-year tactical investment horizon, U.S. stocks are likely to deliver low single-digit returns, while developed international stocks are poised to do better.This positioning has been a headwind to our recent portfolio performance, since the current cycle of U.S. stock out performance versus foreign stocks ranks as the longest streak for U.S. stocks since 1970.
That said, here are just a few points that illustrate why we believe this cycle will eventually turn in our favor:
U.S. profit margins (and earnings growth) have been coming down, as we expected. But margins are still high relative to history and thus are likely to continue falling as the labor market tightens and wage pressures continue to build. Higher interest rates (and therefore higher corporate borrowing costs) would also be a negative for margins. Current corporate profit margins historically have been negatively correlated with future earnings growth. In other words, the high profit margins we see now historically are associated with low five-year forward earnings growth. If top-line revenue growth remains subpar and profit margins decline, U.S. earnings growth will remain under pressure.
Meanwhile, on the valuation side, we see little room for marketmultiple expansion in the U.S.Using analysts’ consensus forward earnings estimates, the 12-month trailing price-to-earningsratio for the S&P 500 is 24x and the 12-month forward P/E ratio is 18x. These are both relatively high levels. Putting it all together, we expect only modest returns for U.S. stocks.
In contrast, developed international stocks are almost a mirror image of the U.S. market, with the potential for faster earnings growth from current low levels. We also expect international valuation multiples to expand somewhat as earnings improve. An additional supporting factor is that many foreign markets have already suffered a steep decline. Investorsseem to expect a global recession,which we think is unlikely. At the low in February, internationalstocks had discounted a lot of negative news, setting them up for a potential rebound if events turned out to be no worse (let alone better) than expected. This seems to be what’s happened.
Credit-Oriented Bonds Versus Treasury Bonds
Treasury bonds (10-year and 30-year Treasuries), and hence broad market indices such as the Barclays Aggregate Bond Index that includes a heavy component of Treasuries, outperformed credit-oriented bonds (such as high-yield) in 2015. This trend continued in the early part of 2016. Treasuries are benefiting from what we believe are technical factors. In the NIRP world described earlier, even the low yields on U.S. Treasury bonds look attractive to many institutional investors – simply because they are positive – compared withthe negative yields on German bunds and Japanese government bonds. Moreover, as investors became increasingly fearful about the downturn in the energy sector and the implications for energy-related high-yield bonds, they shifted to the relative safety of Treasury bonds, driving prices up and yields down.
For our part, even though the yield on Treasury bonds looks attractive relative to the negative yields on German and Japanese bonds, at a meager 1.76% it is not attractive to us. We prefer credit-oriented bonds – corporate bonds, mortgage backed securities, floating-rate bank loans, high-yield bonds, and distressed debt – all of which carry much more attractive yields. While we acknowledge that defaults in the energy patch will pick up, many non-energy bonds are selling at very attractive prices. In their zeal to get out of credit-oriented bonds and into the relative safety of Treasuries, investors may have thrown the baby out with the bathwater. The pendulum that Howard Marks talks about has swung too far in one direction. Though Treasury bonds have continued to post strong returns so far this year, with the 10-year Treasury up 4.8% and the 30-year Treasury gaining 8.9%, high-yield bonds also have staged a nice recovery from their lows. Since February 12, the high-yield index is up 8.8%. High-yield bonds have now gained 3.5% year-to-date and, in our view, remain attractive with an index average yield of 8.18%. We think we may be seeing the beginning of a sustained recovery in credit-oriented bonds, which bodes well for our portfolio positioning.
Both of these cycles– international stocks versus U.S. stocks and credit-oriented bonds versus Treasury bonds – have been headwinds for investors like us who are valuation-driven and look at things on a longer-term “normalized” basis (i.e., based on reasonable estimates of earnings and valuations through an entire cycle). However, the reversal in the markets starting in February may mark a change from cyclical headwinds to tailwinds for our tactical positioning, as well as for many of our active equity managers. Even if the recent positive market trends reverse course in the short term, we remain confident that our disciplined investment and risk-management process, consistently executed over time, will be successful over thisfull cycle, and through future cycles as well. Patience, discipline,and fortitude remain key to achieving one’s long-term investment goalsand avoiding getting swept away by the pendulum’s unceasing swings.
As always, we appreciate your confidence and trust in us, and we certainly welcome your questions and feedback. Please don’t hesitate to reach out to your advisor.
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