Key Takeaways —
As the quarter ended, Greece was making headlines for its June 30th default on a debt payment to the International Monetary Fund amidst increasingly fraught negotiations with its Eurozone creditors, China was in the news for its very sharp short-term stock market decline and surprise interest rate cut, and Puerto Rico announced it would be unable to fully repay its municipal debts. The 2nd quarter was shaping up to be a good quarter for diversified portfolios —until the last three trading days.
U.S. stocks were barely positive for the quarter. On the economic front, first quarter U.S. GDP growth was revised higher in June though it remained in slightly negative territory after a harsh winter depressed economic activity. Job growth remained strong and the housing market appeared in decent shape as average home prices hit levels not seen since 2006.
Developed international stocks were roughly even with U.S. stocks in the second quarter and maintain a lead for the year so far. Greece certainly dominated the headlines in the second quarter, although at the writing of this newsletter, Greece and the European Union have successfully solved the immediate issues. Greece will remain in the Euro and the European’s will once again loan them money in exchange for austerity legislation. Later in this newsletter, I will discuss more about Europe and our viewpoint going forward.
Emerging-markets stocks also rose slightly during the quarter and are outpacing U.S. stocks for the year despite a mixed bag of economic outlooks as well as concerns that higher U.S. interest rates could be harmful to countries with heavier amounts of U.S.-dollar-denominated debt. (This is a risk we monitor closely and it is our view that overall emerging markets are less vulnerable to negative downstream effects from U.S. rate rises than in the past.) Among larger emerging markets, China was a strong positive contributor for the quarter, despite its June decline.
After five consecutive quarters of gains, core bonds declined 1.8% over the last three months as yields on 10-year Treasury bonds increased 40 basis points. Our estimate of core bond returns remains low over our five-year forecast. Consequently, we continue to favor a variety of credit strategies that we believe will outperform our core bond benchmark in flat and rising interest-rate scenarios. These flexible credit strategies have broad mandates, which we believe will allow them to benefit from rising interest rates. That said, we retain a partial allocation to high-quality core bonds as we view them as a source of portfolio protection in the event of a stock market decline.
We are regularly asked for our take on the broad macroeconomic topics of the day. In most cases, we don’t believe we have new insights to add beyond the reams of commentary these topics typically inspire. As we come to the end of this quarter, one of the more noteworthy big-picture subjects we are being asked about is the Greek debt crisis.
This latest Greek crisis provides us with an opportunity to highlight how we think about these types of overarching, large-scale, and often complex events in the context of our investment process and portfolio management approach. (Other examples include the potential impacts and outcomes from national elections, central bank actions, and geopolitical conflicts). These situations fall into the category of important but unknowable. As such, they warrant some attention from us but not, in most cases, a specific reaction. Our approach is to instead consider a range of potential outcomes (or macro risks) and then build portfolios that we believe are resilient and robust across this range.
Using the Greece situation to illustrate, our overall portfolio positioning is based on our expectations for returns and risk across a range of broad economic scenarios we consider to be reasonably likely. The range of scenarios includes best, worst, and baseline cases and, as a result, implicitly incorporates a range of outcomes from the negotiations with Greece. In other words, our current allocation is not based on an assumption that Greece would or would not default, nor on the duration of their tenure in Europe’s Economic and Monetary Union.
As our clients know, Europe has been something we have talked about often over the last 12 months and particularly in the last 6 months. We hoped the Greek crisis might provide that opportunity to increase our exposure to European stocks. Unfortunately there was limited market reaction to this crisis. We will continue to evaluate when and how we will increase our exposure to European equities.
Asset Class Views and Portfolio Positioning
Another source of uncertainty and potential market volatility is Fed monetary policy. While we acknowledge that central bank actions (as well as Fed governors’ speeches) obviously do impact financial markets on a day-to-day basis, we also firmly believe it’s foolhardy for long-term investors to base investment decisions or portfolio allocations on short-term predictions of central bank behavior. We remain conservatively allocated to U.S. stocks in our portfolios as the potential returns looking out across our five-year investment time period are not high enough to fully compensate us for the risks. (Our positioning is not a short-term bet that stocks will drop when the Fed starts raising rates.)
