2016 remains a volatile year for financial markets, headlined by the outcome of the United Kingdom’s European Union referendum on June 23.
With Brexit currently dominating the conversation in political, financial and social circles, we will address this subject first. While it is difficult to say that the event’s outcome was shocking given the tight pre-vote polling figures, financial markets woke up stunned on the morning of June 24. We, along with many others, view this as an unprecedented event in recent history, largely due to the overwhelming number of “ifs” and “possibilities” it has created – and perhaps most importantly, no real sense of a timeline, knock-on effects or contagion. What we can say is that our internationally focused managers that invest in the U.K. and European markets view the event as unequivocally bad for such markets over the short to medium term in terms of impact on economic growth. At the same time, it could be the event that creates real opportunity to generate attractive long-term returns if market sentiment overshoots the fundamentals. Uncertainty is the “four-letter word” for most investors, and this event has created plenty of it. When uncertainty is not countered with facts or information, market sentiment – or emotion – fills in the blanks.
The initial reaction to the Brexit vote’s result was not overly surprising. Investors dumped risk-on assets – particularly those in the U.K. and Europe – and embraced risk-off or safe haven assets; however, the negative response to the news proved short-lived for most risk-on markets. Excluding select investments – such as the pound sterling (down 13% against the U.S. dollar), the common stock of businesses perceived to benefit from rising rates (for example, banks and financial services) and U.K.-based companies with domestic revenue bases – most risk-on assets have recovered most, if not all, of their post-Brexit vote losses. Some markets, such as U.S. equities, have reached all-time highs. Meanwhile, risk-off assets remain highly popular, including sovereign and municipal bonds, metals like gold and silver, and defensive equity sectors such as consumer staples or high-dividend sectors like utilities, real estate investment trusts (REITs) and telecom. While government bond yields were marching lower pre-Brexit vote, the referendum results added lighter fuel to the fire, with the 10-year Treasury reaching percentage lows in the 1.30s and over $13 trillion of sovereign bonds now yielding less than zero – up from $11 trillion before the Brexit decision. Consensus now calls for lower rates for longer, and investors are voting with their feet, plowing into income-producing assets at any cost.
We will share our views on some of these safe haven assets later in this commentary, but generally we are happy to “pass” on owning assets or businesses when the difference between the price we pay and the value we get is razor thin. We also appreciate that expensive assets can continue to get expensive, largely driven by investor psychology of the fear of missing out – or FOMO – and that the trends we see today can persist, perhaps for much longer than anyone expects. Given our strong value orientation and current view that the underlying price risk present in several of these asset categories is underappreciated or largely ignored, we question how “safe” these are for those who invest with a long-term owner mindset.
Despite volatile global equity markets in the first half of the year, our public equity exposure, managed through our Core Select strategy and our likeminded third-party investment partners, performed solidly and in line with expectations. It is worth repeating that our focus is on absolute returns over a full cycle; however, we were generally pleased with our public equity contribution to portfolio returns.
For the first half of 2016, our public equity exposure generated returns of 2.8%, compared with 1.6% for the MSCI ACWI, our global benchmark.1 Brown Brothers Harriman’s (BBH’s) public equity exposure’s cash balance – the aggregate cash position across our equity manager portfolios – as of June 30, 2016, was 10.6%, compared with 8.1% exiting the first quarter. While our managers deployed cash aggressively during the January to mid-February sell-off, they trimmed back positions that reached their intrinsic value estimates with the market rebound from February lows. Though the Brexit vote created one-off buying opportunities, the sell-off that followed proved temporary and benign relative to what we experienced earlier in the year. Widespread bargains have yet to materialize. Our managers are once again generally cautious on overall valuations, remaining patient and disciplined when allocating each incremental dollar of cash in their portfolios. Typically, elevated cash positions across our manager portfolios, like those we see currently, are a good indicator that it is difficult to find value. Our views on valuations across our manager portfolios have not changed materially from last quarter’s update, although our emerging markets manager’s portfolio has appreciated in the low teens year to date and is trading at a tighter discount to intrinsic value than it did entering 2016.
Our equity allocation has maintained a U.S. bias for several years, and our current overweight to U.S.-domiciled companies is between 15% and 20%, depending on the global benchmark one uses. However, we have viewed our non-U.S. equity strategies as being more attractive from an absolute and relative value perspective over the past several quarters leading up to the Brexit vote. Currently, our long-only equity portfolio (that is, all of our equity strategies combined) has approximately 6.5% exposure to U.K.-domiciled businesses; however, most of these companies generate the majority of their earnings outside of the United Kingdom. Accordingly, while the British pound is down approximately 13% vs. the U.S. dollar since the Brexit decision, the immediate foreign exchange hit to these companies’ underlying earnings power will be less significant. In fact, the share prices of a few of our U.K.-domiciled companies are up in local currency terms since the vote, though flat to down on a dollar basis. Our long-only equity portfolio’s exposure to continental Europe is approximately 13% (on a domiciled basis), with more than half coming from global businesses based in Switzerland (approximately 7%). The overwhelming majority of our European-based companies have globally diversified client bases, revenue streams, cost structures and currency exposures.
