The third quarter delivered strong positive returns across equities, fixed income and commodities, although with a moderate pick up in volatility. While the positive momentum in the global equity markets that began on March 23 continued through much of the quarter, investors began to retreat in September (and global equity markets declined 3.2%). The dollar weakened substantially during the quarter, boosting the returns of emerging markets equity and non-U.S. developed equity, although non-U.S. developed equity continues to lag all but its U.S. small-cap peers. Fixed income benefited from contracting credit spreads, as well as the Federal Reserve’s liquidity-driven policies. Overall, the quarter was strong, and we are pleased with the performance of Brown Brothers Harriman’s (BBH) policy portfolios, all of which generated positive returns for the nine months ending September 30, 2020.
As we begin the final quarter of 2020, it is clear we are facing an increasingly complex environment in which to invest. Investors are weighing the risks of a second wave of COVID-19 cases and the probability and timing of therapeutics and a vaccine that will enable the economy to reopen in an unrestricted way. Congress has yet to deliver an additional fiscal stimulus package, and the benefits in the $2 trillion CARES Act in March are no longer available to small businesses and individuals. The U.S. election, just two weeks away at the time of this writing, has raised significant questions as to the market impact of various policy changes that will likely be enacted if the Democrats sweep both the White House and Congress. Further, a rise in mail-in voting and the counting of absentee ballots may delay many election results, including the outcome of the presidential election. BBH Chief Investment Strategist Scott Clemons and colleagues address several of the potential economic, tax and market implications of a Democratic sweep in this issue’s feature article and provide some helpful insights. On a positive note, the Federal Reserve has communicated “lower-for-longer” interest rates and a continued commitment to provide liquidity to the markets. As we weigh all these factors, we have come to the conclusion that now is not a time to take excessive risk in portfolios, and investors should be prepared for increased volatility over the next few months. As always, we are focused on protecting and growing our clients’ capital over time. Next, we highlight several observations regarding the current composition of BBH policy portfolios:
- Equities: In recognition of the wide range of outcomes present in the market coupled with strong year-to-date performance, we have reduced our equity allocation in most policy portfolios from an overweight to a relatively neutral position.1 In addition, we are encouraging clients to rebalance back to targets when the market moves actual allocations out of range. Within our equity portfolios, we are overweight U.S. equities, where our managers continue to find compelling bottom-up investment opportunities, although arguably fewer of them than at the market lows in March. While we do not make top-down decisions to avoid sectors, given our emphasis on owning companies with superior business models, limited capital spending requirements and lower financial leverage, we have virtually no exposure to the energy sector and are substantially underweight financials, particularly banks, both of which have underperformed the S&P 500 on a year-to-date basis. Our portfolios are overweight in the consumer-oriented and technology sectors, which have been strong performers during the year.
- Fixed income: In past years, BBH has made an effort to extend the duration of our fixed income holdings in both taxable and tax-exempt client portfolios, which has helped performance given the recent decline in interest rates. Given the current low level of interest rates, however, clients building new fixed income portfolios will largely be invested in short-duration bonds. We believe that the extra yield one can obtain from buying longer-dated fixed income securities does not compensate investors for the interest rate risk. Although bond yields are unattractive, we continue to believe that fixed income has a place in portfolios as a way to provide liquidity and stability in volatile equity markets. However, recognizing that money market funds essentially provide a 0% return, we are seeking alternatives for short-term cash that can be additive to clients’ portfolios. As always, we will be opportunistic in adding to longer-duration fixed income securities when compelling opportunities arise. Finally, clients that need income in their portfolios should work with their relationship managers to develop a program that provides for regular distributions of capital from the portfolio, not just interest and dividends.
- Private investments: For clients that can tolerate illiquidity, we are finding compelling opportunities in private investments, particularly small and middle-market growth equity investments. Investing in private businesses that provide essential products and services, generate significant recurring revenue, have strong and effective management teams and compete in industries with high barriers to entry and strong growth prospects can produce returns that provide attractive premiums over public markets. We also believe that many companies will experience distress from the economic disruption of COVID-19. These companies will require rescue financing or seek bankruptcy protection, providing attractive opportunities for distressed funds, which have flexible and long-term capital, to invest on favorable terms and see these investments through to their resolution.
