Market & Economic Review - Fourth Quarter 2017
Once again we have seen a sustained rally in asset prices in the midst of what would appear to be turmoil on multiple levels. Through the end of September, the S&P 500 has advanced for 11 months in a row, the most since 1959. It is hard to imagine that fact considering that during the quarter we saw: a dictator threaten another country with nuclear strikes, three of the top five costliest natural disasters in U.S. history, terrorist attacks, social unrest, and the worst mass shooting in U.S. history (Las Vegas October 1st). All the while, markets have experienced its calmest period in over 50 years. As we have mentioned in previous commentary, assets have been inflated as central banks not only pumped massive amounts of liquidity into the bond market, but have also been buyers of other financial assets. The Bank of Japan owns over 70% of Japan listed ETFs and about 3% of the overall equity market. The ECB has purchased over 10% of the European corporate bond market in the past year alone. It is no wonder that volatility has remained so low when you have the deepest pockets of money stepping into financial markets without regard to underlying fundamentals. As long as this continues, volatility will continue to remain low, but we get the feeling that it is like a compressed spring and at some point we will see extreme volatility arise abruptly and unexpectedly.
From a macro standpoint, global growth is holding up well. Global PMI (Purchasing Managers Index) readings are at their highest levels since 2011, and consumer and business confidence continues to be strong. Europe is seeing strong manufac- turing growth while positive U.S. sentiment and less regulatory burden are getting companies to invest in capital expendi- tures. With much of this driven by lower rates and abundant liquidity, it remains to be seen how much eventually will be paid back in the form of increased inflation.
Emerging markets continued to lead for the quarter and for the year, up over 8% and 28% respectively. In the U.S., small caps outperformed large cap, as during the quarter President Trump announced an outline for tax cuts. Small cap stocks tend to have a higher marginal tax rate, so they would benefit more from a tax cut than large multi-national companies. Growth continued to outperform value, with a slight shift in the month of September, and has outperformed value by 1200 basis points for the year in the large cap space. Stocks with the most sensitivity to economic factors did extremely well, while stocks most sensitive to quality and interest rates were the laggards.
It is no surprise to anyone that markets are at historically expensive levels on almost every metric in the universe, yet very little has been done in regards to shifting away from risk. Most investors justify the current levels by pointing out historically low interest rates as well as strong earnings. They believe that once rates rise and earnings weaken, then they will just reduce risk and sidestep any major selloff. So far the justification has held up, but it is being held up by central banks that have bought up a significant amount of assets and pushed investors into areas they would normally not venture as much into. The flaw in trying to time when to get out or reduce exposure, is that by the time it is obvious it is too late. Markets anticipate and discount future earnings and interest rates fairly rapidly. In addition, according to research by Yale Economist Robert Shiller , there have been 13 bear markets since 1871. Leading up to those bear markets earnings growth tended to be high. “In fact, according to Shiller, peak months before past bear markets also tended to show high real earnings growth: 13.3% per year on average, for all 13 episodes” While earnings tend to peak before a bear market there can be as much as a 4 year lag or it can be immediate, such as in 2007/2008.
If markets are historically expensive and it is difficult to know when to reduce exposure, what are we to do? We believe one has to look at the context of portfolio construction and asset allocation. In equities, we expect to take on higher risk, but over long periods of time expect to be rewarded. An investor who invested 10 years ago in the S&P 500 index, near the market peak, has still seen an average total return of 7.42%. With that being said, they would have had to endure a 50%+ drawdown in the depths of the 2008/2009 selloff. So investors need to have an idea of their time horizon and the ability to withstand volatility over that period. Our approach is long term in nature, so we will not engage in market timing in our equity allocation What we will do is look for areas of diversification and relative valuation. With the exception of 2008/2009, most bear markets had pockets of stocks that held up or even generated positive returns. For example, in 2001/2002, large cap growth stocks sold off dramatically while small cap stocks and REITs made money in 2001 with REITs also producing positive returns in 2002.