We continue to believe that the quality of the businesses we own in our non-U.S. portfolios is comparable to that of those in our U.S. portfolios; however, the discounts to intrinsic value of our non-U.S. portfolios have been larger than those of our U.S. portfolios, and this valuation disparity widened further since the Brexit vote. While we maintain our view that valuations are generally more attractive outside of the U.S., the risks in these markets are arguably larger, including those related to currency. We may tactically increase allocations to our existing internationally focused managers should a portfolio’s opportunity set improve over the coming months; however, like our managers, we will not “shoot and ask questions later.” Rather, we and our managers will thoughtfully analyze the situation and its potential impacts on the businesses we collectively own on behalf of clients. We will only “de-risk” if we judge that the probability of permanent capital impairment has risen for certain investments or the portfolio overall. Consistent with our framework of investing bottom-up and worrying top-down, we also may determine that the underlying risks facing the businesses based in these countries outweigh any potential returns and decrease the allocations.
We are always on the hunt for value. Our conversations within our network – most notably with our existing internal and external managers and prospective managers on our watch list, but also individuals who carry out similar capital allocation roles at other institutions – tend to be the most insightful. In our pursuit of value, we also identify areas where we think value is scarce.
We believe yield-chasing behavior has driven massive capital inflows, primarily through passive index funds and exchange-traded funds, into defensive areas, such as consumer staples, utilities, large-cap REITs and other high-dividend-paying businesses. This influx in capital has resulted in expensive valuations, pulling future returns forward in many of these investments. In consumer staples, for example, the sector is up over 70% for the past five years, largely driven by multiple expansion (trading near historically high operating earnings multiples) with uninspiring earnings growth and flat to declining organic revenue gains. Branded foods are trading at a greater than 30% premium to their historical average on a P/E basis.2 Utilities exhibit a similar pattern, with the sector up 35% over the past 12 months and 26% year to date. Utilities are trading near historically high multiples, with P/E of approximately 19x representing a 40% premium above the historical average, and sport a 3.1% dividend yield in the face of modest forecast earnings growth and technological disruption risk over time.
The market seems content owning these asset types due to the relative yield advantage they offer over fixed income and perceived safety in the business models. At current prices, we believe the market is underwriting to a fixed income-like return (at least when fixed income was normal), at best, while assuming significant equity risk. In our opinion, at today’s entry price, long-term owners of these assets will be challenged to earn an adequate equity-like return for the risk they are assuming, even if rates remain at current levels. 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.
While others seem to be chasing yield-oriented assets in fear of missing out (or other factors such as career risk), we are steering our due diligence resources to market areas that are the most out of favor, given the dearth of value just about anywhere: non-U.S. equities – notably U.K., European and select emerging markets equities. Rather than blindly run from the burning buildings, we will carefully assess the damage to determine whether there is underappreciated value to be had. Fortunately, we have built relationships with local managers on our watch list who invest in these geographies, and they have articulated to us that their portfolios are trading at attractive values. Again, our view on valuation is largely informed by the direct investors in our network, rather than market-level multiples, which can be misleading. We are confident that we can act relatively quickly and decisively if a potential investment opportunity survives our rigorous process and meets our criteria.
Fixed Income and Credit
There was no shortage of excitement in fixed income markets in the second quarter, where we would argue that overvalued bond markets got even more so. On March 31, the market was pricing in a 54% chance of another Federal Reserve rate hike in 2016, and the path to interest rate normalization seemed as close as it had in recent years. Following a weak May employment report and then the Brexit vote, that probability plunged to 9%, and the market now judges that there is a 0% chance of a rate cut in July, September and November. Despite a strong June employment report that made May’s weak print appear to be an anomaly, U.S. yields remain depressed across the board due to lingering macro risks and the expectation of continued loose monetary policy. Year to date, U.S. Treasury yields in the five- to 30-year range have plunged by 70 to 80 basis points (bps), giving rise to strong gains in rate-sensitive fixed income sectors. Only one- and three-month yields are slightly higher in 2016, and by just a few basis points. Following the lead of Treasuries, municipals have also turned in a strong performance this year, with a broad muni index rising roughly 4.4% and a one- to 10-year index increasing 2.3%.
Investment Grade Fixed Income
Stepping back for a moment, we believe that current valuations in global fixed income markets are difficult to justify. Despite this, the continued central bank intervention helping drive this overvaluation shows no signs of abating. The average central bank policy rate from an equally weighted sample of 10 developed countries/regions stands at the remarkably low level of 0.5%, with three in negative territory.3 Looking further at the yield curve, nearly 36% of the developed sovereign bond market trades at a negative yield, up from 7.2% in the second quarter of 2015 and 12.2% at year-end 2015. There are new records being set on a daily basis as it relates to negative yields, and it is not only occurring in sovereign paper. For example, about €250 billion (approximately $275 billion) of euro-denominated corporate bonds now trade at a negative yield, according to Bank of America Merrill Lynch. With rates at these levels, there is little upside in fixed income markets currently, and we are reminded of the phrase that bond markets today offer “return-free risk” instead of the risk-free return investors were accustomed to in prior years.
