The perception of calm represented by the 1%-2% returns across global stock markets in Q1 masked meaningful volatility during the quarter. At the end of January, the S&P 500 dropped as much as 6%, matching its most significant decline in 2013. International stocks similarly stumbled out of the gates with the EFA index down 7% and emerging markets down over 11% by early February. Stocks generally recovered into the end of the quarter, rallying 8-10% off the intra-quarter lows to finish mostly in the black.
There has been similar volatility in the bond market so far this year with investors largely benefitting as the equity “risk-off” trade caused a flight to bonds and interest rates to decline. During Q1, the benchmark 10 year U.S. Treasury yield fell from slightly over 3% at the start of the year to about 2.7% at the end of the quarter, resulting in 2%-3% gains for corporate and municipal bond investors.
Bonds were not the only asset class to outperform stocks during Q1 as heightened geo-political tensions, mostly notably surrounding Russia and the Ukraine, caused commodity prices to rise including Gold, which finished up 6.5% for the quarter. Clearly the benefits of a globally diversified portfolio have been more evident at the start of 2014 versus in 2013 for most investors.
At the start of April, stock market valuations in the U.S. are generous and, for certain sectors and stocks, have reached levels requiring enormous future growth and profits to justify. Investors in some of these once-frothy areas, including biotech, internet security and 3D printing, have all suffered meaningful declines of 20%-50%! These recent losses have hardly been limited to these sectors and many individual stocks have begun to struggle. As of Tax Day, the S&P 500 index members are now down an average of 10.5% from recent highs with 213 companies down over 10% and only 72 members of the S&P 500 “beating” the index.
So what’s going on?
While the U.S. economy continues to show signs of recovery, U.S. monetary policy is in transition and, globally, economic & geo-political risks are rising. The Fed’s monthly QE efforts have already been reduced from $85 billion to $55 billion and the expectation that it will be $0 by November. While new Fed Chair, Janet Yellen, has offered reassuring words for persistently low-interest rates, it’s clear that monetary policy will be less of a tailwind in the months ahead.
In addition, significant tax hikes in Japan threaten to create another consumption shock in the world’s third largest economy, adding further to concerns across Asia and broader emerging markets already feeling the weight of heightened credit risks in China and rising political instability in Eastern Europe. Taken together, ongoing investment volatility with pockets of weakness should not be a surprise.
Investment opportunities are created under such conditions and we continue to evaluate numerous individual companies as well as assess the relative risks and returns across different asset classes. In Q1 the stock prices of a number of high quality businesses fell as a result of what we believe to be temporary conditions, creating attractive long-term investment opportunities that were added to portfolios.
Perhaps our most significant portfolio shift over the past few months has been the growing exposure to European equities, with a specific focus on the UK and Germany. This represents a significant shift in our portfolio positioning and is worth further discussion.
An Evolving View of Europe
For the past several years, we avoided European exposure due to concerns over the high unemployment, credit risks, and austerity measures that still face many of its nations. As recently as Q3 2012, Europe was in the second leg of a double-dip recession and economists were speculating on the breakup of the Eurozone. Rapidly rising public and private debt levels led to soaring borrowing costs, particularly for Portugal, Ireland, Italy, Greece, and Spain (known at the time as the “PIIGS”) and an ensuing European banking crisis.
George Soros summarized the situation at the time:
“When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points.”
As bank capital deteriorated, lending dried up and an economic crisis ensued, leading many to speculate that the stronger nations, notably Germany, would leave the Euro. Determined to avoid this fate, Mario Draghi and the European Central Bank (ECB) pledged to “do whatever it takes” to preserve the Eurozone, resulting in accommodative monetary policy as well as unprecedented austerity measures for the southern European countries.
These aggressive actions positioned Europe for the economic recovery that continues to march forward. The EU recently announced a third quarter in a row of positive GDP growth and leading economic indicators such as the Purchasing Managers Index (PMI) have moved into expansionary territory, showing stronger economic activity in countries like the UK and Germany as well as the PIIGS. Industrial activity has picked-up and there are also signs of improving housing markets and rising consumer confidence and spending.
While European equity markets delivered positive returns in the second half of 2013, they lagged the U.S. markets and this relative underperformance, combined with improving earnings, has led to attractive relative valuations. On many valuation metrics, European equities trade at a discount to similar U.S. equities and with Europe still in earlier stages of the business cycle, the EU markets will likely have greater tailwinds and potentially offer stronger earnings growth and multiple expansions in the years ahead.
Our Investment Approach
While the continued economic recovery and valuation disparity presents an attractive backdrop for EU equities, not all regions, sectors and industries are benefiting equally and careful investment evaluation and selection is warranted. Rather than utilize a passive index-focused approach that would give broad sector and country exposure, we have preferred to use an active manager who is focusing their attention on the faster-growing northern European countries and limiting exposure to European financials and other lower quality businesses.
Specifically, we have utilized the FPA International Value Fund, which currently has roughly 70% of its assets invested in European and Scandinavian countries, with an overweight in the U.K. and Germany. This actively-managed mutual fund is guided by an experienced portfolio management team that follows a disciplined investment approach favoring high quality businesses with attractive valuations. With the EU valuation discounts being less warranted now than during the crisis, the improving economic conditions in Europe provides ample opportunity for FPA to build an attractive portfolio.
The ongoing recovery across the major world economies in the U.S. and EU is providing an encouraging backdrop for investors. However, aggressive monetary policy over the past few years has led to richer stock prices and lower yields for investors. Especially given the shifting Fed policies, we believe such an environment requires a diversified and disciplined investment approach that is supported by careful research and selective evaluation of potential investments. Choosing the FPA International Value Fund is one example of how we carefully manage our clients’ portfolios as we seek potential long-term investment opportunities that we believe will be created in the wake of this shifting landscape.