Quarter in Review
Global markets posted an outstanding first quarter.
Expectations of broad economic expansion powered global markets upward throughout the quarter. The global equity index, MSCI All-Country World Index (ACWI), was up 6.32% for the quarter while the Barclays Aggregate Bond Index was up 0.82%. Our reflation thesis has played well and the Singer Xenos portfolios outperformed in both equities and bonds.
The global economy is in the midst of the first synchronized recovery in over six years. This is the anchor of our reflation belief. It is reflected in the improvement in the Purchasing Managers’ Index (PMI) which is up across the globe and has been rising since last spring. “Reflation defined as a recovery of the price level when it has fallen below trend line.”
Europe, particularly, has been doing very well and is witnessing a strong pickup in manufacturing. Japan and China are also expanding, which will also support emerging markets. Combined with favorable valuations, we are positive on international markets.
Europe has appeared to turn the corner. The composite Purchasing Managers’ Index for the Eurozone rose to 54.4 in December, up from November’s 53.9 and aligned with its highest level since May 2011. The economy has benefited from a depreciation of the Euro versus the US Dollar, which helps exports. Confidence levels within the European Union have not only beaten expectations, but rose to levels not seen since 2007. This confidence is translating into higher sales among Europe’s top-five auto manufacturers. Due to the improvement, several German economists called on the European Central Bank to raise interest rates after Eurozone inflation accelerated at a higher rate than expected.
Signs of faster economic growth in the US and Europe spurred hopes that a pickup in global growth will be beneficial to emerging markets. China is seeking financial stability ahead of its 19th National Party Congress. Underpinned by stimulus in China, emerging markets growth rates are now expected to reverse their multi-year decline. This should increase the earnings growth of emerging markets companies. Moreover, it appears that oil prices have firmed and foreign exchange rates have bottomed. Combined with favorable valuations, emerging markets return vs. risk is favorable.
US Economy & Political Climate
The US economic expansion continues to be strong with unemployment below average, wages rising which is pushing business activity higher. As a result, consumer confidence in March reached the highest level since December 2000.
Increased confidence also led to an increase in retail sales and home purchases. Due to the improvement, the Federal Reserve Bank increased the federal funds rate in March by 0.25 percent and is expected to raise it again one or two more times this year. Although market valuations are high, the strengthening economy is lifting US profits which were anemic for more than two years.
Since last November, investors have been very optimistic on Trump’s pro-growth agenda consisting of deregulation, tax reform, and increase in infrastructure and defense spending. This led to a hope that after years of stagnation, the US economy might be on the verge of a durable growth. The burst of optimism has pushed the US equity markets up significantly and have made stocks expensive and this is of concern.
This optimism can be seen in the media. The Investor’s Intelligence weekly sentiment survey finds newsletters more bullish than at any time since January 1987.
With the recent run-up of US stocks, the Shiller P/E now sits above its 2007 peak and a mere whisper away from where it sat right before the October 1929 crash. Other valuation metrics similarly show high valuation with the price-to-sales ratio is now 19% above the December 2000 levels and 38% above the 2007 levels.
Many market participants are ebullient that the new policy agenda will be a second coming of the Reagan era. Consumer confidence is nearing levels during Ronald Reagan’s “Morning in America” commercials. There are many similarities—tax cuts, deregulation, increase in defense spending. It is true that an improvement in animal spirits will be beneficial to today’s economy as it was in 1981.
However, the key question for investors is whether or not Trump’s agenda is the correct policy prescription to increase structural economic growth. The economic and market landscape is significantly different today compared to that of 1981.
Back in 1981 the US economy was in the midst of a double dip recession with economy having contracted in 1980 and followed by a severe contraction in 1981-82. Inflation was running hot with CPI at 12.5% and the Federal Reserve reacted by raising interest rates to 18%. It was difficult for the economy to get worse. At the beginning of 1981 the misery index was 19.33, slightly better than 21.98 in June 1980, the worst in US history. Having hit rock bottom, the economy could only improve. With unemployment at 7.2% and a young labor pool of baby boomers entering the workforce, structural change could unleash the economy’s growth potential of an estimated 4%.
In contrast, today’s economic conditions are much different. The economy is in a long, slow expansion. There is very little slack with unemployment, at 4.6%, below historical average. Moreover, inflation is a fraction of 1981 level. As a result, today’s misery index of 7.44 is much less than half of what it was in 1981.
