After a tumultuous beginning to 2016, which saw our global equity benchmark, the MSCI ACWI Net, decline over 10% through mid-February, the market rebounded almost 22% to finish with a total return of 7.9%. That return was largely driven by outperformance in the United States, with the S&P 500 returning 12%. Also in the U.S., 2016 earnings (including fourth-quarter estimates) have benefited from easy year-over-year comparisons to weak 2015 earnings and as a result were up 8.3%, which, given the increase in the price of the S&P 500, resulted in the market’s price-to-earnings ratio climbing from 20.4x to 20.6x. In comparison, 2016 valuations in global equity markets, which comprise the rest of the ACWI, are on average lower. Last year was yet another example of how forecasting market performance, even with perfect knowledge of future economic events, is a fool’s errand. At year-end 2015, who would have predicted that global equity markets would be up high single digits if we knew the following combination of geopolitical and macroeconomic events would unfold?
- Markets begin 2016 down over 10% with an energy-driven market sell-off
- The U.K. votes to leave the eurozone in June
- The Syrian civil war escalates
- Several terrorist attacks take place worldwide, most notably across Europe, and Europe faces a migrant crisis
- United States-Russia relations are tested over the Syrian war and allegations of hacking the U.S. presidential election
- Underdog Donald Trump is elected U.S. president
- On the same day of the U.S. election, Indian Prime Minister Narendra Modi announces that 86% of the currency in circulation would cease to become legal tender through a demonetization scheme
- Italian referendum receives “no” vote
- Impeachment trials take place for presidents in Brazil and South Korea
- High-yield default rates spike to 5.6% in December – the highest level in six years
2016 may also be remembered as the year populism and protectionism reared its head across the developed world. Both the Brexit vote and Trump’s election surprised voters, markets and pollsters alike, and in 2017, multiple elections across Europe will reveal just how much support is behind these nationalistic movements. Despite these changes and the aforementioned events, on a total return basis, the S&P 500 was able to produce its eighth consecutive year of gains.
The U.S. economy ended 2016 on more stable footing than it entered the year. 2016 started amid an energy sell-off that sent equity and credit markets plunging. In addition, there was a well-documented manufacturing recession, as evidenced by the six consecutive months of decline in the ISM Manufacturing Purchasing Managers’ Index (PMI)1 over the second half of 2015. The economic environment was particularly hard on U.S. exporters due to the combination of weak emerging markets growth and a strong dollar, which makes U.S. exports less competitive.
However, the economy gained steam throughout the remainder of the year, partly due to a bounceback in commodity prices, which eased the strains on the energy, metals and mining, and materials sectors. And after bottoming at 48.0 in December 2015, the ISM Manufacturing PMI ended 2016 at a solid 54.7 – its highest level since January 2015. Meanwhile GDP growth, which came in at 0.8% in the first quarter, rebounded to 3.5% in the third quarter. While subdued GDP growth has been the subject of much discussion, lengthening our timeframe a bit from the standard one quarter shows that since the beginning of 2011, the two-year rolling average of GDP growth has been as low as 1.5% and as high as 2.7%. Spikes above 3% and falls below 1% have been short-lived. In our opinion, the market spends too much time focusing on quarterly GDP growth; we believe that the underlying trend GDP growth has likely been more consistent than generally recognized and that much of the quarterly fluctuations amount to nothing more than noise.
Looking forward, the economic discussion has shifted to the particulars of the Trump presidency – and, admittedly, there is much to digest. With control of the presidency and both houses of Congress, Republicans are claiming a mandate and could potentially enact the most significant new tax and economic policies in years. Whenever real change is on the horizon, there is uncertainty, and we expect the market to focus heavily on the evolution of these policies in 2017. Perhaps most noteworthy is that after several years of the markets hanging on every word from global central bankers concerning the outlook for monetary policy, U.S. markets have started focusing as much, if not more, on fiscal policy – a tool that has largely been on the sidelines since 2009.
In a widely anticipated move in December, however, the Federal Open Market Committee (FOMC) announced its second interest rate hike of the cycle, bringing rates from a range of 0.25% to 0.50% up to 0.50% to 0.75%. Shorter-term yields have moved up in accordance with the hike and in expectation of future hikes. Two-year Treasury rates now stand above 1.2% – the highest level since 2008/2009. Consistent with recent history, the market-implied path of the fed funds rate is still on a shallower trajectory than internal FOMC projections show (the dot plot), at 1.9% and 3% over the next three years, respectively. For 2017, based on a combination of the FOMC’s projections and market pricing, we may see two or three more rate hikes if the economy progresses as expected and no unforeseen macro risks emerge. The evolution of short-term interest rates this year will be important, as it will go a long way toward confirming whether the 30-plus-year bond bull market has officially ended.
