Third quarter 2017 saw another period of robust appreciation in security prices across the globe, with the MSCI ACWI Net and S&P 500 returning 5.2% and 4.5%, respectively. Year-to-date returns in these indices now stand at 17.3% and 14.2%. Third-quarter and year-to-date performance has also been positive for fixed income, which in turn means all Brown Brothers Harriman (BBH) model policy portfolios have experienced strong returns in 2017. Perhaps surprisingly, this all happened as tensions between the U.S. and North Korea rose to the highest level in recent memory, with some saying the threat of a nuclear conflict was as close as it has been since the Cuban Missile Crisis.
As we wrote last quarter, nearly all major asset classes have experienced strong returns over almost all time periods up to 10 years, which is striking. The main exceptions remain certain energy, commodity and natural resources sectors; beyond those, one must look down to the specific value chains or companies to find out-of-favor or unloved securities (for example, recent share price weakness in brick-and-mortar retail). Though we are pleased with the returns that can be generated in rising markets, the higher security prices climb, the less value there is to be had. While the global economy remains on solid footing, some of the excesses present in credit markets warrant a close eye. In addition, equity valuations irrespective of geography or market capitalization appear fairly valued, making it increasingly difficult to find bargains. We remain extra vigilant about the margins of safety1 in businesses and assets that we own and are striving to build as resilient of a portfolio as possible in anticipation of potential speedbumps down the road.
The U.S. and global economies continue moving forward, and various manufacturing surveys, which tend to be good leading economic activity indicators, point up. In the United States, the ISM Manufacturing PMI stands at 60.8 – its peak level this economic cycle – and is consistent with higher economic growth levels than we have seen in recent years. Compared with year-end 2015, when the dollar had appreciated almost 30% in the previous four to five years, exporters are now benefiting from a dollar that has weakened 7% year to date coupled with rising global demand.
The labor market also remains strong. While the back-to-back impact from Hurricanes Harvey and Irma caused the economy to shed an estimated 33,000 jobs in September, we expect that number to bounce back in upcoming months, based on prior weather-related slowdowns. In addition, the unemployment rate, which is less affected by weather, declined to a cycle low of 4.2%. Based on projections of the neutral unemployment rate that vary from 4.5% to 5%, the labor market is running a bit hot at the moment. Though long-awaited wage growth also spiked in the month, this was likely weather-related and should reverse as lower-paid workers return to work.
The biggest economic updates last quarter, though, were likely the Federal Open Market Committee’s (FOMC’s) stance on future rate hikes, its thoughts on inflation and, of course, the horserace for its next chairperson. Entering the third quarter, market pricing of fed funds futures contracts indicated roughly a 50% chance of an additional rate hike in 2017. After bottoming at almost 20% in early September at the height of North Korea tensions, the odds of another increase are now nearly 80%. Much can happen between now and December, but the Fed has clearly started laying the groundwork for an additional hike.
While rates remain low, this would bring the fed funds rate to a target range between 1.25% and 1.50%, and the possibility of several further hikes next year remains real. After seven years of zero rates, and now almost two years of gradually increasing rates, we are getting nearer to a point where investors can earn a positive real return by simply holding cash.
In deciding when and how quickly to normalize monetary policy, the FOMC has grappled with stubbornly low inflation that seems to defy expectations given robust labor markets and a steadily growing economy. Though the Federal Reserve continues to believe that low inflation is temporary, several Fed governors have begun acknowledging other possibilities, such as that the models used to understand inflation could be wrong – and the policy implication is that the Fed cannot afford to be too gradual in normalization. While this comment has been made before, we do not think it has been suggested as prominently as Janet Yellen did in a September speech at the National Association for Business Economics.
Though these views all seem reasonable, they also represent a sea change for Yellen and others at the Fed who have appeared dovish nine times out of 10 in their public appearances, perhaps scared of roiling financial markets. Between interest rate and balance sheet normalization, policy in the remainder of 2017 and 2018 should be interesting to watch as the Fed attempts to unwind an unprecedented amount of monetary stimulus, with implications for equity and fixed income markets as well as the real economy.