Back in 1981 the top individual tax rate was 70% and was lowered to 28% in 1986. By comparison, Trump’s plan to lower the top rate from 39.6% to 33.0% is much more modest and will be less stimulative to the economy.
Moreover, the economy as a whole in 1981 had far greater ability to relever. In 1981, the government’s debt-to-GDP was 31.1%, and as result, had a great deal of room for tax cuts and deficit spending to fuel the economy. Similarly, household debt was low and had significant borrowing capacity. And borrow they did. Debt fueled growth powered the economy forward for more than a quarter century. Today, both the government and households are near the maximum of their debt capacity and have much less room to take on more debt. Critically, economists estimate that the potential growth rate of the US economy is approximately 1.5%, which is about one third of what it was in 1981.
The financial market conditions are also very different. In 1981 interest rates were very high and the lowering of rates fueled a bull market in bonds that lasted 35 years. In contrast, current interest rates are extremely low and rising, which is a headwind to future returns. The Federal Reserve Bank raised rates in March and there are plans for several more rate hikes. Bonds, which were extremely cheap in 1981, are now expensive.
The same story plays out in equities. The equity market in 1981 had 5 years of flat inflation adjusted returns. In contrast, current equity markets are in the eighth year of a bull market and valuations are very high. A useful valuation metric, the Shiller P/E, was 9.26 at the beginning of 1981. Today the ratio is 29.09, the third highest in US history. One of Warren Buffett’s preferred valuation metrics is stock market capitalization-to-GDP ratio. In 1981, it stood at 41x while today it is 130x. In addition, a hurdle to propelling markets forward is profit margin. In 1981, corporate profits-to-GDP was 7.5%. Today, companies are much leaner and tightly managed due to the use of new technology. Profit margins today stand at 11%, slightly down from the 60 year high of 12% in 2015. As a result, it will be difficult to wring more profits out of cost structures. US equity markets do not have the powerful tailwinds as it did in 1981.
Both Reagan and Trump came to Washington D.C. as outsiders and are using similar pro-growth agendas to inject change. While financial markets boomed during the Reagan era, the economic and market conditions today are significantly different from that of 1981. Although the growth prescription was effective in the 1980s, we question the efficacy of that palliative today. While equity markets are bullish about a similar outcome, we urge caution on that comparison and note that the markets are vulnerable to significant policy risk. This has nothing to do with political views, but rather a forthright comparison.
RS Small Cap Growth
Our best performing domestic equity position this year is RS Small Growth (RSYEX), which is a pure growth strategy. It focuses on identifying companies that that have sustainable growth rooted in strong business fundamentals, innovative products and services, and strong management teams. The investment process emphasizes companies with sustainable long-term revenues and earnings growth prospects and is combined with stringent multi-dimensional risk management. In this environment, we find that small cap growth is better linked to US economic growth than other sectors and better able to offset the effects of rising interest rates.
Portfolio Updates and Strategy
During the quarter, we rode the global reflation trade and outperformed in global equities. In equities, we swapped out of SPDR S&P 500 ETF (SPY) and bought DoubleLine Shiller Enhanced CAPE (DSEEX). It is a sector rotation strategy based on the rigorous research of Nobel Prize winner, economics professor Robert Shiller. It invests in the four sectors of the S&P 500 with best relative valuation and utilizes a value trap momentum filter. Managers use a long term estimate of value which is based on the investing principles of Graham & Dodd. At this stage of the market cycle, this is a better alternative to cap weighted indexes, such as SPY.
Through the first quarter of 2017 our bonds significantly outperformed Barclays Aggregate Bond Index (AGG). Our bond allocation held up to the volatile yield curve due to being well balanced between return vs. risk, investments in high quality managers, and low interest rate exposure. As a result, we did not make any new trades in the quarter since our strategies worked well.
At the end of the quarter, our top performers are Harding Loevner Emerging Markets (+11.7%) in equities, Templeton Global Bond (+4.7%) in fixed income, and Tortoise MLP & Pipeline (+2.4%) in real assets.
Putting It All Together
Despite a high level of volatility emanating from US politics in recent months, US stock market volatility has remained very low. That is unlikely to last. Our portfolios are prepared for more oscillations, particularly downside risk to US stocks. We remain confident in our positioning and in our investment process, both of which allow us to look past periods of uncertainty and keep our focus where it should be: on prudently managing our diversified portfolios to achieve long-term, risk adjusted returns.