Second Quarter 2018 Investment Commentary

July 16, 2018

Quarterly Portfolio Performance, Key Drivers, and Positioning Recap 

Our clients know we don’t invest based on three-month time horizons or short-term expected outcomes. To the contrary, we strongly believe that a critical element of our investment process and edge is our discipline to maintain a longer-term (multiyear) perspective while other market participants over-react to short-term performance swings, daily news flow, and other emotional/behavioral triggers. We try to minimize the harmful impact of “myopic loss aversion” on our investment decision-making that can come from paying too much attention to short-term results. Yet, many clients are also naturally curious to know “what worked and what didn’t” in any given period. So, with that in mind, we provide the following update on the key drivers of our portfolios’ recent quarterly performance. 

EQUITIES 

All our globally diversified portfolios have meaningful strategic allocations to developed international and EM stocks. Our active portfolios also currently have a modest tactical overweight to European and EM stocks and are underweight to US stocks. This positioning was beneficial in 2017, as foreign markets outperformed US markets (in dollar terms). But it has been a drag on returns this year, driven by the sharp performance divergence among these markets in the second quarter.  

We provide a more detailed update of our EM outlook below. In a nutshell, our key equity market views and positioning remain unchanged. On a tactical (five-year) basis, US stocks are overvalued, offering very low expected returns across the macro scenarios we think are most likely. Put differently, at current prices and valuations we don’t believe we are being sufficiently compensated for US stocks’ downside risk. European and EM stocks currently offer a meaningful expected return premium over US stocks across most scenarios, and at least sufficient (although not table-pounding) absolute returns to compensate us for their shorter-term risks.  

Overall, on a global basis, our portfolios are tactically underweight to stocks and have significant allocations to lower-risk alternative and absolute-return-oriented strategies. We are waiting patiently for expected equity returns to materially improve before increasing our US equity exposure back toward our strategic portfolio targets. At this point in the cycle, it will most likely take a large market decline (a bear market) for equity returns to become attractive. A bear market will likely unfold in advance of an economic recession, which is likely to be caused by central bank policy tightening or some unexpected macro or policy shock. 

FIXED-INCOME 

Our balanced portfolios have a large allocation to actively managed flexible bond funds and floating-rate loan funds. In aggregate, these funds contributed positively to quarterly portfolio returns and outperformed the core investment-grade bond index, as has been the case over the past several years. We continue to expect these positions to outperform over the next several years, particularly if interest rates continue to rise. The performance of our actively managed core investment-grade bond funds was mixed versus the index for the quarter. We hold these core bond funds largely as risk mitigators in the event of recession or some other shorter-term “risk-off” scenario. These funds have all outperformed their index over our longer holding periods. 

ALTERNATIVE INVESTMENTS 

We hold liquid alternative strategies funds that we believe improve our balanced portfolios’ long-term risk-adjusted return potential. These strategies have different risk and return drivers from traditional stock and bond funds. We find these alternatives particularly attractive from a tactical perspective, given our current expectation of very low returns for US stocks and core bonds. In the second quarter, the performance of these alternatives was mixed. Our lower-risk multistrategy fund was flat, outperforming core bonds and foreign stock markets but trailing US stocks. Our position in a diversified basket of trend-following managed futures funds was positive in June, outperforming both stocks and bonds, but was a net negative for the quarter.  

Trend-following strategies in general have been going through a multiyear period of rough performance—in absolute terms and relative to a mix of US stocks and bonds (from which we have funded our positions). During the second quarter, we spent time revisiting our thesis for allocating to these trend-following strategies within our balanced portfolios. This included a lengthy internal vetting session among our entire research team, as well as in-depth meetings/discussions with two of our managed futures fund managers. While one can never have 100% certainty about any investment decision, we came away from this exercise still confident that holding these non-correlated strategies will pay off, improving the risk and return performance of our portfolios over the longer term. Their benefit should be most apparent during the next bear market, where the positive performance divergence between managed futures and stocks should be sizeable. While we won’t predict the precise timing, there will be another bear market—and likely within our five-year tactical horizon. However, we are not blindly committed to owning managed futures. Should there be a bear market and managed futures do not perform as we expect, we would likely declare the thesis “broken” and exit our positions. In the meantime, while acknowledging the frustrating recent performance, we continue to believe our patience and long-term discipline will be rewarded with this allocation. 

The performance of our private equity real estate funds continues to be strong. Funds that have completed their investment phase are reporting healthy operating fundamentals (strong vacancies and rent growth). Since the recovery from the financial crisis years ago, property sales have consistently delivered strong returns that have been additive to broader portfolio returns. This trend has continued in the first half of this year. It has also been encouraging that newer funds are still able to find real estate investment opportunities that offer promising returns on a relative and absolute basis. We believe this is at least partly, and perhaps largely, due to the investment strategies of the two private real estate firms we invest with. These strategies are heavily based on benefiting from real estate market inefficiencies and finding ways to add incremental value.  