The S&P 500 was up 3.8% on a total return basis in the fourth quarter. While returns in the quarter were negative until the U.S. presidential election, they turned positive on November 9 and did not look back. The market appears to have high expectations for a Trump presidency and a Republican Congress. Since the election, there has been a preference for smaller-capitalization stocks in the U.S., and a clear delineation in returns is visible among large-, mid- and small-cap stocks, up 5.0%, 10.0% and 15.7%, respectively.2 The reasons for this may vary, but two points the market has keyed in on are that many of Trump’s proposals are protectionist in nature and that both the Trump administration and Congress are calling for lower corporate tax rates. Small-cap companies are thought to be greater beneficiaries of these, as they are more oriented toward domestic production and tend to have higher effective tax rates.
Turning to Brown Brothers Harriman’s (BBH’s) portfolios, in 2016, the public equity portion of our domestic taxable qualified growth portfolio produced a solid absolute return of 7.2%3 in 2016 but slightly trailed our ACWI benchmark, as the excess returns we had generated up to the election were more than offset over the final 50 days of the year, which some are labeling the Trump rally. Simply put, our managers’ holdings, which are largely underweight hard cyclicals and balance sheet financials, were left out of the party. Additionally, our equity managers carried an average cash position of over 10% throughout the year due to their collective strict valuation discipline and a dearth of attractively valued opportunities, resulting in solid absolute returns on equity capital employed but a slight lag on a relative basis due to some cash drag. While we put relatively little weight in one-year performance figures (never mind around 50 days) and their corresponding attribution statistics, the makeup of the post-Trump short-term winners vs. losers is interesting – and not altogether surprising, in our opinion. In fact, the outperformance of old economy stocks, such as banks, materials and energy-related stocks over this time period, reminded us of the following question we posed in our InvestorView commentary discussing the second quarter:
"An interesting question we are thinking about is whether what worked in protecting capital on a mark-to-market basis in the 2008 to 2009 crisis, which was owning defensive stocks and avoiding economically sensitive stocks such as banks and energy, would work if the market experienced a sharp correction over the near to medium term. With the former trading at such lofty multiples on potentially peak earnings and the latter trading at depressed multiples on depressed earnings, it is difficult for us to make the blind assumption that defensive would best protect."
To put some data around the old economy outperformance during this time, the Russell 2000 Value Index – which largely comprises heavy cyclicals, banks and other highly financially leveraged businesses – outperformed the Russell 2000 Index by more than 1,000 basis points and the Russell 2000 Growth Index by over 2,000 basis points. While this massive outperformance may leave those who missed out kicking and screaming, we think the direction of the share price movements in a selection of these sectors makes some sense in that some of these industries may well benefit from higher interest rates, a rollback in regulations and more fiscal spending.
Yet as we have articulated in the past, we believe the surest way to generate attractive long-term returns, especially after taxes, is to be a long-term owner of a concentrated portfolio of competitively advantaged businesses that generate attractive returns on invested capital in excess of their cost of capital, operate in attractive industry structures, make their own luck regardless of the macro environment and are run by long-term-oriented management teams that act like large owners. Our managers aim to purchase such companies when they are trading at a meaningful discount to their intrinsic value and sell them when they no longer offer a margin of safety. While certain companies in the old economy sectors fit our managers’ criteria and are owned in our portfolios, there is a strong preference for secular over cyclical free cash flow growth across our manager set.4 We have spent significant time analyzing the universe of equity managers who gravitate toward the most economically sensitive market areas, but to date have not found a manager that fits our criteria.5 For these reasons, we appreciate and expect that our underweight in some of these sectors will likely persist over the long term, as we prefer to own superior business models with limited capital spending requirements, less cyclicality and less financial leverage. In other words, we are looking to balance attractive upside commensurate with the equity risk we take combined with quantifiable downside risk. As a result, short-term sector rotations are something we view as noise that dissipates with the passage of time. The jury is still out on whether the new administration can change the prospects for industries that have historically generated return on capital well below their cost of capital over a cycle. In addition, as long-term owners of businesses, we appreciate the fact that these industries are destined to face at least two administrations over the next decade.
