On behalf of the Altium Investment Committee;
US Stocks no longer the “Only Game in Town;” Europe and Japan lead the way, driven by easy money
When we last communicated with you, the U.S. stock market was “the only game in town” – the S&P 500’s excellent performance continued to dominate the financial news and, in the short term, overshadow the benefits of portfolio diversification. Yet in the quarter just ended, it was the international stocks (most notably European and Japanese), last year’s laggards, that grabbed the market leadership baton. These asset classes outperformed U.S. stocks by a significant margin (most European markets and Japan are up 12-18% year-to-date vs. 2% for the U.S.).
While the S&P hung in there, day-to-day volatility increased and valuation concerns (the Shiller cyclically adjusted price-earnings ratio remains in the high end of its historical range) continued to grow.
So what drove the outperformance of Europe and Japan? The last time we looked, these countries were battling a lack of demand, high levels of indebtedness and unemployment, and disinflation. These factors, which continued in the first quarter, did not go unnoticed by monetary officials in these countries. In fact, they responded with a fresh round of monetary ease, which pushed stocks to multi-year highs. Meanwhile back in the U.S., the FED, given a continuation of good employment reports, signaled that it was poised to begin a money tightening cycle. This highlighted the growing schism between it and the European and Japanese central banks which are headed in the opposite direction. The divergence between global monetary policies was best captured in Q1 by the surge in the U.S. $ vs. the euro and the yen (the rally in the $ may have gone “too far, too fast” as evidenced by the weakness in the dollar recently), as capital flowed out of the euro and the yen into the dollar in anticipation of the higher interest rates that are normally associated with a tightening cycle.
The direction of U.S. interest rates appears to be higher, but when and by how much?
Everyone is talking about the outlook for rates and the daily debate on this subject is accounting for at least some of the increased market volatility that we have experienced recently. The fact that it is a global debate is a key element of the conversation. Money in pursuit of the highest return moves quickly in today’s high tech, instantaneously traded world; currency exposure notwithstanding, wouldn’t most investors prefer to invest in U.S. 10 year Government Bonds yielding just under 2%, rather than in German 10 year Government Bonds yielding less than 1/4%? As long as European and Japanese rates are dramatically lower than their U. S. counterparts, we think that the possibility of much higher rates in the U.S. is reduced, even when the FED moves to initiate the rise, since the interest rate arbitrage trade will tend to limit the spread between U.S. and overseas rates.
Now that the NCAA tournament is over, predicting when the FED will move is getting to be everyone’s favorite sport and this activity certainly does contribute to market volatility. The FED may have dropped the word “patience” from its regular communications, but it remains “dovishly” patient in executing monetary policy largely because inflation and wage growth in the U.S. remain stubbornly below their targets. Moreover, the FED has acknowledged recently that it is concerned about the negative impact of the strength of the U.S. $ on corporate earnings, which could contribute to the central bank’s staying pat for longer. Are there any other clues out there that can help us frame the interest rate debate? What about the outlook for housing and corporate capital spending, both of which are important factors in supporting real growth in the economy? Not much change in either in the first quarter. In fact the report on durable goods spending in February was quite disappointing. We continue to be surprised at how hesitant corporations have been to spend money on the physical expansion of their businesses given how low the cost of borrowing money is. M&A and stock buy-backs; yes, but increased fixed investment; no. The fact that the price of oil has yet to make a convincing bottom certainly does not augur well for a pickup in either inflation or capital spending. The unchanged nature of these indicators increases the odds that the pace of any interest rate rise will be moderate and perhaps drawn-out over several years. Additionally, does anyone at the FED care about the possibility that Greece may leave the European Union and that Russia remains a “wild card”?
Changes to our investment strategy? No.
We hardly ever pass up an opportunity to reiterate our belief in asset class diversification, particularly when we get evidence (as we did in Q1) that supports the benefits of owning a diversified portfolio. The fact that the international stocks took the lead in asset class performance during this period after lagging U.S. stocks for several years is a good reminder of the reality that over time the various asset classes do take turns leading the performance parade. The problem is that predicting which one is going to lead and when they are going to lead is very hard to do. So we do not try. Our job is to take the time needed to truly understand what our clients risk budget is and then mix the asset classes in building a portfolio that over a long period of time gives them the highest possible return for accepting that amount of risk.
But what about bonds? They may be less volatile than stocks, but don’t they perform badly when interest rates rise? We have not abandoned bonds as a useful volatility-reducing asset class just because of the threat of higher rates. Bond market performance in general will depend on how much rates rise and over what period of time. However, bond portfolios can be managed (by increasing quality and shortening maturities) to mitigate the effect of higher rates.
How about the “Coming Bear Market” in stocks? We’re due, right? It’s been a good run (the U.S. stock market’s advance is now in its 7th year) and valuations are admittedly high and corporate profit margins may be at their peak. Shouldn’t we get out of the stock market before we get caught in a bear market? We don’t think so. Stocks are certainly volatile and can go down. But history has shown that the declines are always temporary. It may take a while to get back to where we were, but the advances in the stock market are permanent. “Corrections” in the market are part of the game; the price we pay for higher returns. It’s going to happen because eventually stability breeds instability. The longer the market performs well, the more risk market participants are willing to take. After a period of time they take on excessive risk and the market seeks to correct this excess – sometimes in a modest (down 5-10%) way, sometimes in a more dramatic way (down 15-20%). Diversification can ease the pain, but it’s going to happen, so we should accept downturns in the stock market as a normal part of investing.
So where are we now? Sir John Templeton once said “bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria.” Of course, we don’t know for sure where we are in this cycle currently, but it does appear that the world is still skeptical of holding stocks in general and of a further increase in the stock market at this time. That’s probably good news.
No matter how it turns out, we’ll give you an update when we write next quarter.
Gregory Slater, CFA, CFP®
Chief Investment Officer
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