The first half of 2017 was a strong start to the year for most markets, though it also had its share of surprises. At the beginning of the year, few predicted the following would transpire:
- Global stock markets rallied strongly in the ninth year of this bull market, with the U.S. up 9%, non-U.S. developed markets up 14% and emerging markets up 19%.
- Short-term rates rose 50 basis points (bps),1 while 10-year yields fell more than 10 bps.
- Fixed income increased strongly despite three Federal Open Market Committee (FOMC) rate hikes.
- Oil prices dropped more than 14% to the low $40s.
- Global economic indicators and sentiment remained high, yet the U.S. yield curve ended the half the flattest it has been in the past 10 years.
- The dollar fell over 5%, counter to near-universal predictions from the experts for continued strength.
- Political storm clouds emerged in the U.S. darker than those in Europe.
- FAANG2 stocks regained their popularity after being a source of funds for the post-election Trump rally.
Indeed, these results and events provide yet another example of the futility of trying to predict the short term!
The economy appears to have bounced back slightly in the second quarter of 2017, with the median economist estimate suggesting GDP growth of 3.0% vs. first-quarter growth of 1.4%. And while first-quarter growth was revised from an advance estimate of 0.7% to the final 1.4% figure, it is fair to say that the sky-high expectations for medium-term economic growth seen at the start of the year have settled down somewhat as the Trump administration’s bold plans for healthcare and tax reform, to name just two, have hit substantial roadblocks. With President Trump’s election, both interest rates and expectations for inflation and growth surged; however, after a nearly 2.1% peak earlier this year, 10-year breakeven inflation expectations have since dropped 0.3%.3 Ten-year Treasury yields have also fallen from over 2.6% at the start of the year to 2.3% at the end of June. And while estimates for economic growth indicate a rebound from the first quarter, they too have come down recently.
The labor market remains solid, with 222,000 jobs added in June and an almost 50,000 upward revision to gains in prior months. While the unemployment rate is a low 4.4% – suggesting the economy is near full employment – wage growth remains stubborn. On a year-over-year basis, average hourly earnings rose slightly to 2.5%; however, despite fairly consistent, albeit modest, economic growth, ample monetary policy support and all-time high asset prices, material wage inflation has yet to emerge. The FOMC still appears ready to normalize monetary policy despite this, but an unexpected surge in wage and price inflation is (and has been for years) the one factor that could force the FOMC’s hand to act more quickly.
In addition to the Federal Reserve’s stated intentions to gradually tighten monetary policy, other major central banks recently started making similar comments, and as this issue goes to print, there has been a modest uptick in global interest rates from late-June lows. Time will tell if this is the start of a sustained upward trend in global rates or will prove short-lived. One of the biggest uncertainties markets are struggling with at the moment is how the removal of accommodative global monetary policy will affect asset prices. Until monetary accommodation is removed, we have little hard data to suggest the degree to which policymakers might be manipulating prices.
Once again, equity markets performed solidly in the second quarter. Most major markets were up near or above 10% year to date, with the only exceptions being commodity-related sectors, particularly energy, and certain areas within retail, notably brick-and-mortar retailers and retail property landlords, due to e-commerce and Amazon-driven pressures. Year to date, Canadian equities are the lowest performing developed market – eking out a total return of a few tenths of a percentage point in local currency – and Russian and Qatari equities are the only developing equity markets in the red. Besides a handful of industries undergoing well-documented secular changes, countries in the midst of geopolitical turmoil and volatile commodity- and natural resource-related equities, all market segments are up. Our global search for bargains is yielding very little at the moment.
At Brown Brothers Harriman (BBH), the public equity portion of our domestic taxable qualified balanced growth portfolio produced a solid absolute return of 12.4% in the first half of the year. This very short-term result outpaced our ACWI benchmark and the S&P 500, largely due to strong returns from our international investments, which we incrementally added to early this year, and our mid- and large-cap-oriented domestic investments. Our small-cap domestic investments have had the weakest absolute returns year to date, consistent with broad market trends, and our small-cap investment partners continue to face a challenging opportunity set, indicated by their cash positions averaging in the mid-20% range. In aggregate, our equity investment partners ended the second quarter with a cash position of 13%, up from 9% at the end of the prior quarter, as a result of trimming and exiting positions that were approaching or reached estimated intrinsic value.
