Woody Hayes, the legendary football coach of the Ohio State Buckeyes, built his offensive strategy around the observation that only three things can happen when a quarterback passes the ball, and two of them are bad. Rather than run the risk of an incomplete pass or an interception, Coach Hayes preferred to run the ball, often straight up the middle of the field. He figured that if he had to go ten yards and had four downs in which to do it, then three yards and a cloud of dust would get him there, if his team could accomplish that on each play. Slow and steady might not have been exciting, but it was effective. Coach Hayes and Ohio State won five national championships in that cloud of dust.
The pace of growth in the American economy resembles Coach Hayes’s offensive strategy. Since the trough of the economic cycle in June 2009, the economy has expanded at a modest annualized pace of 2.2% in inflation-adjusted terms, decidedly sub-par relative to history. The lethargic pace of this cycle reflects a similar sluggishness in the recovery of the housing and labor markets, the primary drivers of wealth, income and therefore consumer spending. At the same time, as Americans repair their household balance sheets by paying down debts and boosting their savings rates, not all of the gains in wealth and income flow through to Gross Domestic Product (GDP) through spending. Stronger household finances are good in the long run, but in the short run renewed fiscal discipline at the household level helps to explain why growth continues to be so lackluster.
Curiously, this cycle has been punctuated with three quarters of economic contraction, the most recent of which occurred in the first quarter of this year. The fact that these quarterly setbacks took place in the first quarters of 2011, 2014 and 2015 indicates that something has gone awry with the usual seasonal adjustments to the statistics. It snows every winter, but that seasonal certainty has somehow turned into a bigger drag on economic activity than is usually the case. We will get a preliminary look at second quarter 2015 economic growth at the end of July, but a consensus estimate of 2.5% indicates that the pace of the past several years is not likely to change anytime soon.
The good news is that the leisurely nature of this expansion has inhibited the excesses that all too often arise as an economic cycle ages. Although the Fed is likely to begin raising interest rates this fall, they will do so in response to a more normal economic environment, not out of a fear of inflation or runaway spending. Although we certainly wish for an acceleration in growth, in the meantime what this economy lacks in vitality, it makes up for in durability.
As the date of the first Federal Reserve interest rate increase in nine years draws nearer, bond yields are moving higher, driving total returns into negative territory for most fixed income asset classes. For the first half of 2015, price declines have offset yield for Treasuries, municipals, corporates and inflation-indexed bonds, leaving total returns hovering around zero percent. The richer coupons associated with non-investment grade bonds have provided some protection against falling prices, but a total return of 2.5% for the first half is nonetheless far off the pace of previous years for high yield debt. We remain rather conservative in our bond allocations, preferring the liquidity and price stability of shorter-maturity and higher-quality assets rather than chasing yield through the assumption of inappropriate credit or duration risk. As interest rates rise, and as the compensation for risk becomes more reasonable, we will re-establish a more traditional bond allocation into client portfolios, but this is more likely to be a gradual process than a specific event.
Equities inched higher throughout the first half of the year. In a change from previous periods, domestic equities lagged their international peers, with developed markets (as measured by MSCI EAFE) leading the way at 6.0%. The S&P 500 posted a total return of 1.2% for the first six months of the year, with smaller stocks doing slightly better at 4.8%.
In this seventh year of an equity market cycle, stocks continue to climb the proverbial wall of worry. Earnings growth is waning as the benefits of cost cutting recede, valuations are above historical averages and lofty profit margins imply that future earnings growth is likely to be a function of revenue growth rather than margin expansion. Investor complacency is high, even in the face of the Greek debt crisis and Chinese stock market volatility, and margin debt at NYSE firms stands at a record level of half a trillion dollars. None of these issues spells the end of a bull market, but in combination they do speak to the obstacles facing the equity market as a whole.
How, then, should investors manage risk in such an environment? The traditional Wall Street approach of addressing risk through diversification simply locks in the market challenges summarized in the preceding paragraph. We prefer to manage equity risk through a deep knowledge of our portfolio companies, and the acquisition of those companies at a price that offers a margin of safety.1 Those opportunities are admittedly not as easy to find in the seventh year of a bull market, but concentration, not diversification, is the appropriate risk management approach in such a market environment.
At the same time, investors are confronted with the challenge of either lowering their investment standards to remain fully invested in a market where value opportunities are thin, or allowing cash levels to rise. That decision is easy for the disciplined investor. Cash positions are a drag on relative returns in a rising market, but that forgone relative return is a price worth paying for a prudent balance of risk and return. Furthermore, when those risks come to fruition and prices correct, the option value of that cash will prove very appealing, and allow investors to take advantage of price volatility and the investment opportunities it creates.
Our clients’ portfolios hold a fair amount of short-term liquidity. We continue to seek ways to put those funds to work in more productive ways, and we expect that the probability of encountering those opportunities is rising as this economic and market cycle ages.
Equity Asset Classes: Large cap U.S.: S&P 500; Small/mid cap U.S.: Russell 2500; Non-U.S. developed: MSCI EAFE; Non-U.S. emerging: MSCI Emerging Markets.
Fixed Income Asset Classes: Investment grade taxable bonds: Barclay’s Aggregate; Investment grade tax-exempt bonds: S&P Municipal Bond Index; Inflation protected: Barclay’s U.S. TIPS; High-yield: BofA Merrill Lynch High-Yield (Cash Pay Only).
Source: Bloomberg, BBH Analysis.
Past performance does not guarantee future results.
Index performance is not illustrative of any specific security's performance. Indexes are unmanaged and an investment cannot be made directly in any index.
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© Brown Brothers Harriman & Co. 2015. All rights reserved. 2015.
1 Margin of Safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.