Beyond the same uncertainty from recent years, a new dynamic is in play, with President Trump set to appoint a new FOMC chairman as Yellen’s term expires in February. While the currently rumored lead candidate, current Fed Governor Jerome Powell, is not overtly hawkish, it remains to be seen in which way Powell’s leadership would tilt the balance of the FOMC. In addition, there is always the possibility that Trump changes course at the last minute and appoints a more hawkish Fed chair such as Stanford University economist John Taylor. If the bond market views the appointment of the new fed chair negatively, we would welcome the opportunity to reconsider the positioning of our fixed income portfolios.
October 9 marked the 10-year anniversary of equity markets’ pre-crisis peak, providing a good time to reflect upon the bumpy but solid performance over this stretch, particularly in the U.S. Over the full 10 years, the S&P 500 returned 7.8% annualized, and the MSCI ACWI returned 3.9%. Interestingly, while in local terms the ACWI returned 4.6%, currency headwinds from a strengthening dollar brought U.S. dollar-denominated returns below those of an aggregate U.S. bond index. Though initially rocky, the past 10 years highlight the importance of owning businesses and assets with a long-term business owner mindset and not attempting to time the market. We would like to take this occasion to reflect on the past 10 years.
While actual client returns depend on how closely accounts were allocated along our model guidelines and any account-specific restrictions, looking at the performance of our hypothetical model portfolios over 10 years is still insightful. As expected, investors that maintained a consistently higher equity allocation were rewarded with higher returns net of fees, but at the expense of more severe drawdowns. This is how capital markets are supposed to work, and we believe that after 10 years, all of our model portfolios produced solid absolute returns net of fees. In addition, each portfolio except for our stable value model, our most risk-averse portfolio, exceeded the return of its respective index. On a real basis, our various portfolios compounded wealth at a real rate of CPI plus 2% to 5% net of fees, which is consistent with how portfolios of these risk levels have performed historically. In addition, these outcomes are in line with what we would expect relative to each other. It is important to realize that no one portfolio is superior to another, but that our model portfolios each provide a unique solution for investors that have different risk tolerances and return requirements. Taken as a whole, the past 10 years appear surprisingly normal to us, despite the events of 2008 and 2009 that caused a disastrous start to this most recent 10-year period.
As our model results show, both long-term returns and management of downside risk come from the policy portfolio one invests in, underscoring the importance of choosing the right portfolio so that it is possible to stick with an investment plan through even the most dire market scenarios. Not directly visible in the data is that our managers have also outperformed in downturns relative to their respective indices. This is a large part of the value proposition we believe BBH provides, and we hope our insistence on knowing what we own and why continues to make the turbulent markets more bearable by having strong hands when the pendulum swings from greed to fear.
Nowhere in this framework is an attempt to time the markets. While we are aware a select few managers had the foresight to begin shorting mortgage-backed securities before the crisis, we have yet to hear of a manager who sold all of his or her equities in 2007 or early 2008 and bought back in in March 2009. Instead, those who sold out most likely did so after Lehman Brothers collapsed, crystallizing a good part of their losses. It is highly unlikely they bought back in at the market’s nadir in early March 2009. If they instead waited until there was more certainty about the economy in late 2009, they likely wound up worse off than if they simply held on to what they owned.
Looking ahead, it is logical to ask how our portfolios may fare over the next 10 years. After all, today is a period of elevated valuations vs. history, just as 2007 was. While the future is unknowable, we will offer just a few thoughts on what we expect to be the drivers of our long-term horizon.
