The third quarter was a fairly placid one for investors, though there was major diversity in return profiles depending on what asset class, sector, or country one was invested in. In the U.S., the leading sector was clearly technology stocks, while elsewhere, Japan, Emerging Markets, and European stocks also had positive returns for the quarter. Within fixed income, the broad bond market indices slowed down and posted flat returns, though credit related sectors performed well along with other risk assets. Commodities brought up the rear in the third quarter, as they cooled off from their torrid run in the first half of the year. Summing it up, returns by asset class were mixed, but most investors in globally diversified portfolios enjoyed modest gains during the period.
With the third quarter in the books, the focus now turns to assessing prospects for the fourth quarter and beyond.
Global Economics Misfiring
Economic growth in the U.S. has been frustratingly slow, averaging an anemic 1% during the first half of 2016. While the third quarter showed some early promise of a second half pickup, momentum faded towards the end of the quarter. The good news for now is that the U.S. consumer appears to be in good shape, job growth has held up, and both interest rates and inflation are historically subdued. The bad news is that consumers still appear cautious about spending, and businesses don’t seem confident enough in the future to invest given the lack of top line revenue growth and earnings that remain under pressure.
To add fuel to the fire, world trade continues to struggle in a growth-starved world, and it’s hard to believe that exports will accelerate, considering that our trading partners are facing many of the same challenges as we are here. The bottom line is that we appear to be stuck in an odd zone, where the U.S. economy is grinding forward, but at very low levels of growth.
From a global perspective, the developed world has also been mired in what feels like a perpetual slump. Japan has flat lined, Europe is hovering around 1.5% levels of growth, and while emerging markets have stabilized with commodity prices, many are also levered to exports that are dependent on stagnant growth within the developed world.
One of the recent positive surprises in the global economy has been that the British exit (Brexit) from the European Union has showed few signs of creating the kind of debilitating blow to world growth that some had feared just a quarter or so ago. In the short time since the vote, markets and economic data in the United Kingdom seem to be holding firm on the back of a weaker currency and very little change in business dynamics. This benign outcome clearly could change over coming quarters as Brexit negotiations move ahead, but it doesn’t appear to be on the verge of dragging Europe into another recession at the moment.
Ever since the Great Recession, a low growth backdrop seems more the rule and less the exception. The good news is that low growth doesn’t have to be catastrophic for markets, and can even provide a sweet spot for risk assets when combined with enough liquidity. But the flipside of a very low growth backdrop is that it leaves little margin for error.
Diminishing Returns & Tactical Adjustments
With very little support from global economic trends, markets continue to rely on substantial amounts of global policy stimulus to fill the void. Global monetary policy has had the effect of lifting asset markets to varying degrees since 2009. However, there are a few wrinkles at this juncture that may keep investors on the edge of their seats in coming months.
The first comes from a U.S. monetary policy stance that seems to be leaning towards another increase in interest rates before the end of the year. One reason that the U.S. Federal Reserve (Fed) may raise rates is that the unemployment rate has fallen low enough to convince them that there is little slack left in the labor market after seven years of economic expansion. On the other hand, the inflation picture in the U.S. is much more mixed, with some of the Fed’s preferred measures of inflation still well below the 2% level that would help satisfy their mandate for price stability.
Curiously, at the same time that the Fed is angling towards another marginal increase in short-term interest rates, they have also been downgrading their future assessment of growth and their anticipated ending level for short-term rates during this tightening cycle. Recent forecasts by the Fed seem to acknowledge that there are deep structural problems that exist in the U.S. and many world economies which should keep a lid on potential growth rates globally.
While this outlook appears to be in line with the frail growth conditions that we previously outlined, investors are left to wonder why the same institution that sees structural impediments to growth would be so fixated on raising rates later this year. Some within the Fed may be worried that keeping policy ultra-accommodative at this point will eventually lead to more disruptive policies if they fall behind the curve and inflation takes hold. Others seem to be concerned about managing policy with little to no monetary bullets remaining in the chamber in the event that slow growth slides back into recession. Whatever the reason, the inconsistency in thinking by the Fed is puzzling, and will likely keep investors on guard.
Outside the U.S., policy settings are a bit more in sync, with most countries continuing to keep rates low to keep money flowing so as to offset very subdued growth and inflation levels. The wrinkle here is that policymakers appear to be questioning whether the law of diminishing returns is catching up with some of the unorthodox policy measures they’ve previously applied in an attempt to jumpstart growth.
For example, the negative interest rate policies that Japan and Europe are using have created the unintended consequence of putting pressure on the banking systems of both regions, and when the banking system is broken there is little chance that growth can expand as it normally would. But central bankers don’t give up easily, and rather than simply abandoning these extreme policy prescriptions, they have merely adjusted their tactics instead.
