Fourth Quarter Market Perspective
Jan. 2016

With a few notable exceptions, fourth quarter market returns partially recouped the downturn suffered during the third quarter. Global equities gained 5.0%, with international equity returns impacted by changes in the U.S. dollar relative to foreign currencies. Within equities, gains for the year were most pronounced for U.S. growth stocks1. Specifically, the top ten performers generated an average return of 52.7% while all other remaining stocks lost an average of 3.2%. Although these “popular” stocks may have appeared to act as life preservers to the rest of the market, this market phenomenon exemplifies a narrowing breadth and is often a harbinger of troubled times ahead for equities.

The much anticipated “lift-off” occurred in December, with the Federal Reserve increasing its Fed Funds Rate by 0.25% to a new target of 0.50%. This contributed to a modest decline in the Barclays US Aggregate Bond Index, which fell 0.6% during the quarter. However, municipal bonds performed well with the Barclays Muni Bond Index advancing 1.5%, while the Barclays Muni High Yield Index advanced 1.8% during the quarter. In general, bonds have performed admirably well during periods of dislocation such as Q3 2014, Q3 2015 and, more recently, January 2016. As a result, they have helped to buoy-up diversified portfolios, contributing to long-term performance by enhancing return and reducing volatility.

Major Index & Currency Performance
Periods Ending December 31, 2015

      Annualized Trailing Total Return
Equities Q4 YTD 3YR 5YR 10YR
S&P 500 TR 7.0 1.4 15.1 12.6 7.3
Russell 2000 TR 3.6 (4.4) 11.7 9.2 6.8
MSCI EAFE NR 4.7 (0.8) 5.0 3.6 3.0
MSCI Emerging Markets NR 0.7 (14.9) (6.8) (4.8) 3.6
MSCI All Country World Index 5.0 (2.4) 7.7 6.1 4.8

Indices are unmanaged and have no fees. An investment may not be made directly in an index. index returns are based in US Dollars
Source: Morningstar

Major Index & Currency Performance
Periods Ending December 31, 2015

      Annualized Trailing Total Return
Fixed Income Q4 YTD 3YR 5YR 10YR
Barclays US Aggregate Bond Index (0.6) 0.5 1.4 3.2 4.5
Barclays Municipal TR 1.5 3.3 3.2 5.3 4.7
Barclays High Yield Muni 1.8 1.8 3.1 7.2 4.8
Euro (EUR vs. USD) (2.7) (10.2) (6.3) (4.1) (0.8)
Pound (GBP vs. USD) (2.7) (5.5) (3.2) (1.2) (1.5)
Yen (JPY vs. USD) (0.4) (0.3) (10.4) (7.6) (0.2)
Real Assets          
S&P GS Commodity Index TR (16.6) (32.9) (23.7) (15.2) (10.6)
Wilshire Global Real Estate Securities Index TR 5.0 1.6 8.1 9.6 6.3
Alerian MLP TR (2.8) (32.6) (3.4) 1.5 8.7

Indices are unmanaged and have no fees. An investment may not be made directly in an index. index returns are based in US Dollars
Source: Morningstar

With the exception of Global REITs, up 5.0%, Real Assets endured another difficult quarter. Commodities and Master Limited Partnerships (MLPs) declined by 16.6% and 2.8%, respectively (as measured by the S&P GSCI and Alerian MLP Index). Rightly or wrongly, each of these asset classes has continued to be associated with the glut in oil supply and the corresponding rut in crude oil prices. While the S&P GSCI Index includes significant energy price exposure, fundamental results for midstream MLP companies, continue to show better performance than the market is demonstrating in MLP asset prices. While the experience has been painful, we still believe energy infrastructure assets will play an important role connecting domestic production with increasing global demand for oil and natural gas.

