2018 was a difficult year in the markets, with the overwhelming majority of asset classes ending in negative territory. Following a synchronized acceleration in GDP across all major developed economies in 2017, global growth began to slow. While the U.S. economy and corporate earnings continued to accelerate, largely in response to the monumental corporate tax cuts passed by the Trump administration in 2017, concerns around the Chinese economy, tariffs and U.S. protectionism, the potential for a “hard” Brexit and tightening financial conditions served as headwinds abroad. As the dollar rose, most commodities fell, and oil was particularly hard hit, declining from a high of $77 in early October to a low of $42 in December. Even the darling of 2017 – cryptocurrencies – suffered in 2018, with bitcoin declining 74% during the year. During this difficult market environment, Brown Brothers Harriman’s (BBH) policy portfolios substantially outperformed their relevant benchmarks, and we are pleased with their resilience during such a challenging period. For example, the BBH Taxable Balanced Growth Portfolio (net of BBH’s investment advisory fee) outperformed its blended benchmark of 65% MSCI ACWI/35% Municipal Bond Index by 400 basis points (bps).1
Across global equity markets, U.S. large-cap stocks were the best performers, declining only 4.4% in 2018, while emerging markets equities returned -14.5% as investors remained wary of the asset class for most of the year. Fixed income was also challenged in 2018 as interest rates rose and credit spreads widened. However, short-duration fixed income strategies, where BBH is heavily invested, were among the best performers of all asset classes in 2018. In September, an important shift in monetary policy took place as the eighth interest rate hike of 25 bps in three years turned the real federal funds rate positive for the first time in 124 months. The longest period of easy monetary policy in history finally ended, and despite the correction in the equity markets that followed September’s increase, the Federal Reserve raised rates one more time in December. The fed funds rate now stands at a range of 2.25% to 2.5%, its highest level in over 10 years. Notably, cash generated a return of 1.8%2 during 2018, the highest rate since 2007.
After a quiet 2017, volatility returned to the markets last year with a vengeance, reminding investors that markets can and will go down. The heightened volatility was a surprise to many, and while it felt unusual and certainly uncomfortable, 2017 was actually the outlier. Data on S&P 500 returns shows that there were 20 days in 2018 in which the index moved more than 2%, in line with an average of 21 days per year over the past 20 years. In 2017, by contrast, there were zero days with such a move – what a difference a year can make.
The looming question for investors now is whether the recent volatility represents a turning point for the nearly decadelong bull market or just a pause in the upward trajectory. As of this writing in late January, markets remain volatile as the ongoing budget impasse and recent government shutdown, an unresolved trade war with China and the possibility of further Fed tightening weigh on investors’ minds. It is virtually impossible to predict how the markets will behave going forward. Therefore, we prefer to focus on the tried-and-true principles that have enabled our clients to protect and grow capital over decades:
- We have a fundamental belief that long-term equity ownership of high-quality cash-flowing businesses purchased at discounts to intrinsic value is the surest way to compound wealth.
- We invest only with managers that adhere to strict valuation disciplines and are willing to hold cash rather than lowering their standards to be fully invested. While cash is a drag on returns during up markets, it provides a source of downside protection and option value when markets decline. Notably, our managers have been able to take advantage of the recent market dislocations by redeploying cash into securities that, all else equal, are more attractively priced today than they were prior to the market pullback.
- We partner with active managers that invest high-conviction, concentrated portfolios and have significant personal wealth invested alongside clients. Over the long term, share prices converge with business fundamentals, and this alignment and focus on only the best ideas allows managers to exploit short-term volatility.
- We take a long-term view with continued investment during market dislocations. Data shows that a hypothetical investment of $1 in the S&P 500 in 1927 was worth $151.39 at the end of 2017. Investors that missed the 10 best performance days would have only $50.22. Market timing simply does not work.
