Market Outlook & Commentary Q3 2017
The third quarter had its share of bumps and bruises with political turmoil in Washington dominating headlines, but the market seemed to move past these headlines in late August/early September. By late September, the market rallies had pushed the market to new highs making this bull market the second-longest of historical note. Consistent with prior quarters, volatility as gauged by the volatility index (VIX) was largely muted in the US over much of the quarter, and the VIX has now posted over 30 closes below 10 this year.
As evidenced by the above chart from Alliance Bernstein, US small cap companies narrowed the year-to-date (YTD) gap with their larger cap counterparts, with growth continuing to meaningfully outpace value (e.g. Russell Growth vs. Russell Value indices), which is emblematic of a “risk on” rally though the large cap S&P 500 index has still outpaced the small cap Russell 3000 index this year. The quarter’s rally also featured the following:
Strong performance from US high yield and emerging market debt
Steady-but-not-spectacular performance from the long/short equity category
Continuation of prior sector market leadership (healthcare, technology)
A quarter-end rally in financials and
A rebound in the energy complex
A retreat in bond-proxies such as Utilities and Consumer Staples.
The theme of the year however has been the continued robust performance of International Developed markets and Emerging Markets, wherein high-single-digit quarterly returns and YTD double-digit returns have largely been driven by improving corporate growth prospects, strong economic data including expansionary readings for most global Purchasing Manufacturers Index (PMI) indicators, upward earnings revisions and higher institutional investor allocations in recognition of below-historical-median valuations.
Our Quick Take
As recent hurdles or angst over the passage of healthcare reform, renegotiation of the North American Free Trade Agreement (NAFTA) or potentially-looming tax reform have illustrated, the honeymoon phase of the administration has run headlong into the harsh realities of Washington and global politics, which has spilled over into the tame performance of certain “Trump trade” beneficiaries. Largely, US markets have discounted minimal expectations about meaningful near-term policy changes with the exception of tax reform, and the rally in US markets is increasingly predicated on strong corporate earnings growth and robust economic fundamentals, while interest-rate sensitive portions of the market have reacted positively to Federal Reserve announcements regarding a gradual tightening.
In contrast, most international developed markets are in recovery mode with earnings growth across much of Europe, the fading of populist rhetoric following the ascension of mostly pro-Eurozone candidates (the latest being Angela Merkel in Germany) at the cost of populist contenders, thus putting to rest concerns about the Eurozone’s stability. Profit growth in emerging markets seem to have bottomed in early 2016 even as formerly key concerns such as slowing Chinese growth, impact of currency demonetization in India, a rapidly rising dollar and the commodities rout have dissipated thus creating a favorable setup for foreign assets.
Portfolio Positioning – Asset Allocation & Sector Considerations
As we have described previously, we construct your portfolios with the following categories of investments in mind:
Longer-Term Return Generators, comprising asset classes such as US Equities & Developed International Equities that have the potential to generate mid to high single-digit returns over the duration of an entire market cycle, and Emerging Market Equities that have the potential to generate high-single-digit (or greater) returns longer-term albeit with higher volatility and that have a place within the context of an aggressive portfolio;
Shorter-Term Risk Reducers comprising core fixed income asset classes including municipal bonds which have the potential to generate low to mid-single-digit returns long-term but act as safe havens during market downturns/recessions with the exception of 2008-09 where there were legitimate concerns regarding the fiscal health of state & local governments;
Alternate Strategies, which play the dual roles of return generators and portfolio diversifiers and include long/short strategies, global infrastructure and private real estate, and where returns are less correlated with public markets and where returns benefit from the illiquidity premium.
We believe thoughtful asset allocation, periodic rebalancing and ongoing prudent selection of investments is key to superior long-term performance, and demonstrating this point is a chart courtesy JP Morgan, stretching over a 15-year period through Q317, which illustrates best-to-worst performing asset class performance annually across US and International markets.
Upon closer scrutiny, we see that the best and worst performing asset classes vary annually, highlighting the need to rebalance portfolios periodically to ensure that the overall portfolio mix is consistent with broader objectives thereby preserving investment discipline.
As we enter the classic later stages of what has been one of the longest market cycles to date (over 100 months and counting) in the US, we continue to believe it is important to overweight or underweight sectors that have characteristically outperformed or underperformed broader market indices at similar stages in prior market cycles. To us, this has meant the following:
Favoring defensive, later-stage sectors such as Healthcare over early-stage cyclical sectors such as Consumer Discretionary
Financials which benefit from higher net interest margins on the back of higher rates and less onerous regulation
Favoring asset classes that exhibit lower market correlation such as long-short equity, private real estate and global infrastructure assets.
