Global equity markets continued to rally in the first quarter of 2017, with the MSCI All Country World Index (ACWI) up 6.9%. The S&P 500 rose 6.1%, while non-U.S. developed equity markets increased 7.4% and emerging markets 11.5%. In fixed income, returns were positive in both interest rate- and credit-sensitive market sectors. Short-term U.S. Treasury yields rose in response to the March fed funds rate hike, while longer-term maturities in the 10- to 30-year range fell by 5 basis points (bps). In addition, credit spreads tightened in both investment grade and high yield, which helped fuel further gains in these areas. Lastly, the value of the dollar fell between 2% and 3% in the first quarter when measured against various trade-weighted baskets of other currencies, running somewhat counter to the consensus view of continued dollar strength due to divergent monetary policy (and interest rate differentials) in the U.S. vs. the rest of the world.
Both the U.S. and global economy entered 2017 on solid footing. In mid-2016, manufacturing purchasing managers’ indices (PMIs) in both the U.S. and the rest of the world turned up, and at 57.2 and 53.0, respectively, both are consistent with modest future GDP growth. In the U.S., a rapid increase in the dollar’s value from June 2014 through January 2016 had put pressure on the manufacturing sector; however, at current levels, the dollar is essentially unchanged over the past year, which has helped buoy U.S. exports.
In addition, a 2015 slowdown in China that affected many commodity-producing emerging markets was more recently counteracted in part by stimulus that resulted in resurgent Chinese demand for raw materials. As an indicator of the renewed demand for commodities and intermediate goods, the year-over-year change in Chinese raw material prices has rebounded from -9% a year ago to 14.2% as of February.1 Similarly, in the U.S., the change in the Producer Price Index has rallied from -2.0% in March 2016 to 3.7% in February.2 And oil prices, which for the past 10 months have stabilized in the $45 to $50 range, have led to renewed drilling activity as the number of active rigs in the U.S. has more than doubled from its bottom in May 2016.3
The final estimate of fourth-quarter GDP growth in the U.S. came in at 2.1%, a decrease from a third-quarter increase of 3.5%. While a 2.1% gain is not a figure to get excited about, it is equal to the trailing three-, five- and seven-year U.S. GDP growth rolling averages, and so remains consistent with the levels the United States has been able to produce since the financial crisis. Also important is that if the rebound in inflation that occurred over the course of 2016 holds, nominal GDP may prove to be higher than in the past. Higher nominal GDP growth tends to boost corporate profits and stock prices, which are quoted in nominal terms, and also sends bond yields up and prices down.
Corporate profits data from the Bureau of Economic Analysis also supports the fact that the corporate sector of our economy has recovered. After five consecutive quarters of negative economic growth through the second quarter of 2016, year-over-year corporate profit growth was 2.1% in the third quarter and 9.3% in the fourth quarter. This sample includes the full array of U.S. corporations down to small, privately held businesses and is therefore much broader than S&P 500 profits.
With the Federal Reserve set to make some important monetary policy decisions based upon continued economic progress, economic data – though highly unpredictable – will remain impactful for financial markets.
Equity markets continued their post-election rally in the first quarter of 2017, with the MSCI ACWI Net rising 6.9% and the S&P 500 increasing 6.1%. At Brown Brothers Harriman (BBH), the public equity portion of our domestic taxable qualified balanced growth portfolio produced a solid absolute return of 6.0% in the first quarter.4 While this very short-term result slightly trailed our ACWI benchmark due to our relative underweight to emerging markets, which were up 11.5% in the quarter, it kept pace with the S&P 500. More importantly, we are pleased with the underlying businesses we own and how our investment partners’ portfolios are positioned. Additionally, our equity investment partners carried an average cash position of 9% throughout the quarter, which was a headwind to performance due to their collective strict valuation discipline and a dearth of attractively valued opportunities. While our preference is to own return-generating assets rather than cash over the long term, we believe the option value of cash continues to increase as valuations march higher.
Though earnings rebounded solidly in the third and fourth quarters of 2016, the surge in the stock market of late seems to be very much a story about rising consumer confidence and optimism about the Trump administration. The relationship between consumer confidence and the stock market over the past seven years is striking. The bullish consensus is still intact that the combination of a rollback in regulations, tax reform, an infrastructure spending bill and an “America-first” approach to trade deals will be implemented and in turn deliver tangible benefits to corporate America. Time will tell on what meaningful legislation, if any, will ultimately pass, and in what form. Importantly, unless earnings growth continues to rebound strongly and the market grows into its 18x forward earnings multiple, the market could increasingly begin to trade in accordance with the political or geopolitical winds of tomorrow.
