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INVESTMENT ENVIRONMENT1
Source: Orion Advisor Services
Global equities entered the first quarter of 2016 on poor footing. The Federal Reserve (Fed) raised interest rates in December for the first time in nearly a decade and was signaling that it expected to make three to five more 0.25% rate hikes during 2016—all while international economies, most notably China’s, were stalling, and commodities prices were slumping. US rate hike expectations and the US economy’s relative strength were driving up the US dollar and the Chinese yuan (which is pegged closely to the dollar), putting further downward pressure on commodities prices and the value of emerging markets companies.
However, Fed Chair Janet Yellen struck a much more dovish tone in February by highlighting the substantial risks posed by a stronger dollar and the fragile global economic environment. That did the trick, significantly driving down forward interest rate expectations. The dollar subsequently fell while commodities, fixed income and equities all rebounded strongly.
The Fed wasn’t the only central bank to put downward pressure on interest rate expectations during the quarter. In January, the Bank of Japan (BOJ) joined the European Central Bank (ECB) in pushing its benchmark interest rate into negative territory (-0.1%) in order to encourage commercial banks to make loans instead of parking funds with it. And in March, the ECB went all in with its accommodative monetary policy. It pushed deposit rates even deeper into negative territory (-0.4% now), offered to pay banks to lend money to their customers, and expanded its quantitative easing program in two ways: 1) increased its size by one-third to €80 billion a month, and 2) began buying European investment grade non-financial corporate bonds in addition to the government bonds it was already buying.
We are definitely in unusual times. Japan and many European governments are getting paid to issue new debt. So too are some blue-chip European companies, such as Nestle, EDF and Royal Dutch Shell. And some European banks are getting interest-free funds and bonus payments if they lend that money, all courtesy of the ECB. Bond yields are hitting all-time lows around the world, indicating we are likely in for a long period of low returns for most assets.
Source: Bloomberg, Bank of America
With the yield on the 10-year Treasury falling a dramatic 49bps (0.49%) to 1.78%, fixed income outperformed equities during the first quarter (bond prices move inversely to bond yields). With US rates turning less attractive, the dollar weakened—causing foreign bonds to outperform domestic bonds.
The Q1 earnings outlook for US companies fell 9.6% over the last three months, the most in any quarter since 2009 (FactSet). And although aggregate Q1 earnings from S&P 500 companies are now expected to fall 8.5% from their year ago level, the S&P 500 index was steady year-on-year and slightly up in the quarter. US equities managed to outperform international developed markets, which had their own earnings issues this year. Emerging markets were the star performer in the period, boosted by rising commodity prices, the weaker dollar and Chinese government stimulus.
Looking forward, there are two major voting events that we are watching closely—the June 23rd UK referendum on European Union (EU) membership (the so-called British Exit, or ‘Brexit’) and November’s US presidential election. Both votes involve a strong element of public backlash against free trade and thus have the potential to significantly disrupt each country’s economy.
Polls currently show the UK electorate evenly split between exiting and remaining in the EU. As a result, the UK stock market has properly sold off to reflect the real risk to its economy by a Brexit—over the last 12 months the FTSE 100 Indexf is down 9% in local terms while the British pound is off 3% versus the dollar.
Source: The Wall Street Journal
Source: Nasdaq
Commodity prices rebounded somewhat during the quarter but remain severely depressed relative to the price levels of the last 10 years (see the oil price chart above). There are many emerging markets under considerable stress due to low commodity prices, but when combined with incompetent and corrupt politicians, we potentially have the makings for popular uprisings and the overthrowing of governments. We may be seeing this play out in Latin America where two leaders are particularly vulnerable—Presidents Dilma Rousseff of Brazil and Nicolás Maduro of Venezuela.
Global investors are generally hopeful that Rousseff will be impeached later this month, ending the government mismanagement of the Brazilian economy. Although global investors have little direct exposure to Venezuela, the country’s state-owned oil company is a major oil exporter. A civilian uprising against the country’s authoritarian government could disrupt oil exports.
PERFORMANCE DISCUSSION
All five AlphaGlider strategies deviate from their benchmarks in three major ways: 1) overweight equities at the expense of fixed income, 2) overweight developed foreign markets at the expense of the US market and 3) underweight duration in their fixed income allocations. All three of these deviations worked against us this quarter, causing our strategies to trail their benchmarks.
The decline in interest rates defined our winners and losers throughout our strategies in the first quarter. Within our domestic equity allocations, the funds with large and/or growing dividends benefited. Our staples fund2 (VDC) was up 5.3%, our growing dividend fund (VIG) was up 5.0% and our high yield fund (VYM) was up 4.2%. The decline in interest rates hurt our financials though, as lower rates pinched their lending spreads—our financials fund (VFH) was down -4.0%.