In light of the current returns on offer in investment grade fixed income, our primary allocation to strategic reserves remains short duration and seeks to earn a return through more attractively priced exposure to credit markets as opposed to reaching for yield by extending duration. While this allocation is not designed to produce outsized returns, we believe it is a compelling alternative to sitting in a near-zero-yielding money market fund or taking asymmetric risks in other areas. We are unmoved by the short-term returns that some have earned in benchmark-like fixed income products and are content to wait patiently for more attractive risk-adjusted opportunities to emerge. In the current environment, the highest returns have come to those who have taken the most risk, which in our view is more often associated with long-term failure than success. As such, we will continue to take a measured approach to allocating capital to more traditional, longer-duration fixed income sectors.
It is important to note that a majority of investor portfolios today are based on the market consensus of perpetually weak economic growth resulting in an extended (perhaps perpetual) easy-money cycle. Though the consensus could be right, we believe the upside of being right is muted. If the consensus ends up being wrong – and if some combination of employment, wages and inflation rises at a faster clip than widely expected – we believe the downside could be severe. We do not pretend to be macroeconomic forecasters, but we can point to a string of solid economic data points coming out in recent months that make us believe that a surprise upturn in growth or inflation should not be entirely dismissed. Since we believe the compensation for investing alongside the consensus is grossly mispriced, our decision to remain patient and not chase returns, in our view, is relatively easy. Based on where rates are today relative to 2013, we believe the market reaction to a decompression of the yield curve caused by an upside surprise today could dwarf the fallout we witnessed during the taper tantrum.
High-yield credit markets also bounced back from their minor drawdown in early 2016, with spreads tightening 81 bps in the second quarter, from 693 bps to 612 bps. In the two years since BBH exited our high-yield bond position, the market has produced an annualized return of approximately 1.4%. While current starting yields in the low-7% range seem enticing, there are hidden risks lurking in high yield, and we expect future defaults to pick up materially in sectors such as energy and retail. By comparison, a high-yield non-distressed bond index trading at spreads below 1,000 bps offers a yield 1.5% lower than the full index, illustrating how marketwide yields are being pushed up by the roughly 10% of the market that is currently distressed.
As opposed to public credit markets, where credit discipline ebbs and flows with inflows into liquid credit products, our research indicates that private credit markets offer more attractive and durable valuations. By investing with a manager that has a strong credit culture, investors can earn an illiquidity premium that results in attractive risk-adjusted returns. While investors have to give up a degree of liquidity, this is a known risk that can be managed and offset with liquidity in other areas of the portfolio. We hope to be able to communicate further about a new partnership in this area in the near future.
Lastly, we are confident about the opportunity set over the next few years for our two distressed debt managers. Though public, performing fixed income markets are not attractively valued at the moment, there is a steady pipeline of opportunities in distressed situations that will likely grow for the foreseeable future. If credit markets continue to worsen, our managers stand in a good position to deploy capital at attractive rates of return.
The amount of noise in the current financial markets is deafening, distracting and value-destructive. Time horizons continue to shorten, and “investment activity” continues to compound exponentially in the wrong direction. It is never easy to sit on one’s hands and stay the course in any investing role, but it is typically the most intelligent thing to do. In a world where many consider activity as “adding value,” we view it largely as speculation. Our philosophy, process and criteria are structured such that they enable us to think longer than even the most long-term-oriented investors. It is not a sexy investing approach, but it has proved to work over time. As Warren Buffett has said: “You don’t get paid for activity. You only get paid for being right,” and “The trick is, when there is nothing to do, do nothing.” This is not to say that we have our heads in the sand and are content with our current portfolio. On the contrary, we continually seek to enhance the risk-adjusted return of our portfolio and will be decisive when we see opportunities that deserve to be added and existing investments that we must trim or fully remove.
Our objective remains protecting capital first and growing it second in a tax-efficient manner. Despite a challenging investing landscape, we are highly confident in our value-oriented, disciplined and patient bottom-up investment approach. With valuations across most asset classes globally seeming full at an aggregate level, patience around individual company valuation remains paramount and top of mind.
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. 2016. All rights reserved. 2016.
1 The MSCI ACWI captures large- and mid-cap representation across 23 developed markets and 23 emerging markets countries.
2 Price-to-earnings (P/E) ratio is a company’s current share price divided by earnings per share.
3 Countries/regions included: Australia, Canada, the eurozone, Hong Kong, Japan, Norway, Sweden, Switzerland, the U.K. and the U.S.