Tesla Model 3, PHOTO CREDIT: Tesla
Equities and fixed income markets were strong in the second quarter of 2017. As in the previous quarter, equities outperformed fixed income, and foreign equities outperformed domestic equities. If the year were to end now, 2017 would be an above average year for investors — double-digit returns from global stocks and low single-digit returns from US bonds.
The US economy continued to plod along much like it has for the previous eight years. Slow but steady increases in employment, low inflation, low wage growth, and low interest rates remain as the dominant features of the economy.
US company earnings accelerated as of late, hitting 14% in Q1 as measured by S&P 500 earnings per share (EPS). However, the strong growth was against a poor 1Q16 quarter in which S&P 500 EPS growth was -6.7% thanks to low energy prices hitting the energy sector. Looking through this, 1Q17’s EPS was up a modest 3.1% annually over 1Q15.
The US unemployment rate hit 4.1% in April, matching the previous economic expansion’s 2006 low. The rate has since increased to 4.4%, more a result of previously discouraged workers deciding to restart their job searches than due to a lack of solid job creation by employers.
The US unemployment rate now sits below what the Congressional Budget Office (CBO) considers to be the country’s natural rate of long-term unemployment, i.e. full employment. Wage inflation usually strengthens when workers become more scarce, but that has not been the case for the US economy this cycle — June wage inflation was a lackluster 2.5%. Nevertheless, the tight labor market and its potential to accelerate future wages motivated the Federal Reserve (Fed) to raise its benchmark federal funds rate for the second time this year, this time to a range of 1-1.25%.
The Fed also began to discuss when and how it will unwind the $4.5 trillion dollar balance sheet it built up with its multiple quantitative easing programs over the last nine years. Just like its recent raises of the fed funds rate, the exit of the Fed as a major buyer of US Treasuries and mortgage-backed securities will likely exert upward pressure on private sector interest rates, ceteris paribus.
While not as strong as international equity markets during the second quarter, the US equity market performed surprisingly well given disappointing progress in President Donald Trump’s and the Republican-controlled Congress’s ambitious agenda to reduce taxes, deregulate major portions of the economy, and accelerate infrastructure spending. Market expectations for the timing and magnitude of their initiatives have fallen steadily since January’s presidential inauguration. Above right is a chart showing the betting market’s falling expectations for tax cuts.
Although House Republicans were able to narrowly vote through a large tax reduction bill in May (H.R. 1628, American Health Care Act of 2017), it looks like Senate Republicans, with their more narrow majority, are having difficulties getting 50 votes for their version of the bill (H.R. 1628, Better Care Reconciliation Act of 2017). The two versions of the bill are relatively similar, cutting an estimated $1.0-1.1 trillion dollars in health care spending over the coming 10 years at the cost of increasing the number of uninsured Americans by an estimated 22-23 million over the status quo set by the Affordable Care Act (i.e. Obamacare) — putting the total number of uninsured Americans at around 50 million in 2026. The $1+ trillion dollars saved on cutting health care spending on mostly lower and middle income Americans would go to funding tax cuts, the large majority going to the highest income Americans, either directly in this bill, or in tax bills the Republicans plan to draft later in the year. Public support for the Senate Republican bill stands at between 12% and 17%.
Like with health care, consensus among Republicans on deregulation and infrastructure spending is also far from unanimous. Adding to the Republicans’ legislative challenges is the falling popularity of Mr. Trump, who is the subject of numerous investigations over alleged ties between Russian operatives and members of his family and 2016 presidential campaign staff.
The Republican’s agenda of tax cuts, deregulation, and increased infrastructure spending would be stimulative to the economy and given the tight labor market, it was reasonable for investors to begin pricing in higher inflation when they swept the executive and legislative branches in November’s election. But as market expectations for the agenda have been dialed back, so too have market expectations for inflation. The chart to the above left shows the market’s changing implied inflation rate over the next five years.
