Third Quarter 2013 Key Takeaways —
The quarter ended with a surprising turn as the Federal Reserve’s much-anticipated shift toward tapering its monthly bond buying failed to materialize at its September meeting. Shortly thereafter, monetary policy was upstaged by fiscal policy as Congress clashed over the budget and veered toward a government shutdown (which began just after the quarter ended).
Despite these twists and turns, stocks posted another strong quarter. Large-caps rose 5% and are now up 20% for the year to date. These gains have occurred even as the U.S. economic recovery remains only moderate (muddling along) and corporate earnings growth has slowed.
International markets improved in the third quarter following a rocky start to the year, particularly for emerging markets. Among emerging markets, China showed signs of stronger growth (albeit at a lower rate than in prior years) which was an overall positive given the country’s significance among emerging (and developed) market economies. Emerging markets as a group rose in aggregate for the quarter (despite losses for some countries) and developed international markets outperformed U.S. stocks by a wide margin.
Core bonds in aggregate were modestly positive for the quarter thanks in large part to a rebound in September as both the Fed’s decision to stand pat and investor risk-aversion in the face of an impending budget stalemate (and looming debt-ceiling standoff), which proved to be favorable for bonds. Our absolute-return-oriented and flexible bond funds collectively outpaced core bond funds during this changing fixed-income environment, but our exposure to emerging market debt hindered performance for the quarter.
We continue to believe we are investing in a time of uncertainty, where an unusually broad range of outcomes remain possible. Building a sensible portfolio strategy in this environment is not just about having different pieces in place to ensure the portfolio can withstand different scenarios, it is also about understanding the risk and reward of each asset, the role of each asset in the portfolio, and how assets interact with each other.
We view U.S. stocks as fully valued and are maintaining a small tactical underweight in our portfolios. The case for investing outside the United States, particularly in emerging markets, continues to look compelling. Even though we have increased our allocations outside the U.S., near-term economic risks in China has tapered our aggressiveness regarding our exposure to emerging-markets stocks and bonds.
An important part of our investment discipline is to protect client portfolios against risk scenarios we believe are plausible and not already adequately factored into asset prices. Taking this precaution means we will likely lag the broader stock market if these risk scenarios do not play out. However, the fear of leaving some money on the table over short periods is not sufficient cause to deviate from the investment discipline that has served our clients well over the long term.
Third Quarter 2013 Investment Commentary
The word “fiduciary” is defined as “relating to, or involving one that holds something in trust for another.” Another word that goes hand in hand with being a fiduciary for our clients is “prudence,” which is defined as “careful management.” In our industry, these words—fiduciary and prudence—are used liberally. We want to share what these words mean to us and how they influence our day-to-day management of client portfolios.
Our typical client in a “balanced portfolio” expects us to maximize long-term return without losing more than 10% in any normal 12-month period. There’s an inherent trade-off in this dual objective. Managing to a downside risk threshold sometimes means we have to be willing to leave some return on the table. We have always said we do not manage our portfolios to one economic or asset-class scenario because we don’t think we can know with confidence which scenario will play out. We hope optimistic scenarios play out, but do not build portfolios based on them unless we believe they are the most likely scenario. Investing based on hope would not be in line with acting as a responsible fiduciary for our clients who have specifically entrusted us with the mandate to care about downside risk.
Managing portfolios to withstand various scenarios is as much art as science. In shielding our clients from one scenario, we expose them to others. The key is to strike a reasonable portfolio balance that allows us to meet our clients’ risk and return objectives over the long term. Both inflation and deflation risks exist, and both are bad for risk assets. Our economy is still fighting significant deflationary headwinds due to ongoing private- and public-sector deleveraging. At the same time, the experimental monetary policy of keeping short-term interest rates near zero over extended periods could easily stoke inflation, and we don’t know if and when that would occur. In this inflationary scenario our clients would expect us to protect their purchasing power. It would be nice if we had a crystal ball to know which outcome will occur and when, so we can position our clients’ portfolios accordingly. But part of being intellectually honest is acknowledging that we do not have a crystal ball and there are many unknowns, especially now, when we are going through a major deleveraging episode and the range of possible outcomes is unusually wide. Our job becomes harder in a period when most assets appear to be fully valued. So, how do we balance out two extreme risks—inflation and deflation—given each scenario warrants a vastly different portfolio positioning?
To protect our balanced portfolios from a recession or deflation outcome, we continue to have a decent allocation in investment-grade or core bonds. In such an environment, interest rates would likely fall, and core bonds would increase in value as most risky assets are declining. We cannot ignore this outcome because in this scenario our stated 12-month risk-threshold objective is most at risk. Given their very low yield levels, core bonds would not give as much protection as they did in the past, but would still do a much better job of protecting capital than most other asset classes in this scenario.