Our strategies benefitted from our late January decision to increase emerging markets exposure via a rebalancing operation.4 Our emerging markets fund (VWO) was up 5.9% during the quarter, and up 17.2% from the date of our rebalance.
Our position in US natural gas companies struggled despite the generally positive environment for oil companies during the quarter, down -7.1%. Natural gas is an inherently local business and this past winter ended up being one of the warmest on record in the Northeast.
Source: Bloomberg, Deutsche Bank
Our fixed income allocations benefited from sizable exposure to inflation-protected bonds (VTIP +1.6% & TIP +4.5%). The Fed’s communicated reluctance to raise rates too quickly increased market concern that the Fed may let inflation overshoot its 2% target, otherwise known as being ‘behind the curve.’ As inflation expectations rise, so too does the value of our inflation-protected bonds.
We generally prefer exchange-traded funds (ETFs) over mutual funds due to their lower operating costs, lower embedded trading costs, better tax efficiency and ability to trade intra-day (see our 4Q13 CIO Commentary for a complete discussion of these advantages). However, we do currently own one mutual fund in all of our strategies, Vanguard Market Neutral Fund-Investor Shares (VMNFX).3
VMNFX has a near zero net exposure to all industry sectors in the US stock market by taking long positions in companies it finds undervalued and by shorting companies it finds overvalued. With short duration fixed income paying little to no yield and longer duration fixed income particularly vulnerable if rates normalize, we viewed VMNFX as a relatively attractive vehicle to attempt to generate returns without taking on market risk. This ‘alternative’ investment (alternative because its returns have little correlation with bonds and stocks) is pretty much only available as a mutual fund, or as a hedge fund, but not as an ETF because it is actively managed. Few active managers use the ETF structure because of its requirement to disclose holdings daily.
VMNFX has served us well since we added it to AlphaGlider strategies in December 2014. It generated a 7.3% total return through March 31, 2016, beating out the Barclays US Aggregate Bond Index’s 2.8% and the MSCI ACWI IMI Index’s 1.2%. We are not surprised that Morningstar recently named VMNFX its Alternative Fund of the Year for 2015. This is what Morningstar had to say about the fund:
“Simply put, Vanguard Market Neutral has produced what investors want from alternative strategies: very low correlation, solid returns when equity markets go south, and, on top of that, the lowest fees of any alternatives fund.”
OUTLOOK & STRATEGY POSITIONING
As mentioned in the previous section, AlphaGlider strategies have favored equities over fixed income, foreign developed equities (specifically developed Europe) over domestic equities, and shorter duration debt. This positioning caused us to underperform our benchmarks over the last couple of years, but we continue to believe it provides the best long-term risk-reward tradeoff going forward.
Source: Federal Reserve Bank of St. Louis
Fixed income had an amazing 30+ year run as yields on the US 10-year Treasury collapsed from over 15% to 1.78% exiting March. Going forward, long-term bond investors are taking on substantial risk given today’s extreme, historically low yields. Such investors are either factoring in a high probability of severe economic difficulties over the coming decade, or they are forced buyers with mandates to own long-duration assets—such as central banks implementing quantitative easing programs, or pension and insurance funds. We are not one of these investors.
To demonstrate our preferences, let’s look at the extremes—our preference for developed European stocks and our aversion to longer duration bonds.
Let’s say we have $100 to invest, and we decide to put it into a 1.78% yielding 10-year Treasury bond for its entire 10 year life. If inflation plays out as investors expect (1.6% annually over the next 10 years), then the purchasing power of cash flows from our bond, in today’s dollars, will be $101.65. Not great, but it beats putting that Benjamin under the mattress where it is guaranteed to lose purchasing power if prices of the things you buy continue to go up in value.
Now let’s consider a $100 investment into our European fund of choice, VGK. We like European equities now because they are reasonably valued on a depressed base of earnings. As seen on the following chart, European net profit margins have regressed to levels not experienced since the recession of 2008/2009, and are now 50% below US net profit margins. While the S&P 500 is trading at approximately 16.5x forward earnings (forward PE, price divided by expected next 12 months of earnings) on elevated margins, European stocks are trading at approximately 15.0x forward earnings on depressed margins. Looking at the cyclically adjusted price to earnings ratio (CAPE), a valuation metric that assumes margins revert to their mean by looking at inflation adjusted average earnings over the last 10 years, the S&P 500 is trading at approximately 25.6x (multipl.com) while Europe is trading at approximately 14.2x (JP Morgan Asset Management).