Queasy, but Calm

As shown in Chart 1, global equities have suffered three corrections2 since Q3 2014. The most recent pullback occurred between November 1, 2015 and January 20, 2016 reducing the value of global equities by approximately $3.2 trillion before partially rebounding during the final week of January. As a result, the roiled equity markets are off to their worst start since 1929.

While it’s common for corrections of this magnitude to occur every 12 months or so, investor anxiety grows with each pullback. We certainly understand how unnerving and unsettling periods like the past two years can be for investors. However, enduring these kinds of environments is precisely why investors have an ability to earn positive returns over the long-term. If markets were perennially calm, there would be little opportunity to earn a positive return. We are long-term, value-oriented investors. As such, we do not get overly preoccupied by short-term results, whether good or bad. In volatile periods like this, it is natural to be a bit queasy, but important to remain calm. Despite the short-term disruptions, we stay focused on the long-term and continue to seek out opportunities to generate attractive risk-adjusted returns.

Chart 1: Total Return of Global Equities1

Total Return of Global Equities
Source: Bloomberg Aspiriant.
Total Return accounts for the price impact of an index, taking into account the reinvestment of any dividend distributions. Data points rounded to the nearest whole percent.

Caution! We May Be Entering a Low Growth Zone

In previous Insights, we have discussed our concerns regarding the cooling rate of growth across the planet. Contrary to the popular press, it isn’t just an isolated phenomenon afflicting China or emerging countries. Rather, slower growth has taken its toll on Japan, the Eurozone, and the United States. In fact, we were not at all surprised to see 2015 U.S. GDP growth come in at just 2.4%3, once again undershooting the growth estimates of the Federal Reserve Board.4 We have been consistent in our view that U.S. GDP growth will likely remain lower for longer. Economic data released during Q4 2015 seems to be proving our thesis.

Higher Standard of Living, but at Price of Sluggish Global Growth

A country’s standard of living (or quality of life) can be defined by the level and sustainability of wealth and comfort in an economy. Wealth can be measured by the consumption of necessity items and luxury goods. Comfort is more difficult to observe, but some recent studies5 have attempted to do so. If we use the change in Real GDP-per-capita as a proxy for the change in the standard of living over time, Chart 2 would imply the standard of living across both developed and developing countries has improved significantly over the past two decades. Unfortunately, the International Monetary Fund’s forecasts for future GDP around the world continue to be revised downward (see Chart 3). So, the price of achieving a higher standard of living may very well be sluggish global growth going forward.

Chart 2: Real GDP-Per-Capita

Fourth Quarter Market Update_Jan2016_Chart2
Source: World Bank, GDP divided by midyear population in current USD minus local inflation, Aspiriant.

The Unintended Consequences of a Higher Standard of Living

While the quality of our lives has improved as a whole, we have apparently lost at least some motivation to continue working hard in order to further improve our lives. In economics, this is referred to as the Law of Diminishing Returns6, which when applied to this scenario would suggest the incremental benefit we enjoy from further improving our quality of life isn’t worth the added effort we would have to put forward. Take, for example, the number of people who are working in the U.S. as a proxy for our collective “workforce effort.” While much attention is given to the new jobs report in the U.S. (which recently surprised to the upside with 292,000 new jobs created), we prefer to pay close attention to the Labor Force Participation Rate (LFPR), which measures the number of people who are either employed or are actively looking for work divided by the number of people who are of working age in an economy. According to the Bureau of Labor Statistics, the Labor Force Participation Rate peaked in the late 1990s and has steadily declined ever since (see Chart 4). Many suggest this decrease is a natural result of an aging population and retiring workers leaving the workforce. However, this trend started well before the Great Recession with the most pronounced impact among adult (ages 25 to 54), working men and young workers (ages 16 to 24) of both genders. Moreover, the trend is expected to continue for the foreseeable future as unskilled labor continues to get displaced by lower cost alternatives in a globally connected economy.

Chart 3: GDP Forecasts

GDP Forecast
Source: Epoch, IMF World Economic Outlook Update, January 2015, Aspiriant.