Earnings on a global basis have bounced back from a rough patch in the first half of 2016, and sentiment is relatively high, as the market has grown increasingly comfortable with current macro and geopolitical risks and investors are content paying higher multiples for equities around the world. As detailed in last quarter’s update, we are comfortable with our current equity positioning, despite our opinion that most equity markets globally appear fully valued. We and our investment partners are preparing for more volatility, knowing the importance of having a strong pair of hands when turbulence arrives and a plan for when market emotions turn from greedy to fearful.
While we continue to seek new investment opportunities, we are also trying to better understand how passive investing is affecting markets. As we have written about previously, the dominance of passive vehicles, particularly ETFs, in daily trading means the price-setting function of the markets has changed significantly. Admittedly, we will not be able to decipher its effect until the balance between active and passive reaches a new equilibrium. Fewer transactions now happen between informed active buyers, so there is also potential for micro inefficiencies where securities are mispriced relative to one another. J.P. Morgan, for example, estimates that just 10% of trading is now executed by normal fundamental investors.4 The relentless tide of inflows into passively managed vehicles has put pressure on relative valuations between securities to stay the same, even when company fundamentals may change. While many marketwide fundamental measures such as revenue and earnings growth have improved, the fact that so many geographies and industries have produced such positive returns for so long, and that equity market volatility is so low, should be at least mildly concerning to those who may have benefited from these trends.
The potential for market distortions of all types is an important part of why we are bottom-up fundamental investors – and why we do not attempt to time the markets. In our opinion, to decide whether or not to buy equities based on macro-oriented predictions, such as the movement of interest rates, or short-term market sentiment forecasts is not a high probability way to protect and grow one’s wealth. As concentrated investors, we do not own the whole market, and BBH and our external investment partners can steer our clients’ capital toward high-quality companies that are reasonably priced, or in some cases, allow cash to build in portfolios until bottom-up opportunities meet our valuation criteria. While we generally expect our managers to be wary of historically high valuations, our expectation is for them to allow their bottom-up opportunity set to drive portfolio construction and not to use cash as a market timing tool.
There will be short-term winners and losers as the result of short-term market noise and certain investors flocking to passive funds. However, as long as our portfolio companies continue to grow their intrinsic values, we can afford to be patient with our capital and wait for the long-term realization of that value, as opposed to tactically shifting around money in response to macro and micro trends that we deem to be largely unpredictable and impossible to forecast.
Fixed Income Markets
Armed with the knowledge that the federal funds rate would increase three times between December 2016 and June 2017, investors might have also expected medium- and longer-term interest rates to rise as well. However, for most of the first half of 2017, that was not the case. From the second FOMC rate hike of the cycle on December 15, 2016, to June 26, 2017, the 10-year U.S. Treasury yield dropped almost 50 bps from roughly 2.6% to 2.1%. In late June, the spread between two- and 10-year Treasury yields, which has averaged almost 1.8% over the past 10 years, touched below 0.8% – its lowest level in well over nine years. While longer-term rates rebounded somewhat in the closing days of June and into July, the yield curve remains flat, and at present, there is little compensation available for extending duration.
This flattening of the yield curve helped most fixed income markets perform well over the past quarter and half year, despite overnight interest rates more than doubling. Year to date, only TIPS provided a negative total return, due to a decline in inflation expectations. Part of the reason behind the flat yield curve is that, in recent years, the market has consistently projected a path for the fed funds rate below that of the FOMC. After overreacting to the first mention of monetary policy tightening in 2013 (the taper tantrum), the market has since been induced to think that the Fed always tightens at the slowest of all possible paces. Market-implied probabilities now suggest the fed funds rate will end 2019 between 1.75% and 2.00%, whereas the FOMC median projection is close to 3%. If overnight rates do in fact rise to 3% in the next 18 months, and the economy continues to strengthen, this would certainly shock the bond market and lead to losses in long-duration fixed income. Adding to this the unknown effects of balance sheet normalization that will gradually begin to remove a large, price-insensitive buyer from the market, we continue to believe a short-duration posture seems prudent.