A Fairly Valued Environment
A case can be made that most equity markets globally look fully valued, particularly in the U.S. Whether one is analyzing the trailing or forward P/E of market indices, the the Shiller CAPE ratio5 or figures such as U.S. market capitalization as a percentage of GDP, or is measuring U.S. profit margins relative to history, everything points to a market with an elevated level of price risk. We concede that valuations are generally full and believe that one is paying up if buying the market via an index fund; however, we are not actively reducing our overall equity exposure today for several reasons.
First, we focus on generating above-average long-term returns and protecting the long-term safety of our principal by owning a select group of superior businesses that we believe can compound their value over time. The careful selection of competitively advantaged businesses that experience a steady upward march of intrinsic value is what truly matters in earning attractive long-term returns, provided one has not overpaid. In terms of the risk of overpaying, we are highly confident that our investment partners focus on paying an appropriate price for the value they receive and that they seek to part ways well before any investment ever reaches extreme price levels.
Second, we do not pretend to be market timers and prefer to stay on the sidelines as it relates to short-term tactical activity. As Peter Lynch says, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves,” and “I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.” Additionally, beyond the difficulty of calling a market peak, market timers usually realize capital gains and also have to buy back into the market. Therefore, there are two trades they have to get right, not just one.
Third, our investment partners have the ability to hold cash in their portfolio, and current cash levels are healthy. On a look-through basis, our underlying cash position at the manager level is about 9%, which gives us comfort that our investment partners remain disciplined and patient with respect to their valuation criteria. Our managers are eager to take advantage of any market weakness assuming specific investments meet their criteria.
Fourth, our investment partners manage highly focused portfolios where they only need to find a few good ideas annually. We believe this makes their lives easier across a full market cycle, but even more so in today’s environment, where there are no obvious bargains. With high active share portfolios that look very different from popular benchmarks, we are comforted knowing that we do not own the market today and are more inclined to let our managers continue looking for opportunities to deploy their excess cash than we are to downsize our positions.
Lastly, based on the data we receive from our investment partners, such as their estimates of expected portfolio internal rates of return or discounts to intrinsic value, the qualitative insights we glean from them and our own assessment of their opportunity set, we are comfortable with the margin of safety across our equity portfolios from a business quality and valuation perspective. We also believe that we are positioned to generate equity-like returns over the long term from our equity investment partners. If valuations reach levels where we believe that is no longer the case, we will likely see that in the positioning of our managers (for example, in their cash levels) and through the honest dialogue we have with them regularly. Given that our investment partners are absolute return-oriented and have a significant amount of their own personal wealth invested alongside us, we are confident they will remain highly disciplined in periods of market euphoria. A quote from one investment partner’s most recent annual letter serves as a good reminder of the mindset one needs when investing in public equities:
We think of each investment as a corporate subsidiary that we own outright. We can’t promise anything, but we try to acquire each one at a rational price – a price that reduces our risk of permanent loss, while hopefully ensuring that our long-term rewards from ownership will be bountiful. It’s important to add that if we truly ran a conglomerate, we would never trade one of our valued subsidiaries for a new one unless we were convinced that we were getting significantly more than we were giving up. And we would never sell a well-performing business just for the sake of having more cash on hand. The only time we would make an exception to this would be if someone offered us an absurdly inflated price, in which case we would reluctantly sell and hold the proceeds until we could find something intelligent to do. In many ways, you could boil down our investment philosophy to the following: just because we deal in easily traded equities does not mean we should behave any differently than we would if we owned the businesses outright … so we don’t.
U.S. vs. Foreign Equities
As discussed in last quarter’s portfolio update, we have been taking a hard look over the past several quarters at our overweight to U.S. equities given their significant outperformance relative to foreign equities over trailing one-, three-, five-, 10- and 15-year periods, with the trailing three- and five-year relative returns being particularly stark. During the first quarter, we chose to begin increasing our position size of our developed ex-U.S. investments. It should be noted that our sizing adjustment was more of an incremental first step than a wholesale change, but directionally we are seeing more opportunity outside of the U.S.
We strongly believe that any investment thesis from our investment partners should be boiled down to no more than three key points, or what we call the business card test – whether one is able to write the entire investment thesis down on one side of a business card. Our thesis for increasing our allocation to our developed ex-U.S. investment partners can be summed up as follows:
- Our ex-U.S. equity investment partners are seeing larger discounts to their estimates of appraised intrinsic values relative to our U.S. managers, despite similar business quality (including competitive positioning, margin profile and returns on capital), growth prospects and higher discount rates (that is, more conservative assumptions) applied in their valuations.
- Our ex-U.S. investment partners have recently put their cash positions to work, while cash positions have gradually increased in our U.S. portfolios – particularly so for our small-cap managers, who are having difficulty finding new attractive opportunities.