Chart 4: Labor Force Participation Rates

Labor Force Participation Rates
Source: U.S. of Bureau of Labor Statistics, Census Bureau’s 2012 Population Projections, Aspiriant

Impact of LFPR on GDP Growth

The change in the size of a workforce combined with the change in the workforce’s productivity is equal to its growth rate, which can be represented by Change in Real GDP7. As shown in Table 2, the U.S. leads developed economies in the growth of its workforce8 and is still benefiting from steady gains in productivity. As a result, the U.S. has and, we believe, will continue to benefit from relatively strong GDP growth, even as global growth cools. Across developing economies, the growth of China’s workforce lags other countries, but what it lacks in workforce growth it makes up for in productivity gains. As a result, we believe China’s economy will slow, but will remain among the strongest global growth engines.

Table 2: Real GDP Growth Rate

Real GDP Growth Rate
1. Includes all 28 members of the European Union as well as Iceland, Norway and Switzerland, Australia, Canada, Hong Kong, Israel, New Zealand, Singapore, South Korea, Taiwan
2. Includes China, India, Bangladesh, Cambodia, Indonesia, Malaysia, Myanmar, Pakistan, Philippines, Sri Lanka, Thailand, Vietnam, Argentina, Barbados, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, Guatemala, Jamaica, Mexico, Peru, St. Lucia, Trinidad & Tobago, Uruguay, Venezuela, Algeria, Bahrain, Egypt, Iran, Iraq, Jordan, Kuwait, Morocco, Oman, Qatar, Saudi Arabia, Sudan, Syria, Tunisia, United Arab Emirates, Yemen, Angola, Burkina Faso, Cameroon, Cote d’Ivoire, DR Congo, Ethiopia, Ghana, Kenya, Madagascar, Malawi, Mali, Mozambique, Niger, Nigeria, Senegal, South Africa, Tanzania, Uganda, Zambia, Zimbabwe
Source: Epoch Partners, The Conference Board. 2015. The Conference Board Total Economy Database™, May 2015, http://www.conference-board.org/data/economydatabase/

Implications for Expected Equity Returns

GDP growth is highly correlated with corporate growth and profitability. As result, it is a key driver of long-term equity and bond returns. However, in the short to medium term, history suggests changes in equity valuation have the propensity to drown out the impact of growth. Unfortunately, we don’t currently see valuations acting as a tailwind to equity returns. To the contrary, we see them as a headwind. As a result, we believe diversified portfolios will likely generate more modest returns over the next seven years than they have over the previous seven years.

Buoyed Up By Bonds and Defensive Strategies

Over the past two years, we have advised clients to prepare for a prolonged period of stormy seas,9 especially across equities. Given our concerns, we recommended clients take a more defensive posture in their portfolios by increasing exposure to risk-managed equities and fixed income assets.T

Entering 2016, we are continuing our risk-reduction theme by further recommending clients add a meaningful allocation to defensive investment strategies. The term, “defensive strategies” can mean different things to different people. To us, and to avoid getting overly complicated, it means managers pursuing strategies that tend to have (i) less market risk than equities, but somewhat more than bonds (ii) relatively low correlation with either equities or bonds. We manage allocations to these strategies with a goal of generating annualized returns of 2% to 4% above cash (e.g. short-term Treasuries) over a complete market cycle of approximately seven years. As a result, we believe defensive strategies have the ability to generate returns in excess of bonds, provided investors are willing to accept more risk (volatility and drawdown).

We believe the combination of risk-managed equities, fixed income and defensive strategies can help investors remain fully invested and mitigate capital losses while we await a more favorable environment with higher expected returns for risk assets.