The public fixed income portion of BBH’s domestic taxable qualified balanced growth portfolio produced a return of 0.7% in the second quarter and 1.6% year to date. Our fixed income investments have benefited from tightening credit spreads and falling rates; however, owing to our short-duration positioning, our portfolios underperformed the index. Standard fixed income indices take on significantly more interest rate and credit risk than our portfolios, so on a risk-adjusted basis, we view these as solid absolute returns generated in a low-risk manner and remain pleased with our performance. Against comparable duration and quality benchmarks, our fixed income strategies have performed well.
Recent events in German bond markets illustrate the asymmetric risks in fixed income. From June 26 through July 7, the yield on the 10-year German note rose from just over 0.24% to more than 0.57%, which took the bond’s price from just above par to roughly 97 cents. As Grant’s Interest Rate Observer pointed out, that markdown in the principal value of the bond represents roughly three years of coupon income – all brought on by a less than 30 bps increase in the yield on the bond. While circumstances in U.S. Treasuries are slightly less skewed, owing to higher starting yields over 2%, they are still not enticing. A relatively modest 100 bps increase in 10-year yields over the next year (to 3.4%) would result in a -5.3% total return in the on-the-run 10-year U.S. government note, and it would take two-plus years for the total return to re-enter positive territory.
Credit markets are one of the hottest market segments recently – inflows are strong, pricing is tight, leverage multiples are creeping up, and borrowers have the upper hand in raising capital. High-yield and broadly syndicated loan (BSL) markets are two areas that we spend significant time watching, as historically they have been harbingers of recessions and distressed credit opportunities. Sell-offs in performing high-yield markets also provide attractive opportunities to allocate capital into market dislocations. Loose lending standards take time to affect returns but are a good predictor of market distress in the long term. Across almost every credit metric we can track today, credit markets appear frothy.
The market is also replete with anecdotes about the abundance of capital seeking a return in this low-yield world. Most recently, Argentina was able to place 100-year bonds. Despite the fact that the country has defaulted on its debt six times in the past 100 years, including twice in the past 20 years, investors were enticed enough by its current pro-market leadership that its $2.75 billion USD-denominated debt issue was oversubscribed. The total yields on offer in European high-yield markets also seem to defy any rational risk-return calculation. Here, yields spent most of the second quarter below 2.6%; however, due to negative base rates, the 2.7% quarter-end yield actually represents a spread of 2.9% above comparable maturity German bunds. While nowhere near an apples-to-apples comparison, currently the European high-yield index and the 30-year U.S. Treasury yield are within 10 bps of each other at 2.8% to 2.9%, with neither seeming very appealing.
At a basic level, high-yield credit spreads are at extremely low levels vs. history, on top of already-low underlying Treasury rates. Currently, the high-yield market offers a yield to worst5 of roughly 5.65%, which is composed of a 2% U.S. Treasury yield and a 3.65% credit spread.6 Credit losses in high yield have averaged approximately 2.5% over the past 20 years, though they are currently running somewhat below average. Compared with average defaults, investors are receiving roughly 1% additional compensation vs. a risk-free Treasury – a slim margin considering that high-yield markets do not follow a predictable pattern. Years of below-average defaults are inevitably followed by periods of above-average defaults – it is not difficult to envision a default scenario in which the high-yield market underperforms Treasuries over the next three years, for example.
Today’s market is one where both strategic and financial buyers are flush with cash, and coupled with the abundance of cheap debt – lenders, too, are sitting on a fair amount of capital to deploy – purchase multiples are beginning to creep up.7 While the amount of debt financing companies obtain for these purchases appears reasonable relative to the price paid for the company (or on a debt-to-total capital basis), compared with more normalized valuation levels, debt levels actually look quite a bit higher. In the BSL market, total debt levels averaged almost 6.5x EBITDA in the second quarter, representing roughly 50% or more of what may turn out to be peak valuation levels on an enterprise value-to-EBITDA multiple basis. Something as trivial as a moderate interest rate increase that would put pressure on equity multiples, coupled with widening credit spreads that increase borrowing costs, could squeeze debtholders into a much more precarious position.