While political developments in the US disappointed the markets during the quarter, they developed positively in Europe. The most notable event was the election of Emmanuel Macron as president of France over Marie Le Pen, the populist candidate who had run on the promise to remove France from the European Union (EU). Also important was the British general election which saw the Conservatives lose their majority but narrowly remain in power by bringing on a coalition partner, the Democratic Unionist Party (DUP), with a pledge to invest £1 billion ($1.2 billion) in the DUP’s country of Northern Ireland. The result was a defeat for Prime Minister Theresa May and her agenda to make a “hard” Brexit, and has ignited hope within many in the UK and Europe that either Brexit will be “softened” or cancelled entirely. Meanwhile, economic activity and fundamentals continued to improve in Europe.
Outside of Europe, there were several developments that could cause damage to the global economy if they continue to deteriorate. One was North Korea’s first successful test of an intercontinental ballistic missile (ICBM) on July 4th. Although it may be years before North Korea is able to master the technology to deliver a nuclear warhead to the US with this or similiar ICBM designs, North Korea has long had the ability to deliver massive destruction to South Korea, and possibly Japan, with conventional and nuclear weapons — effectively restricting the US to non-military strategies to contain a bellicose North Korea.
Political instability escalated in two of Latin America’s larger countries, Venezuela and Brazil, during the quarter. The economic structure of Venezuela continues to slowly collapse under the weight of government mismanagement and corruption, and low energy prices. As we have stated before, Venezuela has minimal direct impact on emerging market funds, but its outsized position in energy markets (it has the most proven oil reserves in the world, but it is very expensive to produce) has the ability to indirectly affect the global economy should its oil production significantly change, either up or down.
Brazil, on the other hand, makes up nearly 8% of the emerging market exchange-traded funds (ETF)2 owned by AlphaGlider (VWO) — so its impact on diversified portfolios like AlphaGlider’s is more substantial than Venezuela’s. It has been less than one year since its last president, Dilma Rousseff, was impeached, but Brazil is again facing the possibility of another presidential impeachment, that of current president Michel Temer. The largest Brazilian ETF (EWZ), not currently owned by AlphaGlider, fell nearly 20% in May when news of a recording of Temer directing bribes was made public. Even before this scandal hit, the ETF was still trading 60% below its 2008 highs, reflecting the damage done by the recession, low energy prices, and economic mismanagement that partly led to Rousseff’s impeachment. It should also be noted that the president before Ms. Rousseff, Luiz Inácio Lula da Silva, was just convicted of corruption and money laundering, and that more than half of Mr. Temer’s cabinet, a third of the Senate, and dozens of representatives are also being invested for corruption.
One development threatening the global economy that probably does not get the airtime it deserves is the increasing frequency and damage caused by cyber attacks. This quarter saw two major ransomware attacks, “WannaCry” in May and “Petya” in June, which hit tens of thousands of government and private company computers running Windows, and the disclosure by Homeland Security and the FBI that there have been sophisticated, but apparently unsuccessful, hacking attempts against the US’s power infrastructure, including at least one nuclear plant. This follows last year’s high profile Russian state-sponsored cyber attacks to influence the US presidential election in Mr. Trump’s favor. Although computerization and the connectedness enabled by the internet have generated massive amounts of value for the global economy, we fear that bad individual and state actors, and western governments’ weak efforts to combat them, will increasingly impact the value of our investments going forward.
On the environmental front, the US announced its intention to withdraw from the Paris climate agreement, joining Syria and Nicaragua as the only countries not to participate in the non-binding effort to keep global temperatures below 1.5oC above pre-industrial levels (we are currently just over 1.0oC above pre-industrial levels). While there are short-term benefits for America’s fossil fuel industry and its consumers, we are concerned that the US, and its companies, have given up the moral and technological leadership in the premier growth industry of the 21st century.
