Third Quarter Market Perspective
Thrown Overboard in Stormy Seas
Third quarter market returns were driven by a pronounced “risk-off” mentality emanating from concerns related to the strength of global economic growth, the prospect of weaker corporate earnings and ongoing volatility in the energy sector. Against this backdrop, global equities posted losses of 9.5%, with international equity returns impacted by changes in the U.S. dollar relative to foreign currencies. Within equities, losses were most prominent for emerging markets, which lost nearly 18% as anxiety about China coupled with S&P’s recent downgrade of Brazilian sovereign debt to junk status weighed heavily on the asset class.
Fixed-income returns were generally positive during the quarter, as a flight to safety acted as a modest tailwind causing short-term interest rates to remain unchanged while long-term rates modestly declined. Broader bond market indices advanced roughly 1.2% to 2.0%, helping to buoy-up the languishing equity markets. However, some areas within taxable fixed income faced weakness, especially corporate high yield bonds.
Across real assets, commodities and master limited partnerships endured a difficult quarter, suffering deep bear-market type losses of 20% and 22%, respectively. Each of these asset classes were weighed down by the plunge in crude oil prices of 25% during the quarter. Global REITs held up much better, but were still down 0.7% during the quarter. One bright spot across real assets were U.S. REITs, which gained nearly 2.9% benefiting from improving U.S. property market fundamentals.
Major Index & Currency Performance
|Annualized Trailing Total Return||Equities||Q3||YTD||3YR||5YR||10YR|
|S&P 500 TR||(6.4)||(5.3)||12.4||13.3||6.8|
|Russell 2000 TR||(11.9)||(7.7)||11.0||11.7||6.5|
|MSCI EAFE NR||(10.2)||(5.3)||5.6||4.0||3.0|
|MSCI Emerging Markets NR||(17.9)||(15.5)||(5.3)||(3.6)||4.3|
|MSCI All Country World Index NR||(9.5)||(7.0)||7.0||6.8||4.6|
|Barclays US Aggregate Bond TR||1.2||1.1||1.7||3.1||4.6|
|Barclays Municipal TR||1.7||1.8||2.9||4.1||4.6|
|Barclays High Yield Muni TR||2.0||0.0||3.7||5.9||4.8|
|Euro (EUR vs. USD)||0.2||(7.8)||(4.6)||(3.9)||(0.8)|
|Pound (GBP vs. USD)||(3.7)||(2.9)||(2.1)||(0.8)||(1.5)|
|Yen (JPY vs. USD)||2.2||0.1||(13.4)||(7.0)||(0.5)|
|S&P GS Commodity Index TR||(19.3)||(19.5)||(19.8)||(9.8)||(10.0)|
|Wilshire Global Real Estate Securities Index TR||(0.7)||(3.2)||8.2||10.2||6.2|
|Alerian MLP TR||(22.1)||(30.7)||(3.6)||3.9||8.2|
Indices are unmanaged and have no fees. An investment may not be made directly in an index. Index returns shown are based in US dollars.
Quelling the Storm; and Riding the Thunder
The returns in Table 1 indicate the market threw almost everything overboard in Q3 2015. We were not surprised by the pullback because we have been writing about how expensive most financial assets are for more than a year. Last year, we wrote1:
When risk assets (e.g., stocks and bonds) become too expensive there are two ways for the market to correct the problem. First, the market can experience a pullback until such time that assets are once again at a Fair Value2. Alternatively, valuations can remain constant and the companies/securities that today are overpriced can “grow into their valuations” over time by increasing earnings. Both scenarios pose challenges for investors and, going forward, we expect both to occur, which is why we are projecting increased volatility.
Major Index & Currency Performance
|S&P 500 TR||9.0|
|Russell 2000 TR||7.2|
|MSCI EAFE NR||8.1|
|MSCI Emerging Markets NR||8.7|
|MSCI All Country World Index||8.5|
|Barclays US Aggregate Bond TR||0.3|
|Barclays Municipal TR||0.5|
|Barclays High Yield Muni TR||1.2|
|Euro (EUR vs. USD)||(0.9)|
|Pound (GBP vs. USD)||1.1|
|Yen (JPY vs. USD)||(0.7)|
|S&P GS Commodity Index TR||(0.3)|
|Wilshire Global Real Estate Securities Index TR||7.2|
|Alerian MLP TR||6.3|
*As of 10/28/2015
We continually remind clients that we are long-term, value-oriented investors. As such, we tend not to get overly preoccupied with short-term results, whether good or bad. So, we are always apprehensive about spending too much time dwelling on quarterly results, including quarters that have yet to be completed. With that said, Table 2 shows investment markets generally reversed course during October, recouping a large portion of the drawdown experienced in Q3. This type of quick turnaround precisely illustrates why making too much out of short-term performance is a fool’s game.