That said, we acknowledge that relative to history, core bonds carry a significant opportunity cost. Despite a recent spike, interest rates remain very low by historical standards, which mean that expected returns from core bonds are extremely low across all of our five-year scenarios. As a result, more than half of our bond allocation has gone to absolute-return-oriented and flexible bond funds. Over 12 months, in a recession/deflation scenario, these funds are likely to lag core bond funds that have a longer duration and heavier emphasis on Treasury bonds. But over our five-year investment horizon, absolute-return-oriented and non-core bond funds are likely to generate significantly better returns. The value of these bond funds comes from their underlying managers’ ability to add value by investing opportunistically across fixed-income sectors (without being constrained by the core benchmark) as well as from individual issue selection.
Some of our U.S. equity underweight has also gone to fund international and alternative strategies (hedged equity strategies), and here we see the latter’s role differently. Over a 12-month period, we expect our hedged equity investments to have much less downside risk than stocks, and similar or better returns in all but our most optimistic five-year scenarios. Through a strong period for stocks, they have provided a reasonable return with much less risk. In addition, by having a lower allocation to stocks, we worry a bit less about capital preservation in a deflation/recession scenario and can afford to have less protection in the form of core bonds, which, in addition to having poor return prospects over our five-year investment horizon, expose us to the risk of rising interest rates. This year, U.S. stocks clearly trounced the other assets by a large margin, but even then our overall performance was solid as other areas of our portfolio (such as our actively managed bond funds) performed well. As such, despite being underweighted to the best-performing asset class (U.S. stocks), our balanced portfolios have maintained strong performances relative to their benchmarks over the past few years.
Why are we adding to our investment outside the United States?
This is a question we have been getting a lot lately. We were getting similar questions back in the late 1990s after U.S. stocks experienced a great run of outperformance over international stocks. Developed international stocks subsequently went on to outperform U.S. stocks for six years, and emerging-markets stocks did even better. It is important to revisit why we have investments outside the United States as part of our very long-term or “strategic” allocations. The strategic allocations are the starting point for our investment process. They are intended to be an appropriate, fixed-asset allocation for a long-term investor, as they reflect a weighted mix of asset classes we believe offer the best long-term-return potential for a given risk threshold, which we define as a maximum acceptable loss over a 12-month normal worst-case period. Our investment horizon in regard to strategic allocations is 10 years or longer. The most important reason for having a globally diversified strategic mix is that it should provide a much smoother ride than just being invested in U.S. stocks. The second reason to invest outside the United States is to tap into a broader investment opportunity set—much of which is not well-covered by Wall Street—allowing active managers to add significant value.
The case for having a dedicated long-term allocation to emerging markets is particularly compelling. On a purchasing-power-parity basis, emerging-markets’ share of world GDP has grown from 37% in the late 1990s to nearly 50% as of 2012. Yet emerging markets still represent a much smaller share of global market value (on a market cap basis). The rapid pace of knowledge transfer from developing nations ultimately contributes to higher productivity, per-capita incomes, GDP, and profit growth in emerging economies. As this plays out emerging-market countries will see the gap narrow between their share of world GDP and market cap. We want our clients to participate in this long-term opportunity.
Taking Stock of Emerging Markets
Emerging-markets stocks were hit especially hard this year after the Fed indicated its intent to taper QE, and over the last couple of years have underperformed U.S. stocks. During this time we have taken advantage of price weakness in emerging-markets stocks by moving our weighting at a gradual, measured pace. We now have the highest allocation to emerging markets that we have had in the last twenty years. As we’ve reiterated along the way, the primary reason we have not increased our weighting further is our longstanding concern related to China’s credit and infrastructure bubble.
Coming to emerging-markets local-currency bonds, they too suffered this spring and summer as emerging-markets currencies declined versus the U.S. dollar. Therefore, we believe it is important to review how we think about this allocation, which we have primary through PIMCO’s Emerging Local Bond fund. Our time horizon for this position has always been longer than the five years typical for our tactical positions. We see it as a good way to hedge a potential decline in the U.S. dollar/U.S. inflation. Insuring against this risk remains prudent in our view, given the Fed’s unprecedented monetary policies in recent years that have bloated its balance sheet. In aggregate, long-term fundamentals—primarily balance sheets and growth prospects—for emerging markets are stronger than the United States. As such, in a normal scenario we believe we can get at least mid- to upper-single-digit returns over our investment horizon. These returns are better than what we expect from U.S. bonds and carry different risks.
We believe the problems we’ve seen this year in emerging markets are only a blip on what we expect to be a very long-term, upward path. At the same time, we are cognizant of and continue to analyze risks to our emerging-markets investment thesis, but that does not negate the strategic case for owning emerging-markets stocks (and bonds) in client portfolios.
An important part of our investment discipline is to protect client portfolios against downside risk scenarios we believe are plausible and not already adequately factored into asset prices. Taking this precaution means we will likely lag the broader stock market if a more optimistic scenario plays out. However, the fear of leaving some money on the table over short periods is not sufficient cause to deviate from the investment discipline that has served our clients well over the long term. We appreciate your continued confidence and trust.
Jon Houk, CFP®