The technologies that are coming out, and will continue to come out, of the effort to meet the Paris goal will displace 20th century technologies not because they will result in lower pollution, but because they will offer better performance at lower costs. Solar and wind are now generally cheaper than coal in generating electricity, and they are traveling down cost curves to beat out natural gas within the next decade. The new $35,000 (before incentives), 5-seat Tesla 3 scoots from 0 to 60mph in 5.6 seconds, putting it into, or ahead of, the price, performance, and safety territory of the BMW 3-Series, Audi A4, and Mercedes C-Class. While the US shifts incentives and priorities back to fossil fuels and 20th century technologies, foreign countries continue to incentivize their clean technology industry, putting US companies at a major disadvantage. For example, China targets 40% of its new car sales in 2030 to be plug-in hybrids or pure electric. And last week France announced it will ban the sale of fossil fuel powered vehicles from 2040. We are not surprised that it was Volvo, a Chinese-owned, Sweden-based car company, and not General Motors, that announced earlier this month that all of its new car designs will either be hybrids or pure electric starting in 2019. We doubt that Elon Musk would choose to headquarter his company in the US (or even be allowed to, as I discuss later in this piece) if he were starting Tesla today. We are not surprised that the other 19 countries in the G-20 reiterated their commitment to the Paris agreement at this month’s G-20 meeting in Hamburg — it is in their economic interest to do so.
AlphaGlider’s large cash and cash proxy exposure, and the defensive positioning within its equities and fixed income investments, caused our strategies to lag their benchmarks in a quarter which favored more speculative positioning.
The primary drag to our relative performance during the period was from our large cash positions (ranging from 2% to 5%) and psuedo-cash positions (e.g. our market neutral fund, VMNFX, which ranged from 7.5% to 10% in position size). Our benchmarks have zero weighting in cash, so strong market performance creates a drag in this low interest rate environment.
Within our undersized equity position, we benefited from our geographic positioning — modestly overweight emerging markets and underweight the US. However, our defensive sector positioning hurt relative performance. For example our value, high dividend yield, and consumer staples funds (VTV, VYM, VDC) were only up 1.3%, 0.7%, and 0.3%, respectively, well below the S&P 500’s 3.1%.
OUTLOOK & STRATEGY POSITIONING
As I have argued earlier in this piece as well as in my other quarterly commentaries over the last year, I believe the environment for global business has deteriorated as the US, under the new leadership of the Trump administration, begins to withdraw from its seven decades of leading and promoting capitalism and democracy throughout the world. The US, along with most of the rest of the world, grew much richer under these seven decades of American leadership – especially its investors. A dollar invested in the S&P 500 after the end of World War II grew to $1741 in nominal terms (+11.0% annually), and to $128.47 in real terms (i.e., 1945 dollars; +7.0% annually). And non-investors did well also, with the prevention of another major world war and the dramatic reduction in extreme global poverty (from 55% of the world’s population in 1945 to less than 10% today). While there may be some short-term winners in this new environment (e.g. US-based steel, fossil fuel, finance companies), I think that the overall global economy and the majority of investable companies within it may suffer in the medium to long-term. And it is US companies, I believe, that may be most at risk.
On his first working day in office, President Trump pulled the US out of the Trans-Pacific Partnership (TPP), an important multilateral trade deal between the US and 11 other Pacific-rim countries that would spur trade through lower tariffs, and raise all countries’ environmental, labor, intellectual property protections closer to those in the US, creating a more level playing field for US companies. It served as an important instrument to deflect China’s growing influence over global rules and standards of trade, not just in Asia and the Pacific, but across the world. Besides pulling the US out of the TPP, Mr. Trump has also effectively pulled the US out of the negotiations on the proposed US-European Union (EU) trade agreement called the Transatlantic Trade and Investment Partnership (TTIP). Mr. Trump also confirmed that he will act upon his campaign pledge to renegotiate or terminate the 23-year old North American Free Trade Agreement (NAFTA) and the younger US-Korea Free Trade Agreement.
Mr. Trump’s recent trade protectionist moves will likely serve to reduce the future growth rate of trade between the US and many of its largest and most important trading partners. Both US and foreign companies will suffer, but the impact will be larger for US companies as these moves affect nearly all of their export opportunities, while it will only affect foreign companies’ trade with one country, the US. Foreign companies will continue to benefit from unaffected non-US foreign trading conditions, and continued improvement to them. For example, with Mr. Trump’s shelving of US-EU trade negotiations, the EU did not waste time before moving on to another deal with a major trading partner, Japan. Earlier this month the two announced a broad agreement, the Japan-EU Economic Partnership Agreement (JEEPA), to significant lower barriers on most of their trade. Another example is the TPP itself, which may continue without the US (Japan and New Zealand ratified it after the US withdrawal). And China continues to forge closer trading relationships around the world. Its latest trading initiative, the Belt and Road Initiative, involves an ambitious $900 billion transportation infrastructure plan to better connect China with 60 other countries in Asia, Europe, East Africa and Oceania. The void in global trade leadership that the US is creating by its recent protectionist actions is being occupied rapidly and enthusiastically. Just as withdrawing from trade agreements hurts US companies, so does lowering environmental standards and withdrawing from environmental treaties, like the Paris Agreement. I discussed this in the Investment Environment section above, so I will leave it there.