Our key takeaway from exercises like this is that the longer the timeframe one has, the more that growth in intrinsic value matters, and the less that changes in valuation matter. The reason for this is that there is a compounding effect when a company can consistently grow revenues, earnings and cash flow (resulting in commensurate growth in intrinsic value), whereas a change in valuation is a one-time event. Using a simple example, if an investor invests in a company today with a P/E of 20x, and that company’s earnings multiple reverts to 16x over the next 10 years, he or she takes a -20% one-time hit in his or her return. However, if the business can grow its earnings at 10% annually over the same period, the investor would wind up with a nearly 8% return over the decade. If, instead, this valuation change happened over five years, the return would be closer to 5%. The nearby table lays out the resulting 10-year return that results from a given level of earnings growth and starting valuation when the P/E ratio reverts to 16x over 10 years.
There are many other factors that influence returns that we have intentionally omitted from this example, but the key point remains that investing in quality businesses that can achieve profitable growth over the long term provides a steady upward march in intrinsic value that over time becomes the largest driver of return. To take advantage of this “time arbitrage,” as it is sometimes called, requires investors to have a long-term investment horizon, refrain from market timing and seek out talented investment partners who share an investment philosophy that appreciates the power of compounding.
To that point, if one were to purchase the “market” today, we would argue that investor expectations for equity returns over the next 10 years should be lower than the past 10 on a probability-adjusted basis, largely due to current market valuations. Fortunately, we do not own the market, and on an aggregate basis, we believe we own a portfolio of above- to well above-average businesses with above- to well above-average growth prospects. Thus, while we acknowledge the following 10 years may be challenging, we believe we can generate commensurate returns with appropriate risk over this period, as we did the trailing 10 years, if we execute well. The path to these returns, though, is unknowable and will likely be bumpy. Bumpiness that arises from changes in market valuations (sentiment) should not deter long-term investors from their primary goal of investing in companies that grow their intrinsic value over the long term.
It is for these reasons that we look to form long-term partnerships primarily with managers that have long time horizons and focus on owning quality investments that grow their intrinsic values over time. We believe that regardless of what the market presents us with over the next 10 years, this is the surest path to meeting our goal of preserving and growing our clients’ wealth, and thus should form the core of our equity offering. There are strategies that can add value that do not fit this rubric (for example, deep value, cyclical equities or distressed debt) in which we invest, but paying reasonable prices for high-quality, growing businesses is what we do best.
Turning to our third-quarter results, the public equity portion of our domestic taxable qualified balanced growth portfolio produced a solid absolute return of 15.8% year to date. Absolute performance was strong as a result of security selection across most of our strategies. On a relative basis, the figure fell short of the ACWI benchmark due largely to our equity partners’ aggregate cash position; however, it outpaced the S&P 500, thanks in large part to strong returns from our international investments, which we incrementally added to early this year. In aggregate, our equity investment partners ended the quarter with a cash position of 13.5% – up from 12.5% at second quarter-end and from the 8% low marked in January 2017 – as a result of trimming and exiting positions that were approaching or reached intrinsic value. We are pleased with their execution.
Fixed Income Markets
Fixed income markets provided solid returns in the third quarter, with aggregate taxable bonds up 0.8% and aggregate municipal bonds up 1.1%. In comparison, BBH’s strategic reserves allocation earned 0.7%, and our municipal bond allocation earned 0.9%, with both taking substantially less risk than typical taxable and municipal bond benchmarks. Ten-year Treasury yields declined over 25 basis points (bps)2 intra-quarter but finished relatively unchanged. Thus, most of the return in fixed income last quarter came from changes in spreads, which tightened in both investment grade and high-yield bonds.
We believe that many forces that have been at play in fixed income markets for some time, such as near-zero rates and unprecedented quantitative easing, are beginning to pause – and even reverse. The U.S. has experienced several short-term rate hikes, and plans for balance sheet normalization are well telegraphed. The European Central Bank has started discussing normalizing policy in Europe, and other major central banks may follow suit. Just as no one could predict the effect of extraordinary monetary stimulus on markets, we also do not believe it is possible to predict what will happen as those policies are (partially) unwound.