Real estate markets are much pricier now than they were a few years ago and for this reason we expect returns to decline from the high teens and 20%-plus range realized in recent years. However, we continue to believe it is likely that the funds we are investing in will generate attractive absolute and relative returns.  

Reiterating our EM Stock Thesis and Outlook 

Our research continues to suggest attractive return potential for EM stocks relative to US stocks over our five-year tactical investment time horizon. We believe EM companies in aggregate are underearning relative to their normalized potential, and this is not fully priced into their stock prices. US stocks, on the other hand, are overearning and are expensive, implying very low five-year expected returns. 

We added a slight overweight position (relative to our strategic weight) to EM stocks in September 2015, following a 20%-plus decline in the summer around the time China devalued its currency. As the global economy began firing on all cylinders for the first time since the financial crisis, our thesis began to play out, with EM stocks gaining 12% in 2016 and 32% last year. EM stocks bolted out of the gates in 2018, with an additional 11% return through late January. Since then, however, EM stocks have declined sharply, and returns are now in negative territory for the year. 

The selloff in EM stocks appears to have been driven by a combination of investor concerns about  

  • a potential trade war with China (and possibly other global trade partners such as the EU, Mexico, and Canada);  
  • deceleration in global growth outside the United States as emerging markets tend to be perceived as more sensitive to shifts in overall economic growth—although the sector composition of EM indexes has changed meaningfully over the past decade, from traditional heavy-cyclical industries like materials and energy to more growth-oriented technology and consumer-driven sectors; and 
  • a stronger US dollar coinciding with rising US interest rates and tightening Fed monetary policy—although evidence suggests EM stocks do fine when interest rates in the United States are rising as long as global growth is solid.  

These macro developments, in particular the risk of a US trade war with China and the rest of the world, are indeed risks to EM stocks, at least in the shorter term. We also know that investor perceptions and over-reactions can create a self-fulfilling market reality for some period of time (e.g., financial market outflows causing lower asset prices and depreciating currencies, causing more investor fear, causing more outflows, and so on). However, these are not new risks to emerging markets.

 

President Trump campaigned on a promise of trade protectionism, and EM stocks sold off sharply in the days after his election. At the time, we acknowledged that while protectionism would be a negative for emerging markets, there was great uncertainty as to what, if any, trade policies would actually be implemented. We also believed in the event of trade restrictions, it was not obvious that EM companies would necessarily be worse off than US companies, given how much US businesses (and profits) have benefited from free trade and the globalization of labor markets and supply chains.  

Ultimately, we thought it likely that cooler heads would prevail and a mutually damaging trade conflict would not ensue. As it happened, the market’s concerns about protectionism receded and EM stocks significantly outperformed US stocks. Those concerns have now re-emerged, and with more concrete threats and reprisals on the table. Our view, however, remains broadly the same. It is in the best interest of both the United States and China to negotiate a resolution and prevent trade skirmishes from becoming an all-out trade war. However, the potential for a severely negative shorter-term shock to the global economy and risk assets (not just emerging markets) can’t be dismissed. Even absent an actual trade war, the negative impact on business and consumer confidence from the uncertainty and fear of a trade war is a risk to the remaining longevity and strength of the current economic cycle. 

Aside from protectionism, investors appear to again be concerned with emerging markets’ external debt levels (i.e., EM debt held by foreigners). This concern tends to resurface when EM currencies are weakening, as it can make it more expensive for these countries to service their foreign currency debt. It can also contribute to a loss of confidence and capital outflow among lenders causing interest rates on EM debt to rise, which can reinforce the negative cycle. In a few countries (such as Turkey and Argentina) this does look to be a problem, but for most it’s not. According to Capital Economics, foreign exchange reserves in the emerging markets are, in aggregate, about the same size as their external debts, whereas they were only about 30% of the size of external debts in the late 1990s. So, EM countries now have better debt coverage. Second, at the aggregate country level, most EM debt is in local-currency terms (whereas external debt measures include both local-currency and dollar-denominated debt held by foreigners). There is therefore less of a currency mismatch between borrowings and payments at the country level.  

On the other hand, private sector/corporate EM debt denominated in US dollars does appear to be relatively high. It’s a question we’ve raised and analyzed several times in the past. There are a few mitigating factors though. Some EM exporters have a natural dollar hedge. And a lot of private sector dollar-denominated debt is concentrated in places like China, which we believe we have already adequately factored into our base-case scenario. (We’d expect strains at the individual company level, but expect our active EM stock pickers to navigate the risks there.) In addition, the fact that most EM countries now have floating rather than dollar-pegged currencies helps release pressure in their economies (i.e., it lowers the likelihood of sharp currency declines that result in deep and sudden crises, as happened in the 1980s and 1990s). This could be one reason why we haven’t yet seen major debt defaults in EM countries despite the local-currency weakness since the Fed taper tantrum in 2013.  