Some financial professionals believe that the fiscal authorities may soon join their monetary brethren and engage in an alternative to quantitative easing that economists call “helicopter money.” In theory, this would entail the monetary authorities permanently running the printing press to help finance growth inducing fiscal initiatives. The overall intention would be to lift inflation expectations in order to encourage consumers and businesses to spend today. The hope is that if consumers and businesses spend more, corporate earnings would benefit, employment and wages would rise, and a positive feedback loop and a virtuous economic cycle would evolve.
At the moment this vision of fiscal intervention is mostly speculation, and no one knows whether it will come to fruition, when it might be enacted, or how effective it would actually be. But the idea can’t be ignored, and investors must now begin to contemplate whether monetary financing of fiscal projects could provide the next wave of high powered money that finds its way into asset markets.
Seeking Value, Avoiding Value Traps
Economics and policy settings are important considerations that tend to drive cyclical moves in the market, but investors can never turn a blind eye to asset valuations. Valuation is not very useful as a market timing indicator, but it does give us important information about the margin of safety inherent in an investment, and it can also help identify acute risk and the potential for outsized reward when valuation hits extreme levels in an asset class or a particular security.
One of the current conundrums for investors is that most estimates of long-term valuations don’t look particularly attractive, especially for large cap U.S. stocks. For example, our models for the MSCI U.S. Index imply five-year annualized returns of less than 4%, and the ‘All Country World Index’ of global stocks is not much better with projected returns that are just slightly higher than the U.S.
We won’t argue that classic valuation measures for equities look expensive on the surface, but it’s important to note that aggregate index level readings can often be deceiving since not all sectors and industries are created equal. For instance, the low interest rate environment we’ve been in since the Great Recession has been forcing investors to chase higher yielding investments, causing those sectors to look particularly expensive. One of those, Utilities, is forecasted to deliver dismal five-year annualized returns of -2%, according to our models.
On the other hand, Financials have been out of favor given a perfect storm of heavy regulation, low demand for loans, and a 0% interest rate environment that has compressed net interest margins for many financial institutions. While they’ve underperformed recently, yesterday’s woes could be tomorrow’s spoils given that our models are projecting five-year returns of nearly 7% annually.
Of course, we can’t know with certainty how long valuation anomalies like this will last, but we can infer that Utilities have likely discounted a lot of good news, and Financials have probably baked in a lot of problems. Given this starting point, it seems prudent to prepare for the possibility that any negative news could tip the balance for Utilities and create a poor future return profile, and similarly, if anything goes right for Financials they could be set up for disproportionately higher relative returns. This is just one example of how looking beneath the surface can identify return profiles that differ materially from sector to sector, and from a sector to the overall index. Similar differentials exist in other asset classes as well.
With lower than average return forecasts for most broad asset classes, investors will be increasingly challenged to decide between the values to own and the value traps to avoid in the coming years.
What is encouraging for us is that our investing process gives us the freedom and flexibility to avoid overvalued assets and rotate into assets where we believe attractive valuation has collided with an appropriate catalyst to unlock that value over a cyclical time frame. In a return-challenged world, the ability to identify and rotate sectors, industries, countries, currencies, rate sensitivity, and credit may be a critical ingredient in generating future returns.
Investing In A Low Conviction World
The current investing landscape leaves us in a low conviction environment, which mostly serves to keep us from getting overly bullish or bearish. We won’t argue that there are legitimate risks floating around the backdrop: World fundamentals are weak, an election year is upon us, financials conditions are tightening modestly, and the Fed is sending confusing messages at the same time the broad averages look expensive.
But despite downside risks to markets, there are also reasons this market might defy logic and move higher. For starters, a case could be made that the February lows represented the pivot point from a global cyclical bear market to a new cyclical leg up. If so, the bear market likely washed away some of the prior complacency and reset the market’s cyclical timetable—thereby refreshing valuations in certain sectors and industries, as opposed to the overall index (at least in the U.S.).
The current backdrop also contains the prospect of more liquidity abroad, the specter of future fiscal easing, and a pessimistic feeling amongst investors, all of which could contribute to a market that continues to climb a healthy wall of worry.
At times of low conviction, we don’t think it’s prudent to make big bets in allocation, which is why we have been slowly edging our portfolios towards neutral levels of risk over the last few months. While we have been neutralizing volatility levels, we also continue to carry some hedges, given the highly unusual backdrop and in case risk suddenly reappears with today’s computer driven markets.
Without a big allocation bet, much of our risk-adjusted returns will come from rotating within assets classes and avoiding asset classes that we believe are classic value traps.