We evaluate the attractiveness of stocks by analyzing the five-year outlook for company earnings relative to stock prices across a variety of economic scenarios we believe are plausible. By this standard, stocks look less attractive, offering only a single-digit return potential over the next five years in our base case scenario. As we’ve discussed in prior newsletters, with corporate profit margins at historically high levels and stock market valuations expensive, the potential for earnings to disappoint the market’s expectations (as reflected in those high valuations) is meaningful. We think that is a likely outcome over our five-year time horizon, and it could happen sooner than later. Counter intuitively, it might even be improved economic growth that is a negative catalyst for stocks to the extent that a strengthening labor market leads to accelerating wage growth, which in turn puts downward pressure on profit margins and earnings. Looking back at what we’ve seen so far this year, S&P 500 profit margins, while still high, have turned down over the past two quarters. Further, S&P 500 earnings growth expectations have been steadily coming down since last year.
We know U.S. stocks may continue to deliver attractive returns over short- or intermediate-term periods (supportive monetary policy can be a powerful influence, as we’ve seen), and we expect the actively managed stock funds we own to outperform the broad market over multiyear periods. So we own U.S. stock funds in all of our portfolios but at a lower allocation than if return potential were higher. We continue to believe there are better opportunities for our clients outside the U.S. market.
As we discussed earlier in this commentary, the Greece situation was something important, but not knowable. Today we know that Greece won’t default on their debt, they will remain in the European Union and legislation has been passed for severe austerity measures in Europe. Our assessment remains that expected returns for European stocks are very attractive relative to U.S. stocks looking out over the next five years. Despite a rebound earlier this year, European stock market valuations and corporate earnings (which are well below their long-term trend) still have room to improve, both on absolute terms and relative to the United States. For example, the following chart shows the wide gap in net profit margins of non-financial companies in the Eurozone compared to the United States. We don’t believe this wide a disparity is sustainable and believe it will adjust in favor of Europe over the next several years. Our assessment does not assume that the situation with Greece is solved. Ultimately the agreement that was reached just buys them a little more time down the road. There is a high probability by the end of this decade that Greece and Europe will be back in the same situation as they are now.
We continue to like emerging-markets stocks on a longer-term strategic basis and on a more intermediate-term tactical basis, where we have an equal weighting relative to our strategic allocation. Our top-down analysis for emerging-markets stocks is similar to our analysis for European stocks, in that their valuations look attractive and earnings appear to be depressed relative to our longer-term expectations. We also take into account specific risks to emerging markets, namely the potential for a sharper slowdown of growth in China and the risk from a stronger U.S. dollar. However, even when taking these risks into consideration, over our five-year investment time horizon, our analysis still shows low double-digit annualized returns in our base case scenario and mid-single-digit returns in our most bearish scenario.
Given that our base case scenario assumes that we’ll be in a longer-term trend of moderately rising short-term interest rates, we are maintaining a significant underweight to core bonds and interest rate risk in our fixed income side of the portfolios. Therefore, we are using flexible bond funds and absolute-return-oriented bond funds that we believe can generate higher returns and better manage their interest rate sensitivity.
Looking ahead, we know there are inevitably going to be shorter-term surprises, including negative ones. This should not be surprising, yet we know it will still feel uncomfortable for many investors. In those moments, it’s useful to remember that volatility is the shorter-term discomfort an investor must often experience in order to earn attractive longer-term returns from owning stocks. For it’s exactly those volatile market movements that can create compelling longer-term investment opportunities: tactical asset allocation fat pitches for us, and great stock- and bond-picking opportunities for our active managers.
Jon Houk, CFP®