We continually remind clients that we are long-term, value-oriented investors.
U.S. Equities: Doomed to Sink or Destined to Swim?
Q: Why has the market been so schizophrenic about whether U.S. Equities are doomed to sink or destined to swim?
A: We think a key reason is the extreme difficulty in analyzing the impact of quantitative easing (“QE”).
The term “Quantitative Easing” itself was nary a phrase uttered until late-20083. At that time, the Fed had exhausted its ability to provide monetary easing via reductions in the Federal Funds Rate (which it had reduced to 0.25%). So, in late 2008, the Fed embarked on an asset purchase program in an effort to put downward pressure on interest rates in order to help promote economic recovery as well as to induce investors to purchase riskier, higher yielding securities. The asset purchases indeed helped boost the overall prices of financial assets, generating attractive investment returns for risk-taking investors. Below is a reminder of the $3.3 trillion in QE initiatives undertaken in the United States since November 20084.
Before the fall of 2008, few investors knew what QE was, what it was intended to do or how long it would last. Over the next few years, they learned that QE was the most extensive (by far) monetary easing intervention ever orchestrated by a central bank. But while the size and scope of the Fed’s QE initiatives became better known, investors have continued to struggle with accurately assessing the overall effectiveness of the programs, and most importantly their impact on growth, inflation and interest rates. To complicate matters further, the Fed’s willingness to continue supporting the economy makes estimating the duration of QE’s effects extremely challenging. Given these factors, amongst many others, we believe the market will continue to experience elevated levels of volatility as investors continue to estimate the overall impact of QE on the Fair Value of asset classes.
All Asset Prices Rise in Rising QE Tides
Q: So, what quelled the Q3 storm and allowed markets to ride the thunder in October?
A: More QE was a key factor; but this time by foreign central banks.
The impact of QE measures enacted by any central bank is not isolated to the market in which the QE is implemented. Moreover, the concept of QE is not foreign in foreign markets. In fact, the Bank of Japan (BoJ) is often credited with pioneering quantitative easing back in 2001 when it purchased assets to attain a target quantity of reserves (i.e. “quantitative easing”). At the time, it hoped that QE would end deflation and increase asset prices.
More recently, in addition to other monetary, fiscal and structural reforms, the BoJ announced $550 billion of annual bond purchases in Q1 2013, and later extended the program to $650 billion per year in Q4 20146. Faced with the spillover effects of the slowdown in emerging markets, and specifically China, the BoJ recently announced that it was evaluating additional measures to expand the size and scope of its QE program.
The European Central Bank (ECB) followed suit in January 2015 by unveiling a massive program designed to stimulate growth in the Eurozone by purchasing €1.1 trillion of bonds issued by Euro-based central governments, agencies and other institutions. The asset purchases are being made in the secondary market at a pace of €60 billion per month through at least September 2016. Faced with the same challenges beleaguering Japan, the ECB reaffirmed its commitment to support growth and stability by remaining flexible regarding the “size, composition and duration” of the existing QE program. In fact, some market participants believe the ECB may double the overall size of the program and extend it well beyond its original end date of September 2016.
Just like we saw when the Fed announced QE1, QE2 and QE3, we believe the recent announcements from the BoJ and ECB have been largely responsible for the rapid recovery of financial asset prices since the end of Q3 2015.
European Equities: Overseas Castaways?
Since the onset of the Global Financial Crisis (GFC), inflation (which in modest amounts is considered a sign of economic health) across the Eurozone has been low to negative, depending on how one adjusts for the impact of decreasing commodity prices. That’s a far cry from the ECB’s inflation target of approximately 2%. To a significant degree, the low level of inflation is attributable to the high levels of unemployment that have been plagued the EU since the ECB enacted austerity measures in response to the GFC. Unemployment across the Eurozone is currently 11%7, with the level varying considerably by country. Accordingly, we would not be surprised to see inflation languish for a considerable time longer. The combination of low inflation coupled with high unemployment has resulted in sluggish growth, a trend that may face new challenges with the recent slowdown in emerging markets.
