The world financial markets are reflecting a wider divergence between economic fundamentals and investor hope and sentiment. The US economy is showing meaningful life with much improved GDP readings, a declining rate of unemployment, improved corporate balance sheets, and quarterly S&P 500 earnings per share growth annualizing at 8%. However, despite five years of near-zero interest rates, expectations for real growth (nominal minus inflation) are barely above one percent, hourly wage gains are de minimis, and consumer confidence is waning. Despite less than robust economic fundamentals, US equity markets are at or near all-time highs.
As for economic fundamentals outside of the US, with just a few exceptions, the news is not good. Japan is in recession, Europe is fighting to stay out of recession, and China is trying desperately to meet growth targets that are cosmetic fabrications of the Chinese government. However, the equity markets of China and Japan are both at seven-year highs and the Euroland equity markets are all back at multi-year highs after a brief correction. The conflicting data is most evident in the bond market where the 10-year US Treasury yields 2.3%, well more than the 10-year government yields of France, Italy, Ireland, and Spain. Of course, this would imply that US Treasuries are a riskier investment than the sovereign debt of the Euroland countries in question. At the same time, credit default swaps (CDS), which price the risk of default, tell an entirely different story. CDS for these four Euro-players are priced at four to six times the price of US CDS. Clearly, in the mind of the CDS market, investors in government bonds of France, Italy, Ireland, and Spain are NOT being paid for the risk they are taking. This dynamic carries through to the equity markets and gives us concern regarding the sustainability of the continued climb of global equity markets.
Domestically it’s been a tale of two markets this year. Big stocks have done well and small stocks have struggled. This is the largest margin of outperformance by big stocks in years and an anomaly as small stocks historically have outperformed their larger brethren. U.S. markets face two potential headwinds going into next year, tighter monetary policy and higher valuations. A historically weak economic recovery is not helping top line growth enough to drive stock valuations and prices materially higher from here. A strong dollar is also a negative for the economy, but lower energy prices are a positive for a consumer driven economy. While the global equity markets are making us nervous, U.S stocks are still the prettiest girl at the global dance and we’ve increased our domestic exposure. We’re invested in mostly large-cap and mid-cap stocks with a modest allocation to small cap stocks.
Most major overseas markets have performed poorly with the real exception being Japan and India. Overseas markets look cheaper than the U.S. at the present time, but they look more like a value trap to us. Most foreign central banks are well behind the monetary action of the Federal Reserve and are now looking to prime the pump even more as a way to stimulate growth. Weaker currencies and lower rates will help but won’t be enough to create a strong rally from these levels. Recent studies have shown that the increased correlation of international markets to the U.S. have reduced the diversification benefits of investing overseas. We have recently made the decision to meaningfully reduce of our direct international exposure as the diversification argument loses validity.
Interest rates in the U.S. have been the big surprise this year with yields dropping due to relatively stagnant global growth and global yields driven lower by aggressive monetary easing on the part of global central banks. We were in the camp that thought rates wouldn’t rise much, if anything, but even we are somewhat surprised by the rally that has taken place. Credit risk did well up until the sell-off in late September and early October when slowing global growth was thought to be contagious. Credit risk investments have yet to recover, but look inexpensive to us relatively speaking. We like private lending funds, when appropriate, where better risk-adjusted yields can be found. We continue to keep our domestic maturities short and our credit risk exposure in place.
Global bond markets have also rallied on the back of central bank easing as noted above. However, weakened global currencies against the U.S. dollar have offset some of the gains. We continue a relatively modest allocation to global bonds and hedge the currency risk where possible.
Inflation doesn’t currently seem to be an issue anywhere but the financial markets. In fact, a broad basket of commodities have fallen in price, most significantly oil, and expectations remain muted for future increases. We are currently limiting our inflation sensitive investments to a relatively small exposure to real estate.
Oil prices in the $60 range were not on anyone’s radar a year ago, but there is a growing consensus that a new-age of oil prices is settling in well below $100 per barrel. We don’t typically invest directly in energy, but we do invest in oil and gas master limited partnerships (MLPs) which transport and process crude, natural gas and derivative products. MLPs have been a very rewarding investment over the past few years and we continue to like the fundamentals for the industry irrespective of the pullback in oil prices.
Our concern regarding the mispricing of risk is important in context to our goals-based investment process and we’ve spent considerable time and effort thinking about bringing more certainty and predictability to our investment returns. At the same time we’ve been thinking how to truly diversify risk in an increasingly correlated investment world. As a result, we are allocating money to some new areas, including option-hedged strategies, insurance linked securities, and life settlements, all of which will help us to mitigate portfolio volatility. We continue to actively look for investments that provide true diversification to the portfolios. While traditional investments like stocks and bonds will continue to represent the bulk of our investments, we think adding truly non-correlated investments to this mix will help us compound money more effectively for clients over time with lower risk.