Nearly every global equity index finished lower than it started in 2018. The S&P 500 was the best performer, although after nine straight years of gains, it ended the year down 4.4%. In November 2018, it seemed that the S&P 500 might hold onto a positive return, but the sell-off in December – the worst month for U.S. stocks since October 2008 and the worst December since 1931 – wiped out all the prior months’ gains. With a peak-to-trough decline of 19.4%, the S&P 500 avoided bear market territory (that is, a 20% or greater decline), but the record run of positive returns from 2009 to 2017 ended, tying the 1991 to 1999 period for the longest positive streak of performance in history.
Not all U.S. equities performed as well as large-cap stocks, and small-cap stocks especially struggled during the year, declining 11%. Even over longer periods, large-cap stocks have outperformed their smaller counterparts, leaving investors to wonder when the extra return premium that is expected from small-cap stocks will return. In terms of sectors, healthcare and utilities fared the best, while the more cyclical sectors, including energy and financials (particularly banks), were hardest hit. After going nowhere but up in 2017 and much of 2018, FAANG stocks as a group – Facebook, Amazon, Apple, Netflix and Google – declined 21.6% during the fourth quarter of 2018. Apple, which passed the historic trillion-dollar market cap level on August 2, 2018, lost $372 billion of value since its peak on October 3 through the end of 2018.
International developed and emerging market equity returns were the clear losers in 2018, although some of the loss generated in these markets related to currency movements, as the U.S. dollar strengthened against all major currencies other than the Japanese yen. International developed and emerging markets equities in local currencies outpaced their U.S. dollar counterparts by 2.8% and 4.8%, respectively. Given more reasonable valuations that currently exist outside of the U.S., the medium- to long-term outlook for non-U.S. equities appears favorable.
Turning to BBH’s policy portfolios, in 2018, the public equity portion of our Domestic Taxable Qualified Balanced Growth Portfolio produced a return of -5.3% (net of BBH’s investment advisory fee),3 well in excess of the MSCI ACWI Net return of -9.4%. While cash hurt relative returns in 2017, it helped during 2018. Our policy portfolios also benefited from overweight positions to U.S. equities as the S&P 500 outperformed all other markets, as well as underweights to underperforming sectors, such as energy and financials, particularly banks. While we do not make top-down decisions to avoid such sectors, we do prefer to own companies with superior business models and limited capital spending requirements, less cyclicality and lower financial leverage. Therefore, it is not surprising that our portfolios were underweight these more cyclical sectors. Overall, we are very pleased with how our managers navigated this challenging market environment.
Fixed Income Markets
2018 was also a volatile year for fixed income markets. Through early November, 10-year U.S. Treasury yields had risen as much as 83 bps, which put pressure on the returns of interest rate-sensitive areas of the market. During the year-end equity market sell-off, the flight to quality caused yields to reverse course, and fixed income recovered its losses for the year. For the full year, 10-year Treasury yields were up 28 bps. Accordingly, the Bloomberg Barclays U.S. Aggregate Bond Index was down as much as 2.6% through early November but finished the year with a small gain of 0.01%.
Perhaps the biggest story in bond markets in 2018 was the flattening of the yield curve. While short-term yields rose in line with increases in the federal funds rate, long-term yields were less affected. As of December 31, 2018, the 10-year U.S. Treasury had a yield just 19 bps greater than a two-year Treasury and 31 bps higher than a three-month Treasury bill, and a portion of the curve between one and seven years is “inverted.” Because an inverted yield curve has been an early indicator of a recession in the past, this has given the market some trepidation about the state of the economy, despite little evidence to suggest that the seven-year vs. one-year spread has much predictive power.
In addition to interest rates, credit markets were also noteworthy in 2018. In the fourth quarter, high-yield credit spreads widened substantially after a two-year period in which they were between 300 bps and 400 bps above U.S. Treasuries – an extremely low level that did not offer much compensation for the risks of investing in high yield. From October 3 to December 26, the high-yield market was down 5.4%. Despite their abrupt widening, high-yield spreads remain just above long-term averages, and we believe high yield is still not an attractive opportunity.
