“Summertime is always the best of what might be.” ― Charles Bowden
While the severe winter weather may seem a distant memory in the midst of the current summer heat, its impact was more longstanding as evidenced by the -2.1% contraction in economic growth in Q1 2014, the first quarterly contraction since Q1 2009. Fortunately, the economic slowdown proved to be short-lived as the warmer weather brought the reemergence of economic growth with GDP rebounding to +4.0% in Q2. Investment markets have reacted favorably to the stronger economy and the S&P 500 index is up a respectable +5.7% through July. Perhaps in a bit of a surprise, virtually every broadly watched global index also produced low to mid single-digit returns with the MSCI All World Index up 4.9%, the Barclays Aggregate Bond Index up 3.5%, and gold up 6.7%.
Remarkably, despite unnerving geo-political events, these returns have been achieved with market volatility at its lowest level since 1995. So far, investors continue to shrug off the tragic exchange of missiles and the ground war in Gaza, the rise of the fanatical lunatics of ISIS in Iraq, the fears over a spreading Ebola epidemic in West Africa and the escalating threat of war in Eastern Europe between Russia and Ukraine. This relative calm in the investment markets has created an anxious environment where many investors seem to be waiting for the proverbial “straw that breaks the camel’s back”, prompting a long-awaited pullback in U.S. stocks. This anxiety has been heightened by the shifting sands of the accommodative monetary policies of global central banks that have spurred the ongoing bull market in stocks and elevated the valuations of most investable assets.
However, what is sometimes overlooked is that the underlying economic environment in the U.S. remains increasingly constructive, offering the potential for the benefits of the economic recovery to spread beyond the investor class. Employment has been gradually improving and the country has added more than 200,000 jobs each month for six consecutive months (the longest stretch since 1997), which has helped bring the unemployment rate to just above 6%. More jobs and a stronger housing market has contributed to rising consumer confidence, which along with a 5-year high in the PMI (Purchasing Managers Index) and accelerating loan growth at major money center banks (~ 3.5% in the 2Q), provides an optimistic backdrop for a slowly improving U.S. economy which can continue to support modest revenue and earnings growth.
However, improving fundamentals alone are insufficient to drive equity market returns as investors also need a favorable interest rate environment and attractive valuations. Though the Fed’s quantitative easing (QE) efforts are steadily coming to an end, the Fed Governors have made it clear that they plan to keep overnight rates low until at least the middle of 2015. We view the ending of QE and the debate of 2015 rate increases as signs of confidence that the economic recovery can endure without such significant monetary stimulus. With inflation still in check, we anticipate interest rates will remain relatively low and mostly range-bound for the foreseeable future and more closely correlated to GDP growth. Likewise, stock market valuations, though hardly “cheap”, are not excessive, based on historical standards. Currently the S&P 500 trades at about 15.6x anticipated earnings, coincidentally the average over the past 25 years.
SOURCE: JP MORGAN
Throughout 2014, we have opportunistically increased our exposure to growth assets, both in the U.S. and Europe, as we continue to believe that equities offer more attractive long-term returns than what can be achieved in the current bond market. While at the broadest level, stock markets appear to be drifting only higher, the dispersion of returns among the stocks making up the indices has increased (i.e. correlations are lower), creating opportunities for us as fundamental investors who use bottom up analysis to identify individual businesses at attractive prices. With valuations full, some quality companies have become just that when they’ve hit an inevitable speed bump in their businesses, allowing us to selectively add to our portfolio of high quality growth-oriented companies with strong free cash flows, healthy balance sheets, and improving fundamentals.
We also believe that European equities are presenting opportunities as those economies, though fragile, are gradually improving with signs of modest corporate earnings growth. Europe remains much earlier in their recovery compared to the U.S. and, while the U.S. Federal Reserve is tapering QE, the European Central Bank remains committed to maintaining and if necessary, increasing their monetary stimulus policies. While the increasing trade sanctions with Russia threaten to dent European economies, the relative equity valuations make this an increasingly attractive investment.
Though challenged in 2013, emerging markets have staged a strong recovery since bottoming earlier this year (the MSCI EM index is up almost 20% since early February) and we continue to believe specific country and consumer exposure will offer attractive long-term investment opportunities given current valuations. In our view this excludes China as the lack of transparency around “reported” economic data and the likelihood of a major adverse credit event taking place are too great despite reasonable valuations.
As for our fixed income exposure, we remained defensively positioned with shorter duration portfolios as we do not believe investors will be rewarded by purchasing longer-dated maturities or lower-quality bonds for a few basis points of additional yield, especially if interest rates rise more quickly or more dramatically than currently anticipated.
Today there are few “cheap” assets as monetary actions of the U.S. Federal Reserve and other government central banks have created full valuations across most asset classes. Given the expected slow growth environment, this suggests that the opportunity for future returns will likely be more modest compared to the recent past. However, we believe investors will benefit from thoughtfully diversified global portfolios crafted to generate attractive total returns while mitigating volatility and protecting against unforeseen risks. So far this year, this approach has delivered competitive investment returns while allowing us to prudently take advantage of unique opportunities as they become available. Importantly, should we experience increased volatility and/or the decline some observers seem to be anticipating, we are confident this disciplined approach will enable us to weather the storm and take advantage of shifting valuations to best position portfolios for attractive long-term investment returns.