Another area to watch is the use of proceeds when a new bond or loan deal comes to market – what a company does with borrowed money matters. For example, in a dividend recapitalization, which becomes increasingly popular in the late innings of a credit cycle, private equity firms borrow just to pay themselves a large, one-time dividend and decrease their exposure to the business. From the perspective of a debtholder, this transaction type serves only to increase the leverage and riskiness of the enterprise. When these deals become more prevalent, it signals that lenders are desperate to put capital to work – yet another early warning sign.
Overall, we believe the non-investment grade credit markets today are fairly valued only if a near-perfect “Goldilocks” economic scenario unfolds. There is currently no real distress outside of the energy and retail industries, and investors seem to be betting on this to continue. Our view is that if financing is available on easy enough terms for long enough, it is a near certainty that a credit market dislocation will eventually result. In our opinion, investors that own most broad high-yield funds today, and certainly lower-quality high-yield funds, have little margin of safety.
In contrast to public markets, we continue to find more enduring value in private credit markets, where direct lenders tend to show more discipline. There is pricing pressure in this market, as capital has aggressively entered this space, too; however, the presence of even one financial covenant that forces borrowers to return to the negotiating table with lenders in the event performance suffers is much more likely than in public markets. Without a covenant, a company can continue a slow, downward spiral, and as long as it makes its interest payments, there is nothing lenders can do to protect their capital. Even with a loosely set maximum leverage covenant, a company must come back to the table with its lenders to “cure” covenant breaches, and the lenders have the option to continue backing the business or to begin to force repayment of its debt, among other options. In contrast, in BSL markets, covenant-lite deals have become the norm, which we do not believe bodes well for holders of those loans.
The tide can turn quickly in credit markets, so we continually monitor them. On better terms, we stand ready to make an allocation to public non-investment grade debt in client portfolios, but we are a long way from there. We believe that relatively high-quality short-duration credit is currently the best option in fixed income given the pricing of interest rate and credit risk. The potential for volatility always exists, so we will be watching developments over the remainder of the year with an especially keen eye.
The combination of paranoia and optimism is required to successfully invest in any environment, including that which we face today. Our paranoia currently lies with overall valuations across all asset classes and the potential consequences that may eventually surface from the normalization of central bank policy and the massive transition of asset ownership to passive hands. At the same time, we are optimistic about the future prospects of the underlying businesses and assets we own and the long-term returns they can generate, albeit somewhat lower relative to the recent past given high entry valuations. We are mindful that the path to long-term returns is unknowable, and while we are not predicting that the waters will be choppier in the near future, we are mentally preparing for it.
Past performance does not guarantee future results.
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.
PB-2017-07-19-1566 Expires 07/31/2019
1 One basis point, or bp, is 1/100th of a percent (0.01% or 0.0001).
2 FAANG: Facebook, Amazon, Apple, Netflix and Alphabet/Google.
3 The breakeven inflation rate is a market-based measure of inflation expectations calculated by subtracting the yield on a 10-year TIPS from a 10-year nominal U.S. Treasury bond.
4 Source: Cheng, Evelyn. “Just 10% of trading is regular stock picking, JPMorgan estimates.” CNBC. June 14, 2017. http://www.cnbc.com/2017/06/13/death-of-the-human-investor-just-10-percent-of-trading-is-regular-stock-picking-jpmorgan-estimates.html.
5 Yield to worst (YTW) is the lowest yield an investor can expect when investing in a callable bond.
6 High-yield spreads are quoted as the yield above comparable maturity Treasuries, which for the high-yield market is typically between five and seven years.
7 As measured by enterprise value-to-EBITDA (earnings before interest, taxes, depreciation and amortization).