Despite a shaky year for fixed income, BBH’s public fixed income returns for taxable clients were quite solid – up 1.8% (net of BBH’s investment advisory fee)4 compared with the benchmark, the Bloomberg Barclays Muni Aggregate, which returned 1.3%. In addition, BBH took advantage of the higher interest rate environment in the middle of the year to increase our allocation to longer-duration fixed income for both taxable and tax-exempt clients. While our fixed income allocations have heavily skewed toward short duration for years, our portfolios now stand at a roughly 50-50 balance of short and longer duration. Overall, we are pleased with our fixed income results for 2018, as they provided an important source of stability for our portfolios in a difficult year for markets.
Although we are fundamental bottom-up investors, it is our practice each year to develop capital market estimates for major asset classes. While we do not rely on these estimates for making investment decisions, we do utilize them to help frame expectations for returns and in certain instances to prioritize our research efforts during the year. Notably, these estimates are based on index returns and do not include estimates of manager alpha.5
For 2019, our capital market estimates are depicted in the nearby table.
As we look ahead, we are preparing for returns that are likely to be more modest than historical averages. In this type of environment, we will continue to partner with managers that can generate above-index returns by investing in a concentrated group of high-quality, cash-generative companies that trade at discounts to intrinsic value. In particular, investments in emerging markets and international equities, which today are valued more attractively than U.S. equities, have favorable long-term outlooks. As we have indicated in prior quarters, we are also preparing for a credit cycle and have added another drawdown fund to our investment platform that invests in distressed credit (that is, one that buys the debt of stressed or bankrupt companies that are trading at substantial discounts). When the credit cycle turns, we think that distressed investments will offer very compelling opportunities.
Finally, we are working to determine whether a Qualified Opportunity Fund (QOF) could play a role in our clients’ portfolios. As a reminder, QOFs were created by the Tax Cuts and Jobs Act of 2017, and they provide several tax incentives in exchange for investment into certain low-income areas. We have been meeting with several managers that plan to offer a QOF, and we will update clients as soon as we develop a more informed view on this opportunity.
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
The BBH Taxable Balanced Growth Portfolio (“model portfolio”) was incepted in January of 2007. The model performance results are shown for illustrative purposes only and are not meant to be representative of actual client results achieved by the manager. Some funds that form part of the model portfolio, such as those funds with inception dates beginning after January of 2007, were not available during the duration of the time period listed. The actual composition and performance of a client's account has and will differ from those of the model portfolio due to deviation from the asset allocation guidelines, availability of managers and asset classes, differences in the timing and prices of trades, and the identity and weightings of securities holdings. When available, BBH uses proprietary investment products as one of the investment vehicles for each asset class. Where BBH has no proprietary investment products, a third-party investment vehicle may be selected. The asset allocation decisions (which are subject to change) are driven by the manager’s proprietary analysis of past and current market conditions. The model portfolio is rebalanced to the manager’s prevailing allocation guidance on a monthly basis. Client accounts following the model may not be rebalanced on a monthly basis or whenever the manager chooses to make a change to the model portfolio allocation and as a result may have significantly different performance. Any changes made to model portfolio asset allocation guidelines or addition or deletion of investment managers on the Wealth Strategy platform are reflected on the first business day of the following month. Not every asset class included in the model portfolio is available for investment or available to all investors. The model portfolio assumes a full allocation to private funds (e.g., the private equity asset class) and a pro-rata based allocation based on current capital deployed in each underlying fund. The model portfolio also assumes that the account is sizable enough to fully participate in the Core Select Strategy. Smaller accounts may be invested in the mutual fund employing the Core Select Strategy, which may have different returns as a result of the different fees, expenses, charges, number of securities, and regulatory requirements and/or restrictions applicable to the vehicle.