As of this writing, the market has shown a large reaction to a rough outline of a few proposals, but nothing concrete has yet been publicly articulated or is even close to being enacted. While one may argue that the recent outperformance in these sectors could ultimately be fundamentally driven, current expectations being priced in for some of these business models could just as easily reverse as the market digests the impact of actual legislation, or the lack thereof, that makes its way through Congress. Whether this sharp rotation is built off a sugar high or something more fundamental remains to be seen, our inclination is never to chase, particularly on stroke of the pen legislation with little clarity or predictability. We are comfortable with how our managers’ portfolios are positioned as we continue to face an environment where screaming buys are relatively scarce.
Speaking of stroke of the pen changes, we believe that corporate tax reform could have substantial implications to intrinsic values, but the outcomes for individual businesses will differ. Whether a reduction in tax rates flows through to a company’s bottom line or is shared with customers in the form of lower prices will depend on how competitive the industry in which a company operates is and the degree to which it has pricing power over its customers, among other factors. At the same time, we may see myriad other changes to corporate tax reform that could have larger effects than a reduction in the statutory corporate tax rate. This is a topic on which we and our investment partners are highly focused, and we will report more on these developments in future issues.
The Long-Term Outperformance of U.S. Equity
With the benefit of hindsight, our long-term bias to U.S. equities has served us well for many years. Looking at 2016 returns, the performance of U.S. equity markets on both an absolute and a relative basis to non-U.S. markets is something to ponder. Since the depths of the market in March 2009, the S&P 500 has compounded at an 18.8% annualized clip, which is good for a total return of almost 200% in just under eight years. Over the past three years, the S&P 500 has returned 9% annualized and over five years almost 15% annualized. Over the trailing 10-year period, which includes the financial crisis, the S&P 500 has returned almost 7%. After accounting for inflation of 1.8%, the market has provided a real annualized return of 5% over 10 years, which we believe is a positive result given that it includes a (hopefully) once-in-a-lifetime financial crisis. These returns are quite solid in their own right, but even more so in comparison to non-U.S. developed (EAFE) and emerging markets (EM) stocks.
Over the past three years, the MSCI EAFE has returned -1.6% annualized in USD terms,6 while the MSCI EM has returned -2.6%.7 Though local currency returns are better at 2.2% and 4.4%, respectively, even before translating returns into USD, U.S. returns are far higher in local currency terms. Over 10 years, non-U.S. stocks have managed 0.8%, while EM stocks have returned 1.8%. The outperformance of U.S. large- and small-cap stocks vs. the rest of the world over the past three, five and 10 years is striking.
With the combination of greater U.S. earnings growth, a strong dollar and higher valuations being placed on U.S. equities, a belief in mean reversion in any (or all) of these variables would lead to the conclusion that now is a good time to invest in foreign stocks. While there may be small pockets of dislocation in markets at most times that nimble managers can take advantage of, the differences in earnings, currencies and valuations discussed are at a large scale and potentially involve a substantial portion of global equity markets. But is this a true dislocation, or do these differences merely reflect widely known risks? This is the single largest question on which we are focused, as our portfolios maintain a U.S. bias; our dollars continue to strengthen, which in turn increases our purchasing power overseas; and the discounts to intrinsic value of our non-U.S. portfolios are penciling in relatively more margin of safety today vs. our U.S. portfolios.
Though looking at index-level earnings can be a useful first step to answering this question, in reality, there are many differences between the U.S. and other countries that make index-level comparisons a potentially misleading effort. First, industry compositions and market capitalizations are wildly different between the U.S. and other global equity markets. Furthermore, valuation differentials may simply reflect widely known risks. To get a better handle on this question, it is necessary to dig beneath the index level to see if the valuation dispersion holds up after adjusting for obvious differences between the U.S. and the rest of the world.
Our first inclination is to always stay the course. Such inactivity is typically the hardest thing for any investor to do, but is usually the right thing to do. However, if we conclude from our findings that there is a very high probability, at least by our calculation, of generating a better attractive risk-adjusted return relative to the one our current positioning offers, we will act decisively.