Notwithstanding these economic challenges, there is some good news for international equities. First, equity valuations and corporate profitability seem to be more reasonable than in the U.S. Second, the massive QE program enacted by the ECB in January 2015 appears to be showing early signs of taking hold. For example, the ECB’s recent Bank Lending Survey (BLS) indicated improving credit conditions for both lenders and borrowers for the first time in several years. Third, if the nascent economic recovery falters, the ECB will likely extend its bond buying program as discussed above. The cumulative effect of these monetary and valuation tailwinds should help to stabilize the EU and lead to relatively attractive investment returns. Anticipating these results, last year we removed our underweight allocation to international equities, which we expect to contribute to longer-term performance going forward.
MLPs: Sunken Treasures8
After a decline of 30% since the beginning of the year, Master Limited Partnerships (MLPs) have clearly won the “race to the bottom.” While painful to endure, at current valuation levels, we believe MLPs represent a sunken treasure in client portfolios. Indeed, from our perspective, no other publicly-traded asset class possesses the combination of current cash flow, consistent income growth, and valuation characteristics that MLPs have today. Consequently, we believe long-term investors should remain committed to this asset class. However, given the negative sentiment and other factors mentioned in our forthcoming Market Perspective entitled, MLPs: the Ultimate Test of True Grit, we do not believe investors should become aggressive and overweight the asset class. Negative headwinds may persist for a while longer. So, this may not be the best time to increase the exposure. With that said, if valuations continue to fall and actually become “cheap,” then we may indeed recommend increased exposure down the road.
When considering the emotional difficulty of buying a beaten down asset class, investors may be well-served to recall the investment opportunity presented during the depths of the Global Financial Crisis. An investor purchasing an S&P 500 index fund on December 31, 2008 saw a 25% decrease in value to March 9, 2009, but ended the year with a 26% gain based on the initial December 31 purchase date. Holding that index fund through yesterday (10/26/2015) would have generated a cumulative return of 163%, notwithstanding the initial setback.
Given current valuations and profitability amongst other factors, we expect emerging equities to be one of the best performing assets classes over the next seven years. However, as we noted in our 2014 Capital Market Expectations Insight published last year, we also fully expect emerging equities to be amongst the most volatile asset classes over that time. We believed that to be the case then (and now) because emerging markets, even more than developed markets, are reliant on economic stability, global growth and international trade as well as reasonable predictability across financial, currency and commodity markets. As mentioned, QE programs enacted by any central bank can help propel economic and financial prosperity; the effects of which are felt by virtually every economy around the planet. Given that emerging countries benefit more from global QE, as long as central banks continue to remain committed to their programs, including responsibly unwinding them in the future, we believe emerging markets will indeed prove to be a relatively attractive asset class over the next several years.
Buoyed Up by Bonds
While equities were soaked during the quarter, bonds managed to remain afloat. Over the past year, yields have generally remained unchanged for short-dated maturities and have only modestly decreased across maturities of five years or more. Surprising some investors, domestic demand for intermediate to longer term maturities of U.S. Treasuries has been high; helping to offset some of the selling pressure coming from foreign central banks. As a result, core bond indices have been stable to slightly positive, but with riskier segments (like corporate high yield and emerging market debt) selling off a bit. Last year, we began recommending an increased allocation to fixed income followed by a reallocation of our municipal bond exposure toward more defensive bonds. These decisions have served our portfolios well, acting as a ballast to the market risk inherent in equity portfolios.
We expect economic conditions to remain stable, but weak for at least the next several quarters. Moreover, since a portion of a bond’s yield is earned to compensate investors for inflation, stubbornly low inflation will likely repress yields for a while longer. As a result, we expect yields to generally remain range-bound, facing upward pressure as the effects of QE gradually dissipate, offset by downward pressure related to lower and slower economic activity. Despite indications from the FOMC that “lift-off” will begin later this year, interest rates futures indicate that investors generally believe the first rate hike will occur in March 2016.