From inception to March 1, 2017, the BBH Core Select return used in the model portfolio was the equity-only return. On March 1, 2017 the BBH Core Select return used in the model portfolio was changed to the full BBH Core Select model return (inclusive of any cash allocation in the Core Select Strategy). Additionally, on March 1, 2017 the model portfolio’s transactional cash allocation was reduced from 3% to 0% to account for the cash balances of the underlying investment managers. Performance of the model portfolio is calculated using a time-weighted rate of return using monthly returns. Dividends are incorporated into the return on the ex-dividend date. Stocks are presumed added to, or deleted from, the model portfolio at the time of purchase or sale. Performance of the model does not take into consideration the reinvestment of income. Instead any income is allocated to cash and rebalanced as stated above.
The model performance results have inherent limitations. Unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees and other costs. Also, since the trades have not actually been executed, the results may have under-or-over compensated for the impact of certain market factors such as lack of liquidity. The model performance results do not take into consideration the impact on cash flow, which varies from client to client. No representation is being made that an actual portfolio is likely to achieve returns similar to those shown. Returns will fluctuate and an actual investment upon redemption may be worth more or less than its original value. Performance calculations have not been audited by any third party.
The model performance reflects the deduction of any brokerage or other commissions or fees charged by BBH or other parties that investors will incur when their accounts are managed in accordance with the model. The model performance does not consider taxes, the inclusion of which would cause actual performance to be lower than the performance shown.
Reference to a benchmark does not imply that the respective BBH Policy Portfolio will achieve returns, experience volatility, or have other results similar to the index. The composition of a benchmark may not reflect the manner in which the respective BBH Policy Portfolio is constructed in relation to expected or achieved returns, investment holdings, asset allocation guidelines, restrictions, sectors, correlations, concentrations, volatility, or tracking error targets, all of which are subject to change over time.
Opinions, forecasts and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.
This material contains “forward-looking statements,” which include information relating to future events, projected future performance, strategies, expectations, and competitive environment, and regulations. Forward-looking statements should not be read as a guarantee of future performance or results and will not necessarily be accurate indications of the times at, or by, which such performance or results will be achieved. Forward-looking statements are based on information available at the time the statements are made and/or BBH’s good faith belief as of that time with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in, or suggested by, the forward-looking statements. Actual results or activities or actual events or conditions could differ materially from those estimated or forecasted in forward-looking statements due to a variety of factors, some of which may be beyond BBH’s control.
This material is not meant to be, nor shall it be construed as, a representation as to future performance, and no assurance, promise or representation can be made as to actual returns. There can be no assurance that the projections will be achieved or that any investor will not suffer losses or a decline in value.
Yield: A measure of cash flow received from an investment over a given period of time expressed as a percentage of the investment’s value. For fixed income, the cash flow is composed of interest income; for equities, the cash flow is made up of dividend payments.
Geometric return (CAGR): The compound annual growth rate (CAGR) is a geometric return that represents the single rate of return that an investment would have achieved by growing from its beginning balance to its ending balance assuming all cash flows were reinvested at the end of each year.
Standard deviation: Measures the historical volatility of returns. The higher the standard deviation, the greater the volatility.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.
This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services 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 other applicable tax regimes, or for promotion, marketing or recommendation to third parties.
All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH.
All trademarks and service marks included are the property of BBH or their respective owners.
© Brown Brothers Harriman & Co. 2019. All rights reserved.
1 The BBH Taxable Balanced Growth Portfolio return includes public investments through December 31, 2018, and private investments through September 30, 2018, and is net of the highest BBH investment advisory fee of 100 bps. The BBH Taxable Balanced Growth Portfolio returned -1.59% compared with its blended benchmark of -5.59%. One “basis point,” or “bp,” is 1/100th of a percent (0.01% or 0.0001).
2 Bloomberg Barclays 1-3 Month U.S. Treasury Bill Index.
3 Net of the highest BBH investment advisory fee of 100 bps.
4 Net of the highest BBH investment advisory fee of 100 bps, where applicable.
5 Returns of an active manager above those generated by a passive index.