Fixed Income Markets
The fourth quarter and 2016 as a whole saw a great deal of change in fixed income markets. In high-grade markets, where interest rate changes have the largest impact on returns, markets have been left in a perpetual state of uncertainty while being whipsawed by various global policymakers’ explanations of why rates have been so low for so long and what the future might bring. Interest rates did a head fake in 2013, when then FOMC Chairman Ben Bernanke’s talk of ending QE38 caused the so-called taper tantrum. Ten-year U.S. Treasury rates then spiked, ending the year at 3%, before ultimately falling to a new all-time low of 1.36% on July 8, 2016. Across the globe, there was pricing in fixed income markets that defied logic, including two European corporate issuers placing a new debt issue at negative yields and the Swiss yield curve that was negative well beyond 20 years, or a full one-third of developed sovereign bond markets trading at negative yields. We acknowledge that there seems to be a semi-consensus that due to a host of reasons, such as demographic change and a global savings glut, interest rates may be somewhat lower than a simple historical average would indicate. However, in the fourth quarter, the opposite happened, and rates increased in abrupt fashion, giving rise to losses in long-duration and higher-quality sectors.
In this environment, the public portion of BBH’s fixed income investments in our Growth portfolio for full-year 2016 was up 2.8%, vs. the BofA/Merrill Lynch U.S. Municipal Securities Index 0.4% return and Barclays Aggregate 2.7% return. These returns, while all positive for the year, belie the sharp sell-off in longer-duration fixed income that happened in the second half of 2016 due to rising interest rates. We welcomed the sell-off in fixed income markets, as it allowed us to gradually begin purchasing municipal bonds for the first time in several years. Due to BBH’s short-duration/long credit positioning, our returns were less volatile than the broader fixed income market and relatively more attractive, and we were able to begin to allocate assets toward full duration municipal bond ladders from a position of strength. In just a few months, our fixed income portfolios made up all the lost ground vs. an aggregate muni bond index going back almost two years. While this process has just begun, we would welcome further interest rate increases that would allow us to continue re-establishing traditional fixed income allocations to taxable and tax-exempt bonds.
In 2016, returns in high-grade, interest rate-sensitive fixed income were a tale of two halves. Through the first six months, bond markets rallied on declining rates before reversing course and falling for the balance of the year. A key factor behind the movement of rates was improvements in economic data, which drove expectations of rising short-term policy rates as well as a rebound in inflation expectations. While survey-based inflation measures have been consistent at roughly 2.1% to 2.2%, market-based inflation expectations rose from a low of 1.37% in June to 1.97% by year-end. It has been some time since rising inflation has been a legitimate worry for fixed income investors, but even slight fears over inflation can immediately affect bond prices.
Going forward, fixed income markets will be searching for confirmation as to whether the 30-plus-year bond bull market has finally ended. If that is the case, the future environment will be vastly different for bondholders. Investors who may be used to seeing unrealized gains on their individual bond holdings as they clip their coupons may instead see a period of unrealized losses due solely to rate increases. It is for this reason that we are carefully staging back into bond markets as rates rise. Though further rate increases will cause temporary unrealized losses in existing fixed income portfolios, over the long term, investors will be better off with higher rates that allow for reinvestment at higher yields. We stand ready to allocate more assets to traditional fixed income if the interest rate environment cooperates and believe that if the Fed hikes rates two or three more times this year, we may get the opportunity to establish a more meaningful allocation.
While 2016 was difficult for long-duration fixed income, it was a strong year for credit strategies overall, though the beginning was dominated by a sell-off in high-yield energy bonds that at its peak saw energy debt trading for an average of 50 cents on the dollar. Public high-yield markets have been a popular funding source for energy exploration and production firms recently, and accordingly, the decline in oil prices from 2014 to 2016 hit the market hard. Credit problems were not confined to energy, however, and other sectors such as retail have had their own difficulties as shopping patterns change and the disruption from e-commerce continues. Even though oil prices rebounded, high-yield default rates have picked up noticeably, led by the energy and metals and mining sectors, though overall returns soared in 2016 due to compressing credit spreads. While $50 oil is much healthier for the market than $30 oil, anecdotally, many companies raised funds for projects anticipating at least $80 oil – which was then a substantial discount to the spot price – and are unable to earn economic returns even at current prices.