Source: JP Morgan Private Bank & Datastream
We think a reasonable 10 year base case for European companies would be nominal (inclusive of inflation) revenue growth of 3% annually and net margins to progressively rise 75bps to 5.0%. Assuming no PE multiple expansion (i.e. maintaining its 15.0x forward earnings multiple in 2026), 1.6% US inflation, and that VGK’s dividend grows inline with earnings, our investment would generate $175.59 in purchasing value, as measured in today’s dollars. We’re obviously taking on more volatility, and thus risk, with an investment in European equities than with a 10-year Treasury, but the expected returns would appear to more than compensate us for this added volatility.
How bad would things need to get in the global economy for these two investments to match one another over the next 10 years? Assuming that this downside case would coincide with nil inflation, net margins remaining constant at today’s low level of 4.25%, stable forward earnings and dividends declining inline with earnings, European company revenues would need to decline by over -14% over the 10 year period. Our VGK investment would generate $117.80 in purchasing value in this scenario—the same amount as a 10-year Treasury bond yielding 1.78% held for duration in an environment without inflation. Although I would not reject the possibility that European company revenues and profits in 2026 will be 14% below their current levels, I think it is rather low probability.
But let’s throw in an even worse scenario. We’ll keep the nil inflation assumption, but we’ll build in a 2% annual revenue decline and a steady fall in net margins to 3.5% (resulting a in 30% profit decline after 10 years), and again assume that dividends fall inline with earnings and that forward multiples do not change (the VGK share price would thus be 30% lower than today’s value). Our VGK investment would generate $97.61 in purchasing value in this case—only marginally worse than had we put our money under our mattress—demonstrating the power of VGK’s high dividend yield (3.6%) and not much different from owning the 10-year Treasury in our base case scenario.
Now what if investors are underestimating the level of global growth and inflation over the coming 10 years? This ‘good’ case for European stocks would be a poor one for a 10-year Treasury. Let’s say our European companies grow revenue 5% annually and are able to gradually raise net margins to 5.5%, but that US inflation runs at 3%. Our $100 investment in VGK would give us $217.66 in purchasing value, as measured in today’s dollars. But our $100 purchase in a 10-year Treasury would pay us only $89.34 in purchasing value in this scenario. Who knows what the probability of this scenario occurring, but I would imagine it is in the ballpark of the chances of the global economy stalling and European company revenues and profits declining 14% over the next 10 years.
Source: AlphaGlider
To the right is a graphical representation of the purchasing power generated by our two investment choices over the next decade, in our base, good & bad case scenarios. We think that European equities provide an attractive asymmetric risk-reward investment opportunity over the long run. I hope this little exercise provides some insight on how we think about risk and reward while building and maintaining your AlphaGlider strategy.
NOTES & DISCLOSURES
The views expressed in this commentary are exclusively those of the author, and are not meant as investment advice and are subject to change without notice. The commentary does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive it. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. There is no guarantee that any investment program or account will be profitable or will not incur loss. You should note that security values may fluctuate and that each security's price or value may rise or fall. Past performance is not necessarily a guide to future performance. Individual client accounts may vary.
1This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete, and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
2Mutual funds, exchange-traded funds and exchange-traded notes are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
3Alternative investments, including hedge funds, commodities and managed futures involve a high degree of risk, often engage in leveraging and other speculative investments practices that may increase risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are subject to the same regulatory requirements as mutual funds, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. The performance of alternative investments including hedge funds and managed futures can be volatile. Often, hedge funds or managed futures account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, including hedge funds and managed futures and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products including hedge funds and managed futures often execute a substantial portion of their trades on non-US exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in the US markets. Additionally, alternative investments including hedge funds and managed futures often entail commodity trading which can involve substantial risk of loss.
4Rebalancing can entail transaction costs and tax consequences that should be considered when determining a rebalancing strategy.
^Indices are unmanaged and investors cannot invest directly in an index. The performance of indices do not account for any fees, commissions or other expenses that would be incurred.
aThe Standard & Poor's 500 (S&P 500) Index is a free float-adjusted market capitalization weighted index that is designed to measure large cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization in the US equity markets.
bMSCI Europe, Australasia and Far East (EAFE) Index is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of developed market equities outside of the US.
cMSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization weighted index that is designed to measure large and mid-cap equity market performance in the global Emerging Markets.
dMSCI All-Country World (ACWI) Investable Market Index (IMI) is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of global equity markets.
eThe Barclays Capital US Aggregate Bond Index is a market capitalization weighted index that is designed to track most investment grade bonds traded in the United States. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds and a small amount of foreign bonds traded in the United States. Municipal bonds and Treasury Inflation-Protected Securities (TIPS) are excluded due to tax treatment issues.
fThe Financial Times Stock Exchange (FTSE) 100 Index is a market capitalization weighted index of the 100 largest market capitalization companies listed on the London Stock Exchange.
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