- We believe the strong – some would argue extreme – currency headwind that foreign equities have experienced over the past five years should temper going forward given that the U.S. dollar has already made a significant multiyear move higher and that currencies are relative and tend to revert to averages.
The consensus view from currency experts, which we do not pretend to be, is for further dollar strengthening due to the divergence of monetary policy between the Fed and other central banks. However, when we look at the U.S. dollar on such metrics as purchasing power parity (PPP), it appears overvalued against most major currencies. Further, we tend to be cautious when the consensus view is skewed strongly to one direction, as is the case with today’s dollar bullishness. All of this makes us believe that the upside/downside of foreign currency relative to the U.S. dollar will more likely than not be neutral to perhaps favorable over the longer term. Our ex-U.S. investment partners who opportunistically hedge their currency exposures seem to share our view, as they have removed all of their currency hedges in the past few months for the first time in several years.
Our investment thesis is not predicated on the fact that foreign equities trade at lower P/E multiples at an index level or that U.S. earnings are far higher than their 2007 peak while many foreign geographies have index-level earnings that are well below prior peaks. Though we are aware of these data points and arguments, we are focused more on the valuation and fundamentals of the businesses we own or could potentially own rather than the entire index. In addition, based on our analysis, we believe the differences in index composition and geopolitical risk explain most of the variance between fundamentals and valuations between U.S. and foreign indices. As we have stated previously, our manager-centric capital allocation approach seeks out and acts on the insights of those closest to the assets – our internal and external investment partners. Today, our internationally focused partners are most excited about their opportunity sets.
In conclusion, with the large U.S. equity overweight position we have had in our portfolios for several years, the significant outperformance of this asset class relative to foreign equities and the constructive view of our overseas investments, we are gradually increasing the ratio of international equity to U.S. equity from our current large U.S. overweight position. For those portfolios that have not rebalanced for some time, we believe it is an opportune time to do so if appropriate from a tax perspective.
Fixed Income Markets
In the first quarter, the Bloomberg Barclays U.S. Aggregate Bond Index returned 0.8%, while the Bloomberg Barclays U.S. Municipal Aggregate returned 1.6% as municipal yields decreased more than Treasury yields. With the increase in rates at year-end 2016, fixed income returns over the past year have been even more subdued, with the aggregate rising 0.4% and the muni aggregate just 0.2%. In contrast, short-duration fixed income strategies, which we refer to as strategic reserves, have performed quite well over the past quarter and year.6 One proxy for the return of short-duration fixed income is the Bloomberg Barclays 1-3 Year Credit Index, which was up 0.7% last quarter and 1.6% over the past year. Because these strategies are designed to earn more of their return from exposure to credit risk, as opposed to interest rate risk, they perform better in comparison to standard fixed income indices during periods of rising interest rates and/or tightening credit spreads.
The divide between short-duration fixed income strategies, which typically manage their duration to a target between six months and two years, and aggregate bond indices has grown wider recently. From 1990 to 2010, the modified duration of the Bloomberg Barclays Aggregate tended to hover around 4.5 years; however, in 2010, the duration of the index started drifting upward and now stands at over six years. There are several reasons for this, most notably that the U.S. Treasury has issued more debt at relatively longer maturities as a result of its high deficits coming out of the financial crisis and that U.S. corporations have taken advantage of all-time low interest rates by issuing debt at the longest maturities possible. The longer the maturity of a bond, all else equal, the higher its duration and the more sensitive its price is to interest rate changes. While duration is an important risk factor for investors to consider, the duration of an aggregate bond index is merely a reflection of the bonds that have been issued in the market. Investors that choose to index their bond exposure are taking implicit investment guidance from debt issuers and extending the duration of their portfolios. At BBH, we are not proponents of indexing in equity or fixed income, but we believe the current fixed income environment where the Fed is actively talking about increasing rates is a precarious one in which to extend a bond portfolio’s duration. In our opinion, the fact that the market has started accepting longer-term debt issuance from the government and corporations does not provide a well-thought-out reason to extend the duration of a bond portfolio from high (4.5 years) to even higher (six years) levels.
In the municipal bond market, yields have declined significantly since their peak in early December 2016, making it difficult for us to add new bonds into client accounts. The 10-year AAA muni benchmark yield stood as high as 2.57% in December and had dropped to 2.26% as of March 31. AA bonds, which carry some credit spread, have fallen even more, declining by between 40 bps and 60 bps across most points on the yield curve. We stand eager to deploy capital into new muni bond purchases but believe it is best to wait for a better opportunity to buy in at yields where our clients can earn a positive real return. Most of our new purchases tend to be in the five-to 10-year maturity range, which we view as too long to effectively lock in a negative real yield. In the meantime, clients are better off in strategic reserves, which are currently generating a pre-tax yield in excess of 2%. Muni yields could change quickly in 2017 in response to inflation or Fed policy, but we believe it is best to stay patient and wait for a more attractive buying opportunity.