Strong 2016 returns, however, are largely just a rebound from poor 2014 and 2015 returns. From the June 2014 high-yield market peak, which is when we exited our high-yield bond position, to the end of second quarter 2016, the market produced a 0.6% annualized return for investors. After a strong second half of 2016 where high-yield benefited from higher energy prices and the Trump rally, the market has returned an annualized 3.4% since we exited – far less than investors should demand from high-yield given the risks it entails.9 In comparison, corporate investment grade bonds over the same period returned 2.7%. While mathematically interest rates affect high-yield markets in the same way they do investment grade markets, because higher rates strongly correlate with an improving economy, the positive effect of an improving economy on credit spreads tends to offset a good part of the theoretical interest rate risk. This development was in full force in the second half of 2016 as investment grade markets sold off (-4.3% return for a broad Treasury index) while high-yield markets posted strong gains (7.4%).
When evaluating the higher-yielding performing credit market space, we tend to find private credit markets offer more value than public markets. While public markets can sometimes present a good risk-return tradeoff, and we have a framework and manager in place to act if the prospective returns meet our thresholds, the markets tend to be exceptionally volatile, which makes it difficult to recommend a strategic high-yield allocation. Instead, we find that value is more enduring in private credit markets, where the terms on offer (origination fees, credit spreads and so forth) do not fluctuate to the same extent because the asset class is less accessible to retail investors. In private credit markets, lenders have the ability to directly negotiate and structure agreements with borrowers, and the asset class’s limited liquidity allows investors to earn reasonable illiquidity premiums. This year, we will be allocating capital to this space for qualified clients.10 We have participated in this market for some time and will partner with a new manager in this space in early 2017 that we believe is attractively structured relative to anything we have seen in the market.
Lastly, while the distressed credit environment now looks benign, we are pleased with our managers’ discipline in capital deployment and believe our dry powder in this asset class will serve clients well. The capital deployed by our larger, global-oriented manager experienced strong returns as numerous credits in the portfolio rerated back toward par in 2016. Smaller distressed situations are always present in markets and both of our partners remain active and are finding enough interesting opportunities; however, large-scale dislocations can emerge at any time globally, and having an allocation to managers with the ability to call and deploy dry powder efficiently gives our clients another potential way to earn strong risk-adjusted returns.
At the risk of sounding like a broken record, there are no obvious fat pitches being offered by the market currently, with most asset classes appearing fairly valued. We are constantly re-underwriting our portfolio, focused on both the prospective returns and the risks being assumed. Fortunately, one of the many benefits to a concentrated, high active share investment approach is that it increases the chances that our managers can find pockets of opportunity when the general level of valuations is high, such as now. We do not have to invest in the most overvalued parts of the market and do not need to follow the crowd, as we believe that staying true to our value-oriented investing strategy applied with patience, discipline and a focus on capital preservation will yield tangible benefits over time.
As we enter 2017, we will spare readers another market forecast or make any predictions on the economy, as we do not have a clearer crystal ball than anyone else. Our focus on finding value and attractive asymmetric investment opportunities guides our positioning. Our main areas of focus are the continuous monitoring of what we already own and new investment areas of prospective interest, including non-U.S. public equity managers, primarily in Europe and Asia, as well as our private equity and private equity real estate activities, which we hope to be able to communicate about in more detail in the coming months. Lastly, we are spending a significant amount of time watching happenings in Washington, as a wholesale tax reform would affect the opportunity cost calculus for all asset classes.
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
© Brown Brothers Harriman & Co. 2017. All rights reserved. 2017.
1 The ISM Manufacturing Index is a composite index based on new orders, production, employment, supplier deliveries and inventories and gathered by surveying over 300 manufacturing executives monthly. A level greater than 50 indicates the manufacturing economy is generally expanding, and a level greater than 43.2 generally indicates an expansion in the overall economy.
2 As approximated by the S&P 500, 400 and 600, respectively.
3 Net of investment management fees but gross of BBH Investment Advisory fees.
4 Most of our managers will invest in companies that operate in cyclical industries assuming those industries have secular growth.
5 Instead, we have preferred to invest in these areas through owning the debt through our distressed debt managers.
6 As approximated by the MSCI Europe, Australasia and Far East (EAFE) Index.
7 As approximated by the MSCI Emerging Markets (EM) Index.
8 QE3: The Federal Reserve’s third round of quantitative easing, announced in September 2012.
9 All high-yield returns refer to the BofA Merrill Lynch U.S. High Yield Cash Pay Index.
10 For more information about this, please contact your BBH relationship manager.