First Quarter 2017 Key Takeaways
Global equities greeted the new year with the same degree of enthusiasm with which they closed 2016. Emerging-market stocks led the way with strong gains, followed closely by developed international and large U.S. stocks.
Our portfolios benefited from their exposure to emerging-market stocks, which outpaced U.S. stocks for the quarter. We have been waiting patiently for our diversification in this higher risk asset class to benefit our portfolios. We continue to be optimistic that this trend will continue throughout the year. Upward revisions to corporate earnings forecasts, GDP growth that far outstrips that of developed economies, and valuations that are still cheap compared with developed-markets stocks all helped drive the strong gains.
In Europe, stock gains also seemed to reflect a combination of bullish investor sentiment and positive economic data, including rising corporate earnings.
Investors took the Federal Reserve’s widely anticipated rate hike on March 15 in stride, treating it as another indicator of the U.S. economy’s return to form. As Fed Chair Janet Yellen stated, “The simple message is the economy is doing well.” On March 31, the Bureau of Economic Analysis released a revised GDP figure of 2.1% for the fourth quarter of 2016 versus an earlier estimate of 1.9%. While investor optimism seemed to leave no contingency for downside surprises in the first quarter, macroeconomic fundamentals were also broadly supportive across the globe.
Defensive assets turned in a solid performance, with core investment-grade bonds making up some ground along with Treasury bonds in the latter half of March after the Fed’s announcement.
It’s too soon to know what the second quarter holds in store, but we remain alert to potentially policy-driven political risk in the United States and worldwide geopolitical risk. In Europe, the outcome of upcoming elections in France and Germany may have unexpected impacts on markets. Syria, Russia, China and North Korea all remain potential disrupters and have the potential to increase volatility. While to date investors have shown a remarkable degree of staying power, that does not mean they will continue to do so.
As we discuss in this quarter’s commentary, a quick survey of the economic landscape suggests the environment should remain supportive of stocks and other risk assets, at least over the next six to 12 months or so. Longer term, we continue to believe high current valuations will be a major headwind to U.S. stock market returns. Our portfolios are prepared for higher volatility should it arise, and we remain confident in our positioning and in our investment process. Our focus remains on prudently managing each of our clients’ portfolios to achieve long-term, risk-adjusted returns consistent with their investment objectives.
First Quarter 2017 Investment Commentary
Global economic growth is in sync and improving. A quick survey of the economic landscape suggests the environment should remain supportive of stocks and other risk assets, at least over the next six to 12 months or so. We continue to believe high current valuations will be a major headwind to U.S. stock market returns looking out over the next five years. We also remain concerned about the unresolved risks stemming from the global debt build-up and unprecedented central bank policies. But for the time being, the global macroeconomic backdrop offers reason for optimism that many of the reflationary trends that have benefited our portfolios in recent quarters can continue.
Across a wide range of measures, the global economy is in its best shape in many years. Economic growth in most countries and industries is in sync and has been accelerating, albeit modestly. Leading economic indicators suggest this trend can continue, and many of the respected economic research firms we follow agree. Global Manufacturing Purchasing Managers Indexes, which have been correlated with global equity returns over time, recently made new multiyear highs in the United States, the eurozone, and China. While unexpected macro shocks can occur at any time, causing at least a short-term flight from risk assets, the likelihood of an incipient U.S. or global economic recession appears low. Without a recession, history suggests a bear market in stocks is unlikely.
Macroeconomic fundamentals appear reasonably solid and are improving from cyclically depressed levels in many regions outside the United States. But financial markets respond to new data, information, and events that differ from consensus expectations already discounted in prices. The Citi Economic Surprise Index is meant to capture whether and to what extent new economic data points are exceeding or disappointing consensus expectations. These indexes have rebounded sharply over the past year. In fact, the surprise indices for Europe and emerging markets both recently hit seven-year highs.
Portfolio Positioning & Outlook
We continue to believe that over the next several years the most likely direction for U.S. interest rates is higher, although the path will likely be bumpy. That would be consistent with the evidence of global economic reflation. In that scenario, the core bond funds’ annualized returns will be extremely low (potentially negative over a 12-month period). We are playing defense where possible by rotating traditional corporate bonds into high-yield bonds, Treasury inflation-protected bonds and real estate funds with predictable income streams. Lower risk models offer little choice but to hold a sizable amount in bonds, and we have been advising our lower risk clients to consider other alternatives if they can handle the change in risk.