Moving to monetary policy, in mid-March, the Federal Reserve completed its third rate hike of the cycle, moving the fed funds rate to a target range of 0.50% to 0.75%. Despite the increase in the short-term rate, longer-term Treasury yields declined roughly 5 bps in the quarter, giving a slight tailwind to returns in interest rate-sensitive fixed income sectors. Since the steep rise in rates that occurred after the election, the 10-year Treasury yield has bounced around in the range of 2.3% to 2.6%. Generally, the tone of Federal Reserve statements has shifted to being more hawkish, with talk about continued rate increases this year that seem more real than in the past. The Fed has telegraphed that the bar for future rate hikes is now lower than in the past, and we believe it is plausible that if the economy continues to muddle along, there could easily be two more rate hikes in 2017. In addition, the minutes of the March Federal Open Market Committee meeting indicate that the Fed has started thinking about decreasing the size of its balance sheet as early as December.
The Fed’s balance sheet increased from just over $900 billion before Lehman Brothers collapsed to almost $4.5 trillion as of early April, the result of three separate quantitative easing programs since 2008. The size of the balance sheet has been roughly constant since October 2014 as the Fed has been reinvesting the proceeds of matured bonds when they come due. At some point, the Federal Reserve would like to begin shrinking its balance sheet size; however, with such a large portfolio, the exact manner and speed with which the Fed unwinds it – and perhaps most importantly, the advance communication around the change – will dictate how smooth a transition it is.
Thus, going forward in 2017, the market will not only be listening to “Fedspeak” concerning the fed funds rate, but also about plans for the balance sheet. As a reminder, in May 2013, when then-Federal Reserve Chairman Ben Bernanke telegraphed that the Fed was considering tapering the pace of asset purchases, the market reacted severely, sending the 10-year Treasury to 3.0% by year-end and emerging market equities tumbling. The Fed will cautiously try to avoid a repeat of that situation this year as it potentially outlines the circumstances around which it will begin shrinking its balance sheet.
In credit markets, the first quarter of 2017 saw a continuation of trends that have been in place for the past year. Credit spreads that peaked in February 2016 continued compressing, although they widened slightly in March. In high yield, spreads peaked at 879 bps above comparable maturity U.S. Treasuries just over a year ago and bottomed at 347 bps in early March, before finishing the month at 385 bps. In investment grade corporates, spreads peaked at 221 bps last year and ended March at 124 bps. At current spread levels, there is little value in performing credit markets, and we are not tempted to increase our allocation to these areas. We continue to find more enduring value in private credit, specifically in direct lending; however, the terms on offer in this part of the market have also tightened since 2016, and our investment partners are demonstrating discipline in deploying capital.
In comparison to our direct lending strategy, which invests only in first lien senior secured obligations, the U.S. high-yield market is generally composed of senior unsecured obligations. In a bankruptcy, first lien loans tend to recover between 70% and 80% of principal, while recoveries in high yield typically hover around 40%. This is part of the reason that middle-market direct lending is a strategic investment – a strategy into which we are comfortable deploying capital in a wider range of credit environments. In contrast, public high yield is an asset class that we may tactically allocate to in times of market dislocation, but because the asset class is so cyclical, we would be unlikely to maintain an allocation throughout a full credit cycle.
As we have said in several recent quarters, we do not believe this is the time to chase performance or take on extra risk to solve for a return need. Every market cycle seems to have fads that surface, and we try to stay away from these, as we think the risks are often misunderstood. We have written about certain smart beta ETFs that fall into this category, such as low volatility strategies, and believe that others may prove to be fads in the next downturn, too. As Warren Buffett has often said, “Only when the tide goes out do you discover who’s been swimming naked.” While we are constantly scouring the globe for new investment opportunities across asset classes, we believe that now is the time to stay disciplined; thus, we are only looking to forge new investment partnerships with investors that possess an enduring edge operating in areas in which returns are not generated through transitory investment fads. In the next quarterly update, we plan to spend time on the private markets and areas we are currently prioritizing.
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 Source: National Bureau of Statistics of China.
2 Source: Bureau of Labor Statistics.
3 Source: Baker Hughes United States crude oil rig count.
4 Net of investment management fees but gross of BBH investment advisory fees.
5 The cyclically adjusted price-to-earnings ratio, or CAPE, takes the current price of an index and divides it by the average of the past 10 years’ inflation-adjusted earnings in an attempt to normalize a P/E ratio over a business cycle.
6 Duration is a measure of the sensitivity of a bond or bond portfolio to interest rate changes. A duration of five, for example, would mean that for a 1% rise (fall) in interest rates, the price of the bond would go down (up) by approximately 5%.