On an ongoing basis, we plan to opportunistically upgrade investment managers across various asset classes, and take advantage of periodic corrections to replace broad stock baskets (actively managed funds or ETFs) especially in the large-cap universe with select attractively-valued, fundamentally-sound equities of industry leading corporations with wide economic moats. For instance, we recently added Visa (V), a payments technology company that connects consumers, merchants, financial institutions and government entities to electronic payments, to some of our more aggressive growth portfolios in the most recent quarter. Aided by ownership of the largest credit and debit network worldwide, Visa benefits from the worldwide move away from cash and toward electronic payments, enjoys a wide economic moat, offers high recurring revenue & free cash flow and we believe it offers double-digit earnings growth at a reasonable valuation.
Our Parting Thoughts
As we enter the last quarter of 2017 and remain in the midst of the 9th year of the market cycle in the US, we see potential for global growth to accelerate in a manner unlike prior years with US growth likely to pick up modestly if the last few vestiges of the Trump campaign platform (corporate tax reform, tax repatriation) come to fruition, which does not seem a given following the fate of other campaign promises this year. With the 3rd quarter earnings season well under way, consensus expectations call for S&P 500 companies to post mid-single-digit year-over-year sales growth and low-single-digit earnings growth, with that growth projected to accelerate to 6% and 11% for Q417 respectively.
We continue to believe that we are in the later stages of the current market cycle in the US. Barring any unforeseen exogenous events such as war, global terrorism, faster-than-expected rate increases or failure to push through tax reform, our base-case market outlook assumes no US or global recession over the next year. However, since global markets cannot forever move up and to the right, we would not rule out a correction over the next six months, given that it has been slightly over a year since we had a 5% drawdown and over 1 ½ years since we had a 10% drawdown.
At current levels, the S&P 500 index is trading a couple of turns above historical average valuations on a price-to-forward-earnings basis, with future up moves likely predicated more on earnings growth than multiple expansion which leads us to a more measured approach to investing in these markets. Developed and emerging markets however are more attractively valued, as they trade either at or below 25-year-median P/E multiples respectively, and we believe they have more room to run. As we have highlighted during our market-focused client events and countless investor meetings over the past year, we seek to build globally diversified portfolios with a nod to quality and value, and international markets fit the bill better.
We expect a reflationary environment to result in higher global bond yields as economic growth picks up, with traditional bond funds at risk of capital losses. Historically, stocks tend to outperform bonds in reflationary environments as growth picks up across the board and rates rise gradually. Accordingly, we continue expect to invest in or evaluate the following investment vehicles:
Floating rate bond funds
Preferreds and converts
Keep the duration of our fixed income investments short
Lean toward non-traditional sources of yield including Private Placement investment vehicles that benefit from the illiquidity premium and exhibit less correlation with the broader equity markets.
Further, as we review capital market assumptions for various asset classes over the next 5 years, we are compelled to favor Emerging Markets (EM) assets over Developed Market (DM) assets due to the gap between current and historical trend growth, signs of stabilization in China with minimal currency turmoil, relative calm in India post the recent de-monetization, improving profitability and below-historical-average market valuations. We believe the biggest risks to the market rally are protectionist trade wars, unexpected military aggression, failure to pass tax reform/tighter-than-expected Fed Policy (in the US) or pronounced moves in the US dollar, but barring a series of adverse macro outcomes, these are likely chances to buy rather than bail.
Also, more to add on the active vs. passive investing vehicle debate, with passive vehicles like ETFs continuing to vacuum up assets at the expense of active managers. 2017 has seen active managers make a rebound of sorts, with 51% of active managers outperforming their respective indices relative to the 5-year average of 34%, which is still underwhelming. In our effort to generate robust risk-adjusted returns over a 3-5-year timeframe, we remain agnostic to choosing actively managed funds, passive ETFs or individual securities with a bias toward active management in less efficient categories such as International & Small Cap Equities, Long/Short Equities and High Yield Credit. Our recent additions both of individual large cap stocks such as Visa, International asset managers such as Oakmark and Lazard that have all outperformed their respective benchmarks bolster our beliefs that active management can add value especially as dispersion between the highest and lowest quality assets widens even as markets trend higher. As always, feel free to reach out to us with questions/comments.
Jodi Vleck (Founder, Wealth Manager) & Giri Krishnan (Portfolio Manager).