…we expect yields to generally remain range-bound, facing upward pressure as the effects of QE gradually dissipate…
The $6 Trillion Booty
Recently, three independent studies evaluating the cumulative influence of the Fed’s asset purchases estimated a reduction in the 10-year Treasury yield of approximately 100 basis points9,10. This result is meaningful (emphasis added) on the present value of bonds, equities and every other financial assets. By our estimates, the impact of permanently reducing the Treasury Yield Curve by 100 basis points across all maturities would have the effect of changing the Fair Value of the S&P 500 from a level of 1750 to 2400. That’s a 40% swing in the value of the 500 companies that make up the index. Framed differently, it means the market is trying to determine whether or not Fair Value on the S&P 500 is $15 trillion or $21 trillion, resulting in a $6 trillion question that is extremely difficult to answer.
Recall the “Taper Tantrum” in 2013, when Ben Bernanke simply floated a trial balloon about winding down of QE. During the four-week period between May 22nd and June 24th of that year, financial assets generally dropped 8% to 14%. That period serves as a real world example of the difficulty in getting the right answer, especially when the Fed has the ability to change the equation whenever it chooses to do so.
We have been consistent in our view that U.S. GDP growth will likely slow to less than 2% per year over the next few years. In fact, with a vulnerable energy sector and a strong U.S. dollar, we would not be surprised to see 2015 GDP come in at less than 2% and decrease further in 2016. Economic data released during Q3 seems to be proving out our thesis. In fact, although household spending increased during the third quarter, virtually every other indicator suggested anemic economic growth accompanied by decreasing inflation. Adding further support, the Federal Reserve Bank of Atlanta recently revised its projection for Q3 U.S. GDP growth to 1.1% or approximately 2.0% for the entire calendar year.
Given our low growth expectations, combined with a cooling labor market and weakening corporate profits, we do not envision a scenario in which the Fed will raise rates in any meaningful way in 2015 or even 2016. In general, U.S. economic growth has been too inconsistent, inflationary pressures remain largely absent and there is still more slack in the labor markets than headline data might suggest. However, we would not be surprised to see the Fed feign a feeble attempt (or two) to normalize rates sooner rather than later. And, the U.S. is not alone. From our perspective, every economic center across the planet is being faced with the same challenges, which will persist for the next several years. Ultimately, however, we expect central banks to continue acting responsibly to support economic growth and will therefore only reduce QE and raise rates when prudent to do so. Given this expectation, we believe current asset prices will remain elevated, dampening future investment return expectations. However, we frequently remind investors this outcome would not be a bad thing. What it means is current portfolios are larger today than they otherwise would be if it were not for the impact of global QE.
The last six-and-a-half years have been marked by a solid recovery following the GFC and has been an attractive time to be an equity investor; especially a U.S. equity investor. The period has benefited from an unprecedented level of global QE along with other contributing factors that have led to stretched corporate profits and expanding valuations. We believe this experience is unlikely to continue going forward. The difficult thing for most investors is to recognize that situation, position portfolios in accordance with that view and manage expectations to accordingly. With this in mind, we are confident that our allocations toward fixed income, defensive and value stocks, and emerging markets will be rewarded.
1For a broader discussion on the valuation of asset classes, see our Q4 2014 Insight.
2Aspiriant defines Fair Value as the average valuation of an asset class across varying market cycles over time.
3Although the Bank of Japan is often credited for pioneering quantitative easing, prior to the Global Financial Crisis, it was rarely been used by central banks.
4Citation: Speech given by (former) Fed Chairman Ben S. Bernanke, at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming on August 31, 2012.
5Under MEP, the Federal Reserve purchased $400 billion of long-term Treasury securities and sold an equivalent amount of shorter-term Treasury securities.
6On April 4, 2013, the Bank of Japan announced a quantitative easing program to purchase ¥60 to ¥70 trillion of bonds per year to help the economy achieve a target CPI of 2% per year. On October 31, 2014 the program was increased to ¥80 trillion of bonds a year.
8For a broader discussion on Master Limited Partnerships, see our Market Perspective, Master Limited Partnerships, the Ultimate Test of True Grit, published in November 2015.
9The three studies estimated the reduction in the 10-year Treasury yield between 80 and 120 basis points.
10A basis point is equal to 0.01%. So, 100 basis points equals 1.00%.
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. 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, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & 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 prerefunded bonds. The Barclays High Yield Municipal Bond Index is an unmanaged index composed of municipal bonds rated below BBB/Baa.
Real Assets. S&P GSCI: 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.