Beyond short-term rates, the most important thing for fixed income investors is the term premium between short- and long-term bonds, as this is the compensation for extending duration, or taking on additional interest rate risk. At present, this premium is low by historical standards, so we are content investing in shorter-duration fixed income. For example, as the nearby chart illustrates, investors earn just 0.75% more by investing in a 10-year Treasury than a two-year Treasury. To us, that means we are being paid to wait for more clarity on the implications of changing monetary policy and are not giving up much return by remaining patient in extending our portfolio’s duration. As rates rise, we will continue to stage into longer-duration fixed income as the risk-return relationship skews more in our favor.
As the following table shows, it would not take that extreme a turn of events to produce meaningfully negative returns for long-duration fixed income investors. A 1% (100 bps) rate increase would cause a 10-year Treasury to return -5% over the next year, while a two-year Treasury would still have a positive return. The higher rates go, the more resilient bonds are in the face of those that may rise further. This is due to higher starting yields that provide the ammunition to offset price declines higher rates bring about. Given current uncertainty with balance sheet normalization, rate hikes and inflation, we remain of the view that it is prudent to wait for more clarity on interest rates before establishing a more meaningful position in longer-duration bonds.
Last quarter’s issue spoke extensively about the state of credit markets, which have only continued to grind tighter over the past three months. Even high-yield energy has rebounded to the point where it shows just a small loss on a trailing three-year basis. We watch credit markets closely, as we believe they can be a harbinger of trouble down the road. History shows that loose credit conditions for a long period of time can result in excess leverage that, when unexpected risks appear, more easily causes companies to fall into financial distress. At times like this in the credit cycle, a strong balance sheet is an underappreciated competitive advantage.
Leveraged loan market data tells a big part of the story. Driven by refinancings and new leveraged buyout volume, year-to-date U.S. leveraged loan volume has set a new record, with two and a half months of 2017 left to go. When credit is this easy, it is best to proceed with caution, which is what we are doing by focusing on lower middle-market, private, directly originated loans for our qualified accounts. While public non-investment grade debt can provide an attractive yield for a broader client set, our hurdles for owning this asset class far exceed current yield and spread levels. As of mid-October, high-yield investors earn a spread of 3.47% above comparable maturity Treasuries as compensation for bearing high-yield credit risk; this is less than 1% above the average level of credit losses the asset class experienced over the past 20 years.3 This is scant compensation given that high-yield default cycles do not move in a predictable fashion, and years of below-average defaults (such as we have seen in the past few years) are inevitably followed by periods of elevated losses.
If the next 10 years look anything like the past 10, there will be opportunities to earn solid returns – but also sell-off periods that test the resolve of all market participants. We do not know when the next recession or market downturn will happen but believe it is best to stay disciplined in our approach and not chase returns at this point in the cycle. At 22x trailing earnings, the market is not cheap vs. history, and screaming buys are difficult to locate. Conversations with our managers provide us comfort that they are sticking to their approach. Our focus today is building resilient portfolios one investment at a time, demanding a comfortable margin of safety and remaining extra vigilant on the risks facing the businesses and assets we own. We continue to like what we own.
Past performance does not guarantee future results.
The model policy portfolios were incepted in January 2007. The model portfolio performance results are shown for illustrative purposes only and are not meant to be representative of actual client results achieved by the manager. The actual composition and performance of a client’s account may 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. 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 or whenever the manager chooses to make a change to the model portfolio allocation. 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. The model portfolio assumes a full allocation to the private equity asset class and a pro rata-based allocation based on current capital deployed in each underlying fund. Performance of the model does not take into consideration cash held by the Core Select Model Portfolio and assumes that the account is sizable enough to fully participate in the Core Select Strategy. Performance of the model does not take into consideration the reinvestment on 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 overcompensated 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.
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.
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1 A margin of safety exists when we believe there is a significant discount to our estimate of intrinsic value at the time of purchase.
2 One “basis point,” or “bp,” is 1/100th of a percent (0.01% or 0.0001).
3 The average of several annual default studies (Moody’s, Standard & Poor’s and Altman) indicates roughly a 4.23 historical default rate and just under 60% recoveries, for total credit losses of 2.5%.