We’d therefore argue emerging markets are fundamentally better placed today than in past cycles. Looking out longer term, currency declines should ultimately help “reflate” EM economies if the rest of the world continues to grow at a decent clip. In a benign global growth environment, if EM stocks were to start pricing in a late 1990s “EM crisis” environment, we are likely to be buyers rather than sellers. If global growth craters, EM stocks will probably underperform US stocks on the downside over the shorter term (although their much cheaper valuations versus US stocks may enable them to outperform, as they did in the early 2000s). But even in that scenario, the global business cycle will ultimately recover and with it EM countries’ long-term earnings power. 

From the outset, we have managed the shorter-term (12-month) downside risk stemming from EM stocks in our balanced portfolios by having only a modest overweighting there, along with our underweight to equities overall. We remain confident in this position, based on our weighing of the potential risks and rewards across a range of scenarios. As always, we will continue to look at new data and analysis with an open mind and go where the weight of the evidence takes us.  

Concluding Comments  

It is understandable that fears of a global trade war are rattling financial markets. The resolution of the current trade tensions is a meaningful uncertainty (a “known unknown”), with the potential to seriously disrupt the global economy at least over the shorter to medium term. (The potential for a positive surprise seems more limited, but also exists.) President Trump’s unconventional negotiating approach adds an additional wildcard dimension. The process is likely prone to several more twists and turns before things become any clearer. (For a recent example: how many experts predicted the 180-degree flip this year in the relationship between President Trump and North Korea’s dictator—from name-calling and nuclear threats to grinning BFFs?) The bottom line is that nobody knows how it will all play out. 

Therefore, we file this under the heading: “There are always risks and uncertainties when investing in equities that have the potential to cause significant shorter-term price declines.” Whether it is a trade war, a geopolitical event, an unexpected economic shock, a monetary policy mistake, or innumerable other factors, stocks can deliver big losses, at least over shorter-term (one- to three-year) periods. Market corrections and bear markets happen. An investor must be able to withstand these drops, stay the course, and stick to their long-term plan (assuming it was well-designed and aligned with their financial objectives to begin with).  

Extend your time horizon

No one can consistently and accurately predict the timing, outcome, and market reactions of these types of macro/geopolitical uncertainties. A corollary, therefore, is that people who try to do so are very likely to detract more value than they add over time. They’re more likely to get whipsawed by the daily news headlines and changing “expert” opinions amid market ups and downs. While they may feel better in the moment of their action, they end up with a worse outcome than if they had remained disciplined in their investment approach. We believe it is far better to stick with one’s long-term strategic asset allocation (with disciplined rebalancing). Or, to only make portfolio changes away from your strategic allocation when you have high confidence (based on strong evidence and analysis) that you have an edge. This is possible if you understand what the market is discounting in current prices, why you think the market is wrong, and why the odds are stacked in your favor that you are likely to ultimately be proven right. Even then, of course, there is no guarantee you will be right every time. In fact, it is guaranteed you won’t be right every time. That’s why portfolio diversification, scenario analysis, and risk management are also critical elements.  

As mentioned earlier, one of the key elements of the edge we think Litman Gregory has is “time arbitrage”—our willingness and ability to take a longer-term analytical view and maintain a longer-term investment horizon than other market participants. We don’t have to respond to all the short-term market noise, and we don’t play the short-term trading (guessing) game.

We borrowed the following visual representation from the “Behavioural Investment” blog, written by Joe Wiggins. It illustrates how what most investors spend time on doesn’t really matter and can often cause them to act in ways detrimental to their long-term investment goals. We try to focus on the things that do matter most, such as asset allocation, investor behavior and risk tolerance, valuations, and market cycles. 

What Matters and What we Focus On

Our globally diversified portfolios are positioned to perform well over the long term and to be resilient across a range of potential scenarios. Should the current trade tensions resolve, and the global economic recovery continue, we expect to generate good overall returns, with outperformance from our European and EM equities positions, active equity managers, and flexible bond funds. Alternatively, should a bear market strike, our portfolios have “dry powder” in the form of lower-risk fixed-income and alternative investments that should hold up much better than equities. We’d then expect to put this capital to work more aggressively by, for example, reallocating to US equities at lower prices and higher expected returns sufficient to compensate us for their risks. 

As always, we thank you for your continued confidence and trust. 

—Liman Gregory Investment Team (7/12/18) 

 

 

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