Another Trump policy that stands to hurt the long-term growth of the US economy, and in turn that of its US companies, is his increasing hostility to immigration. Simply put, growth in gross domestic product (GDP, the total value of goods produced and services provided) is the product of population growth and labor productivity growth. With the US fertility rate estimated to currently stand at 1.87 births per woman, net immigration is required for the US to have positive population growth. Second, studies show that productivity of immigrants into the US also serves to raise overall US productivity. But Mr. Trump would have you believe that the majority of immigrants coming to the US come to live off the state and become a drag to the system. The truth is that the average immigrant has a higher level of education than the average native born American.
US universities and entrepreneurial opportunities have long been the envy of the world, attracting the best and the brightest to its shores. And the immigrants that come in with a low level of education are vital to filling low paid, yet still important, jobs that most native born Americans refuse to do. While Mr. Trump’s wall may never be built, his policies are already slowing immigration that is vital to the US economy. Just this week the Trump administration delayed, and will probably later eliminate, the rollout of the International Entrepreneur Rule which lets foreign entrepreneurs come to the US, or stay on after completion of schooling, to start companies. Slamming the brakes on immigration threatens to turn the US into Japan when it comes to population growth and economic growth.
About one-quarter of the engineering and technology companies started in the United States between 2006 – 2012 had at least one key founder who was an immigrant.
Developed economies have been surprisingly unaffected by changes in their countries’ politics (but that said, few have experienced such a dramatic shift in politics as the US is currently experiencing, but I digress). So even assuming my concerns about the risks introduced by Mr. Trump do not evolve into actual long-term damage to the US economy and the investable companies operating within it, is the US stock market compelling at today’s valuations? Or perhaps valuations already reflect the risks that I identified, making the US stock market a compelling investment?
As I’m a long-term investor, I would like to answer these questions by looking at two valuation metrics that have been relatively helpful in predicting long-term returns (in this case, 15 years), the cyclically-adjusted price-to-earnings (CAPE) ratio, and the price to book (P/B) ratio. As the table on the following page shows, the US has a CAPE of 28.0x and a P/B of 3.1x. You cannot tell it from this table, but these are unusually high values versus its history. But during those rare times that sported these valuations, the range of the middle 50% of annualized nominal returns was 1.8% to 5.2% at today’s US CAPE, and 0.5% to 4.0% at today’s US P/B — so let’s take the extremes, a middle 50% range of US nominal annual returns from 0.5% to 5.2%. Mind you, earlier in this section I indicated that the S&P 500 compounded at an 11.0% nominal annual return since the end of World War II, so a 50% probability of getting an annual return of between 0.5% and 5.2%, and a 75% probability of getting less than a 5.2% annual return, are pretty uninviting. Today’s US valuations surely do not price in any of the political risks that I have identify. Actually, quite the contrary.
Fortunately there are cheaper markets out there. And fortunately we have an active mandate that allows us to pursue investment opportunities wherever they are across the geographic and asset class spectrum.
One such market is Singapore, which has a CAPE of 12.8x and a P/B of 1.2x. These valuations historically map to a middle 50% return range of 6.5% to 11.6% for the country. And then there are the collective emerging markets, which have a CAPE of 15.6x and a P/B of 1.7x. These valuations historically map to a middle 50% return range of 5.2% to 8.6% for these countries. While not spectacularly cheap, these two regions provide returns that are at least commensurate with their volatility/risks. There are no guarantees that Singapore and emerging markets will outperform the US market over the next 10-15 years, but my analysis of their growth prospects and current valuations leads me to believe that there is a high probability that they will. But the short-term is anyone’s guess, as history as shown time and time again.