- Cash in the portfolio: Our managers adhere to strict valuation disciplines and are willing to hold cash rather than lowering their standards to be fully invested. As the markets reached peak levels in February of this year, cash held by our managers (look-through cash) increased as valuations reached more frothy levels. When the markets declined in March, our managers successfully deployed this cash into more attractively valued securities. To put some numbers around this progression, the BBH taxable balanced growth portfolio had a peak level of look-through cash of 5.2% in February 2020, which had declined to 2.5% by March 2020 and stands at the same level at the end of the third quarter.
As we navigate through this unprecedented period, we remind ourselves that staying true to a clear, defined investment philosophy is critical to providing investors with strong long-term returns. As such, we will not stretch for yield, use excessive leverage or invest in fads simply because others are doing so. We will, however, continue to scour the globe for new opportunities that meet our high standards for inclusion in our portfolios.
In the equity markets, the third quarter was largely a continuation of the trends investors have observed over the past several months, following the late-March pandemic-induced sell-off. Despite the many risks, all equities generated positive returns for the quarter. Under the surface, however, there is a substantial divide between those businesses that have been able to withstand the disruption caused by the pandemic (and many that have in fact benefited from the accelerated digitization trends prompted by lockdowns and stay-at-home orders) vs. businesses most negatively affected, whose revenues are directly tied to the resumption of “normal” in-person/on-premise activities (such as hospitality, leisure, travel and retail). Moreover, companies that entered the crisis with overleveraged balance sheets and business models that require high capital expenditures or have thin margins have struggled to navigate the ongoing economic uncertainty (including energy, mining, utilities and financials). Investor capital has disproportionately flowed into businesses across the technology, healthcare and consumer-oriented sectors.
The dominance of the largest constituents of the S&P 500 – FAAMG (Facebook, Apple, Amazon, Microsoft and Google) – has been well documented. These companies have surged toward all-time highs and account for the bulk of year-to-date index performance; approximately 47% of positive contribution in the S&P 500 is attributable to these five companies. This pronounced level of outperformance by a select number of businesses has exacerbated the existing trend toward increased concentration of the index (as depicted in the nearby chart), with FAAMG representing 22.6% of the index at the end of the third quarter. This dynamic has persisted throughout the first three quarters of the year, despite a slight reversal in the month of September, which saw “big tech” sell off around heightened antitrust scrutiny and fears of potential regulation.
While “index-hugging” investors have more trouble beating the market in such environments, concentrated active managers have other ways to potentially outperform. In fact, though the FAAMG stocks have been significant drivers of return, 41% of companies in the S&P 500 (209 companies) outperformed the index’s return of 8.9% in the third quarter. On a year-to-date basis, 35% of companies in the S&P 500 (179 companies) outperformed the index’s return of 5.6%. A quarter or even nine months is not a sufficient time period to judge any manager’s performance, but over the last 10 years, 209 companies in the S&P 500 (of the 427 with 10 years of performance history) outperformed the index, providing plenty of fertile ground for managers to outperform over the long term without owning FAAMG.
Outside the U.S., international developed equities have continued to lag the U.S. despite a tailwind from currency. The MSCI EAFE Index was up 4.9% in the third quarter but is still down 6.7% year to date. In the third quarter, currency added 3.6% to the U.S. dollar returns of the EAFE Index (the vast majority of the return) and 2.4% on a year-to-date basis. Within emerging markets, index returns have been driven by the large exposure to China (38.4% average year-to-date weight) and the strong performance of businesses in China and, to a lesser extent, Taiwan and South Korea. Similar to the dynamic within U.S. large-cap equity, the performance of the MSCI Emerging Markets Index (-0.9% year to date) has been driven by pronounced index concentration in mega-cap technology conglomerates, namely Alibaba (up 38.6% year to date) and Tencent (up 37.3% year to date), whose combined weight in the index totaled 14.4% at the end of the third quarter. In addition, currency was a tailwind to third quarter emerging markets performance, though it was a headwind year to date.
