Second Quarter 2016 Key Takeaways —
U.S. markets were initially range-bound for most of the quarter until June, when the relative calm in global stock markets came to an abrupt end. Upending most forecasts and taking world financial markets by surprise, the United Kingdom voted to leave the European Union on June 23. In the wake of the vote, British pound sterling fell 11% overnight against the U.S. dollar, its lowest level since 1985. The euro fell 2.4% to 1.10 versus the dollar. Global equities plummeted.
Then in the week following Britain’s historic vote, global equities rallied, despite still significant uncertainty regarding the economic, political, and financial market implications of Brexit. When the dust had settled, developed international and European stocks remained in the red, while U.S. stocks edged into positive territory. The big winners in the quarter were emerging-markets stocks, which gained 4.9% and are now up 8.6% year to date.
Before the Brexit vote, the big story in financial markets had been bonds, specifically negative yields on government bonds across the globe. By month’s end, the amount of government debt sporting negative yields had soared by nearly $1 trillion. Falling yields have been driven by economic growth concerns; central banks’ interest rate policies and intervention in bond markets; and heightened demand for perceived risk-free assets as a reaction to the uncertainty surrounding Brexit’s impact.
While we do not expect a sharp rise in interest rates any time soon, at such low starting yields, expected returns for core bonds are extremely low. Investors are earning very little (or actually paying via negative yields) for the safety of holding government bonds.
Given current yields, valuations, and earnings fundamentals, we continue to view the return prospects of a “traditional” portfolio split 60/40 between stocks and bonds as poor. We believe the diversified portfolios we’ve assembled for our clients are well positioned to outperform ones that only feature traditional assets. We saw strong performance for our flexible fixed-income strategies during the volatile quarter, with most of them beating the core bond index. Our alternative strategies positions also performed in-line with our expectations, fulfilling their role as important ballasts to our diversified portfolios when stock and bond markets overshoot.
The quarter’s market upheaval was yet another reminder that successful investing requires patience and the understanding that investing is part of a process, not a one-off decision, toward achieving your long-term financial goals. There will be inevitable and unpredictable shorter-term market ups and downs along the way, and through these periods, it is our job to remain focused on the long-term objectives of our clients, maintaining a consistent investment discipline to guide our decisions over time.
Second Quarter 2016 Investment Commentary
No matter how you slice it, investment return prospects for a traditional balanced portfolio are poor as you look out over the next five years.
If you review rolling five-year annualized returns for this traditional balanced portfolio (60% S&P 500 index and 40% core bond index) since 1950, and assume annual rebalancing back to the 60/40 weights, you will find an average annual return of about 9.5%. Unfortunately, we believe the returns on a traditional portfolio like this over the next five years will be significantly less. If we make reasonable assumptions based upon current interest rates and valuations, we end up with around a 1% annualized return on bonds and a single digit return on stocks. Combining those into our hypothetical balanced portfolio, we get a return of somewhere around 3-4% per year. That’s less than half of what the long term returns have been.
The historical data also show the 60/40 portfolio has generated above-average returns over the past several years. A key driver has been the impact of quantitative easing (purchases of government debt in an effort to add liquidity to bond markets) and other aggressive central bank policies, which have helped push down interest rates. This has meant higher bond prices and capital appreciation for the core bond index in addition to its income yield.
Central bank policies also contributed to the meaningful increase in stock market valuations. In more recent years, a significant majority of the S&P 500’s return has come from P/E multiple expansion rather than earnings growth. For the five years ending March 31, 2016, the S&P 500 gained 73%, but 46 percentage points of that total return came from P/E expansion.
A large part of this P/E expansion came from the earnings decline over the last five quarters. However, to continue to support gains in the market going forward we would need to see significant earnings growth, which seems unlikely given our current low level of economic growth in the United States.
More Than Core Bonds . . . So What?
While we have subpar return expectations for stocks, we do believe they are likely to generate higher returns than core bonds over our five-year horizon. However, stocks have significantly higher volatility, higher downside risk, and greater risk of permanent capital loss than core bonds. You should always be compensated with a higher expected return from stocks.
Since our current analysis suggests expected returns for U.S. stocks as well as core bonds are unattractive from a total return and a risk management perspective, we are invested in a mix of asset classes that along with some exposure to U.S. stocks and core bonds, can be combined in a well-diversified, risk-managed portfolio with comparable risk to a traditional 60/40 portfolio, but with a better five-year expected return.
We are underweight to U.S. stocks, in favor of a mix of developed international and emerging-market equities. However, the recent Brexit vote does call into question our exposure to the UK and Europe, not necessarily because we believe the initial economic analysis of European stocks was inaccurate, but because there is now a level of political uncertainty that adds significantly to the level of risk. Therefore, we are going to reduce our position in developed international equities, with the possibility of adding back to them in the next few years at potentially lower prices.
Over the last five years, small companies in the US have underperformed large companies by approximately 3% per year, and while we have not had any direct exposure to small cap stocks during this time period, we are now going to be adding them back into our portfolios with an eye towards rebalancing to a neutral allocation. Small cap stocks are not necessarily cheap, but conversely they are also not expensive anymore, and potentially have the ability as an investment class to be less impacted by negative global macro events.
We are underweight core bonds in favor of actively managed, flexible, unconstrained, and/or opportunistic fixed-income funds along with international bond funds. We expect to earn a meaningful return premium relative to the core bond index over the next several years. The trade-off is that we are taking on more currency and credit risk and potentially they will not do as well if there is deflation or a short-term shock that pushes Treasury yields lower. However, these funds have less sensitivity to negative price impacts from rising interest rates, playing a valuable risk-management role in our more conservative, fixed-income-heavy portfolios.
We also have a tactical position to various alternative asset classes (with strategies in areas such as managed futures, arbitrage, and currency) that potentially offer an opportunity to earn higher rates of return than fixed income with hopefully a similar level of volatility. Additionally, this volatility is potentially less-correlated to traditional investments, and therefore adds to the overall diversification of the portfolio.
Putting It All Together
Our more diversified alternative to the traditional 60/40 portfolio is still not expected to generate returns as high as the long-term historical average, even with the potential of additional returns coming from our tactical allocations to more attractive asset classes and strategies. Our base case expected annualized five-year return for this balanced portfolio is in the 5.0%–6% range. While that is still meaningfully higher than the approximate 3-4% return we expect for a traditional 60/40 portfolio, there are no guarantees. However, we view our base case as being the most likely and our asset class assumptions as reasonably conservative.
Volatile markets, which we also expect, will likely challenge investors’ convictions and emotions. Remaining focused on the long-term objective is key, as is maintaining a consistent investment discipline. Our valuation-driven discipline means we can use short-term market volatility to our long-term benefit—managing risk while taking advantage of the investment opportunities created by other market participants’ lack of discipline, patience, and flexibility.
Jon Houk, CFP®