The U.S. 10 year Treasury bond ended the quarter pretty close to where it started with a yield around 2.33%. Within the quarter, the yield went from a high of 2.38% in early July to a low of 2.04% in early September. While equities did not react significantly to the major events of the quarter (mentioned above), bond yields had a pretty volatile quarter. Overall the most risky bond markets saw the best performance for the quarter and for the year. Emerging market debt and high yield were the top performers, while U.S. government and agency debt were the weakest.
While most of the news surrounding asset valuations centers on equities, the reality is that the global bond market is twice as large as the equity market. In addition, central banks own about 1/3 of the global tradable bond market. So where we have concerns in regards to distortions and possible future returns lies more in the fixed income space. We have written in previous newsletters about the amount of expansion in central bank balance sheets and the effects on global asset values. To add to those points we will spend some time discussing some of the distortions that have been brought about. The first distortion is the amount of debt that trades at a negative rate. Currently around $9tn worth of debt trades at negative yields (down from $14tn in 2016). Why would an investor buy an asset guaranteed to lose if held to maturity? They wouldn’t, but a central bank trying to boost economic growth would, and that is what has happened. This has caused economic investors (those who seek to make a positive return) to invest in riskier assets. We see this in the European high yield market, where that index is trading within 30 basis points of a 10 year U.S. Treasury Bond. The ECB has also been buying up corporate debt and competing with investors, thus driving down yields. In the U.S. we have also seen distortions in high yield bond space. According to Goldentree, one of our credit managers, debt prices for distressed companies have been flat or even positive as their equities have been hit for 50%+ losses. For example, JC Penney’s stock is down 54% for the year while their 2023 bonds are up 2%. We also see this dislocation in emerging market debt. The Russian 7.5% 03/31/30 bond denominated in U.S. dollars has traded at a lower yield than the 10 Year U.S. Treasury bond. Russia is the 3rd largest holding in the ishares EM debt ETF, which has attracted nearly $3.5bn in flows this year. We could write a whole newsletter with these types of examples. The point is that while we are prepared to take risks in an area like equity to realize the long term returns we are not prepared to take on the risk in non-core fixed income where the potential return is not enough to offset the risk. We continue to invest in quality municipal bonds, corporate bonds, and U.S. Treasuries, which tend to act like bonds in times of equity sell offs; whereas non-core bonds tend to act like equity during those periods.
With all of what has happened in the last quarter and the lack of volatility, we want to be aware that while all seems calm, there are distortions that continue to grow and increase below the surface. We seek to identify them and avoid them where possible. We want to be especially careful in less liquid markets that have attracted a large amount of assets in a short period of time and areas like fixed income where investors in this part of the cycle tend to reach for yield without understanding the true underlying risks. In equity markets, we will continue to look for areas of relative valuation that can hold up during the next market correction, being mindful that while the broad markets are historically expensive there are usually pockets of outperforming stocks during the average correction. In fixed income we seek to maintain discipline and invest in true fixed income assets. Negative yielding bonds are not true fixed income. They are like a Ponzi scheme, whereby investors buy in hopes of unloading to someone else at an even higher price. Within ETFs, we are comfortable with the large and liquid markets, such as U.S. and International Equity. We want to minimize exposure to areas like emerging market debt and high yield where there appear to be liquidity mismatches developing. In alternative investments we continue to see improving performance, especially in long/short equity strategies. Within absolute return we see opportunities developing in distressed debt and capital structure arbitrage. Private equity continues to attract a lot of interest and price multiples are back to historical highs. We are cautious in the space and look for areas that are smaller and more inefficient. These are times where we have to be a little more diligent and likely give up some short term performance in order to compound long term returns.
Synovus Family Asset Management Investment Team
Michael S. Sluder, Chief Investment Officer & Sr. Portfolio Manager
Andrea R. Parker, Senior Portfolio Manager
Zachary D. Farmer, Senior Portfolio Manager
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