In a year like 2020, it is important to remember that even though markets have downturns, in general they trend up over time. While we cannot predict what will happen in the balance of this year, or next year, we take comfort in this fact. As shown in the nearby table, the S&P 500’s returns have been positive approximately 75% of the time, and there were only four out of 87.5 years that the index declined greater than 20%. Furthermore, because BBH invests with concentrated, active managers, we are not doomed to index-like returns, even if markets prove to be volatile. We judge our managers by their long-term performance and don’t expect them to outperform every year – although in 2020, our managers have generally performed well relative to their benchmarks.
Fixed Income Markets
The U.S. Treasury yield curve was relatively unchanged in the third quarter, leading to subdued but positive returns in the higher-quality, rate-sensitive areas of fixed income markets. The Barclays U.S. Treasury Index returned 0.1%, while the Barclays U.S. Aggregate Index returned 0.6%. On a year-to-date basis, however, returns have been quite strong due to the sharp decrease in yields.
Credit spreads, on the other hand, narrowed during the quarter and drove stronger returns in corporate and high-yield credit. U.S. investment grade corporate bonds returned 1.5%, while high yield returned 4.7%. However, on a year-to-date basis, high-yield bonds are still down 0.2%, while higher-quality investment grade bonds have returned 6.7%. Viewed over a longer period, high-yield credit spreads, at 5.2%, trade near their median level over the past 20 years. The default outlook, though, is much more uncertain. According to Moody’s, the trailing 12-month global speculative grade default rate was 6.4% at the end of September and is expected to peak at 8.4% in March 2021, well above the historical average, which is 4.1%2 While investors can buy a stated yield of over 5% in high yield, they do so with significant uncertainty around their future potential credit losses.
Though interest rates were relatively unchanged this quarter, the Federal Open Market Committee (FOMC) was still active in setting expectations about their future path. On August 27, the FOMC amended its “Statement on Longer-Run Goals and Monetary Policy Strategy,” where the committee outlined a new policy of average inflation targeting. This policy aims to let inflation run above its 2% target following periods when inflation has run persistently below this level. With inflation having persistently undershot the Fed’s 2% target since the global financial crisis, the Fed has given itself room to keep rates near zero even if inflation begins to creep up. If we take the Fed at its word, this new guidance, as well as the most recent FOMC projections that show 13 of 17 members projecting a 0% to 0.25% fed funds rate through the end of 2023, give significant support to the view that short-term interest rates will likely stay low for some time.
While the opportunity set in fixed income is not determined entirely by Fed policy – credit spreads and long-term interest rates are determined by myriad other factors – the forward-looking returns in fixed income at this point in time are relatively muted. Instead of reaching for returns, we recommend that investors remember that fixed income’s primary purpose is to provide stability and liquidity to portfolios. We will actively seek additional return and income-generating opportunities to complement our portfolios, but credit quality should not be sacrificed in the core of the fixed income portfolio.
As we look forward, we believe that it will be difficult to generate the same level of market returns that investors have earned historically. Declining interest rates, for one, have undoubtedly been a tailwind to both fixed income and equity returns, and if we take the Federal Reserve at its word, rates will likely stay low for the next few years. Meanwhile, the investment environment has only appeared to get more challenging, given COVID-19, the potential for a contested U.S. election and rising geopolitical tensions, to name a few. In this environment, we believe disciplined security selection will be critical to generating attractive long-term returns. Therefore, now more than ever, we believe that actively managed concentrated strategies offer the best chance to add value over long-term periods. While valuations have certainly become more expensive, particularly in certain sectors of the market, our managers are optimistic that they can generate compelling returns going forward by owning a concentrated portfolio of high-quality cash flowing companies that can compound capital over time. By design, our managers construct portfolios that look different from their benchmarks; thus, performance can and will diverge from market-level returns.
Above all, we recommend staying the course, sticking to your asset allocation and focusing on the long term. While there are admittedly many crosscurrents in the market today, market timing has never proved to be a repeatable investment strategy. A long time horizon and the patience to wait through periods of market turbulence have always served investors well.
Opinions, forecasts and discussions about investment strategies represent the authors’ views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations. Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved. PB-03973-2020-10-06
1 The change was made in equity-oriented policy portfolios (those with benchmarks of 50% or greater to equity).
2 Source: Moody’s. “Default Trends and Rating Transitions.”