We believe all financial assets are currently expensive, and fixed income is no exception. One need only look at bond yields around the planet to conclude bond returns will likely face headwinds going forward. However, we believe bonds will make up for their muted forward returns by providing relative protection during periods of extreme market dislocation. The discussion around Chart 1 earlier in this Report attempts to make this point.
Looking Ahead

Over the past two years, including in this Insight, we have shared our concerns regarding valuation levels, corporate profitability, artificially low borrowing rates and subdued growth rates. We believe those are the primary drivers of future equity returns. Our concern about each driver has led us to generally recommend measures to reduce risk in our portfolios. Our overall message to clients has been to expect more muted returns marked by increased volatility across all asset classes. However, we are not calling for a dramatic and/or prolonged pullback in the market. For the past several years, Central Banks around the world have “spoon fed” asset class valuations in order to keep them plump. Most recently, the Bank of Japan decided to venture into negative rate territory in an effort to stimulate growth. While these kinds of accommodative monetary policies may very well support asset prices, therefore preventing or at least lessening a significant market pullback, we do not believe they will be able to stimulate growth and drive further outsized returns in risk assets. To the contrary, we believe that quantitative easing in its various forms has reached the upper limit of its intended efficacy and are concerned that artificially elevated asset prices may have an undesirable effect: they may make people think they’re richer than they are and may provide an incentive to retire and exit the workforce early. If this concern begins to materialize, this would only serve to further exacerbate the slowing of the global economy.

While the current market environment has proven to be challenging, we are focused on keeping client portfolios on track, emphasizing risk management and continuing to rotate towards assets we expect will perform relatively well going forward.

(1) Global Equities as represented by the MSCI All Country World Index.
1 As measured by the Russell 3000 Growth Index.
2 Technically, a “market correction” is defined by a drop of 10% or more. We include all three pullbacks for illustration.
3 Source: U.S. Department of Commerce, Bureau of Economic Analysis.
4For a broader discussion on the Federal Reserve Board’s history of missed forecasts or GDP growth see our Q2, 2015 Insight.
5As an example of one such study, please see Beyond GDP? Welfare Across Countries and Time, by Charles I. Jones and Peter J. Klenow, Stanford University, September 2010. The study attempts to address the limitations of Gross Domestic Product to measure of economic welfare (i.e. standard of living) by proposing a new composite measure that combines leisure, inequality, mortality, morbidity, crime, among other factors.
6The Law of Diminishing Returns suggests as additional effort is put forth, a decreasing marginal utility of the benefits is earned.
7 According to the Cobb-Douglas Production Function, which is an economic model used to explain the long-term, sustainable growth rate of a diverse economy. It assumes long-term growth is equal to the change in the size of a workforce, plus the change in the workforce’s productivity, plus the change in capital infrastructure. For simplicity, the table ignores capital infrastructure for the purpose of the discussion.
8 At least one reason the workforce in the U.S. has continued to grow steadily is due, in part, to the country’s relative openness regarding immigration.
9 For a broader discussion, please see our Insight, Preparing for Stormy Seas, published in December 2014.
Important disclosures: Past performance is no guarantee of future performance. All investments can lose value. Indices are unmanaged and it is impossible to invest directly in an index. The volatility of any index may be materially different than that of a model.
Equities.1 The S&P 500 is a market-capitalization weighted index that includes the 500 most widely held companies chosen with respect to market size, liquidity and industry. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The MSCI EAFE Index (Europe, Australasia, and Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.
Fixed Income. The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index has four main sectors: general obligation bonds,revenue bonds, insured bonds and pre-refunded bonds. The Barclays High Yield Municipal Bond Index is an unmanaged index composed of municipal bonds rated below BBB/Baa.
Real Assets. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. Wilshire Global RESI is a broad measure of the performance of publicly traded global real estate securities, such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). The index is capitalization-weighted. The Alerian MLP Index is a gauge of large and mid-cap energy Master Limited Partnerships (MLPs). The float-adjusted, capitalization-weighted index includes 50 prominent companies and captures approximately 75% of the available market capitalization.