On the heels of a fourth straight year of underperformance for foreign stocks versus U.S. stocks, the consensus view was for more of the same this year. The consensus view has been wrong so far. International and emerging-market stocks have beaten U.S. stocks. For the past several years we have indicated that U.S. stocks are overvalued and will eventually have difficulty performing as well as foreign stocks. Sometimes a reading of the tea leaves will be correct, but it won’t always play out that way in the short run, causing investors to challenge the analysis. Eventually patient investors will be rewarded, and we believe we are in the beginning of this stage.
On several measures the U.S. stock market is as expensive as it has ever been in the past 50 years, with one exception: the dot-com stock bubble of the late 1990s, from which the S&P 500 Index plunged nearly 50%. We don’t believe this time is different. We do believe valuation matters. When stock market valuations are high, the odds are future market returns will be low. Diversification and a bias to our home country requires a strong allocation to U.S. stocks, but we have underweighted our allocations versus historical patterns.
Developed International Stocks
Our portfolios have meaningful exposure to developed international markets. We continue to be confident that European stocks will outperform their U.S. counterparts over the next several years.
Primarily due to the onset of a regional debt crisis in 2011, European corporate earnings have barely grown since the 2008–2009 financial crisis. Fiscal and monetary policies have not been stimulative enough to offset this. Meanwhile, U.S. company earnings have grown strongly, exceeding prior cyclical highs due to historically high profit margins, stock buybacks, and low interest expenses.
We estimate that over the next five years, European companies will likely grow earnings at a much faster rate than their U.S. counterparts; this would lead to outperformance by European stocks. We believe European earnings are cyclically depressed, while U.S. earnings are near cyclical highs. We do not believe this condition is adequately reflected in their respective valuations. We don’t know the precise timing or exactly what catalyst will lead investors to close the gap, especially now when political uncertainty in Europe is high. Yet, there are reasons for optimism.
Last year, for the first time since the 2008–2009 financial crisis, Europe’s economy grew faster than that of the United States. Improving economic growth ultimately leads to better sales growth and gets consumers and corporations to borrow and spend, furthering the cycle. According to the Bank Credit Analyst, private sector credit growth in Europe is up at the fastest rate since the financial crisis.
The European Central Bank has revised upward both its inflation and growth projections for 2017–2018. We are also finally seeing better earnings from European companies. According to Ned Davis Research, the most beaten down sectors, such as financials and energy, are seeing the fastest earnings growth year over year in local-currency terms. Europe has a relatively large exposure to these sectors, and any improvement will reflect positively in index-level earnings growth.
Emerging-market company earnings are cyclically depressed relative to earnings of U.S. companies, yet investors are essentially pricing that in as a permanent condition. Using what we believe are very conservative earnings estimates, our analysis indicates emerging-market stocks in aggregate are trading at a price-to-earnings multiple well below historical averages. Using Robert Shiller’s valuation methodology—another way of normalizing earnings—emerging-market stocks are trading at around half the multiple of their U.S. counterparts. As emerging-market earnings growth comes through, we expect investors to bid up prices and valuations, generating low double-digit annualized returns.
There remains considerable uncertainty as to whether Trump’s stated policies on border taxes, import tariffs, etc., will actually be implemented in the manner he has proposed. Even assuming they will be, while they would be a near-term negative for some emerging-market countries, they may actually be worse for larger U.S. companies. That is because, among other things, protectionist policies would likely disrupt global supply chains for U.S. multinational corporations. This ability to conduct outsourcing on a global basis has driven down operating costs and has been important in pushing U.S. corporate margins higher.
Emerging markets are better positioned today to weather protectionism, higher U.S. interest rates, and a rising dollar than they were a few years ago. Many countries are implementing reforms and undergoing political change that could be positive over the longer term.
Putting It All Together
Despite a high level of volatility emanating from U.S. politics in recent months, U.S. stock market volatility has remained quite low. That is unlikely to last. Our portfolios are prepared for more oscillations, particularly downside risk with U.S. stocks. We remain confident in our positioning and in our investment process, both of which allow us to look past periods of uncertainty and keep our focus where it should be – on prudently managing our diversified portfolios to achieve long-term, risk-adjusted returns for you.
Committed to your successful retirement,
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]