There is a common saying that time heals almost everything. Yet, even as we embark on the fifth year since the pandemic began, most of
Looking For a Stronger Sequel
Published Date : February 3, 2016
While breaking every established financial record in the movie industry, the release of “Star Wars: The Force Awakens” also brought into clear focus the bifurcated state of the movie industry. Given changes in our collective viewing preferences for entertainment, as well as changing economic forces, studios have gravitated towards the safety and security of producing sequels of winning franchises rather than assuming risk in an uncertain marketplace. Nowhere was this formulaic approach more present than in the last year, where a handful of winning blockbuster movie sequels out-earned all of the other movie releases combined.
Today’s movie industry has much in common with the present-day state of the global stock and bond markets. Over the course of last year, a very narrow set of ‘winners’ in the stock market contributed positively to returns while the world’s broad stock markets lost ground. Risk capital was not rewarded and, for better or worse, the economy simply gave us more of the same.
More of the same hasn’t been a bad overall formula for the markets during this particular recovery. While growth has been choppy, it’s remained on a positive path, averaging 2.2% annually since the end of the Financial Crisis in 2009. Along the way, we’ve put more people back to work and the unemployment rate has fallen steadily, corporate earnings and bank balance sheets have strengthened and despite much concern around the Federal Reserve’s stimulus program, inflation has remained tepid.
With modest growth, modest labor market improvement and modest inflation on the horizon, this year is expected to look a lot like another economic ‘sequel’, with the U.S. economy growing around 2%; however, as the start of the year highlights, that growth will continue to be choppy from time to time. Normally, this kind of backdrop would by and large be a recipe for a better market environment than recent history would suggest. Yet, as the recovery enters its seventh year, investors have become preoccupied with what can go wrong, particularly given the number of cross-currents in the world today.
Those cross-currents have proven to be a strong headwind as we enter 2016 with a variety of divergences, including a soaring dollar and falling oil prices, the recovery in the developed economies broadening while the emerging markets continue to slowdown, and our Federal Reserve raising interest rates as the rest of the world remains accommodative. While headlines are rarely ever as good or bad as they are perceived in the moment and bull markets don’t die of old age but from an aggressive policy response, (which doesn’t appear anywhere in the Fed’s script), our base case remains that markets are in another muddle-through, mid-cycle slowdown.
As we reflect on the present environment, we have three observations that capture our operating view on the current state of the markets:
- The observable rate of return in the market has fallen. We are all painfully aware of the lack of available yield in the bond market today. With the yield on the 10-year U.S. Treasury Bond hovering around 2%, investors can expect less than half the ‘risk-free’ 10-year bond yield available to them just 10 years ago. These low interest rates have been a boon to the economy as well as to corporate and household balance sheets, but have been, and continue to be, a penalty to savers, investors and retirees. Not surprisingly against this backdrop, many asset classes have appreciated, which has further contributed to a lower forward return environment.
- The relative return opportunity has proven challenging. Historically, relative return opportunities have improved as economic cycles have matured. But this time around, perhaps due to the sheer quantity of assets now allocated to hedge funds, high-frequency quantitative traders and arbitrage firms (all vehicles that work to identify and rapidly close any perceived mispricing in the market), active managers have continued to struggle. There is also some evidence that this dynamic may be contributing to the overall volatility in the market, a double-edged sword as volatility can create both challenging near-term investment results as well as opportunities for long-term investors.
- Despite these observations, there are reasons to be optimistic about the year ahead. As we look into 2016, notwithstanding the market-wide phenomenon of low absolute and relative rates of return, and a tough start to the year, we conclude that investor sentiment has become overly pessimistic. With markets now flat for the last year-and-a half, corporate earnings slated to post mid-single digit growth and a relatively benign inflation and interest rate environment, portfolio returns may be better than capital market participants currently anticipate.
Presently, our investment strategy is designed for a world of slow but positive growth – effectively, more of the same. That said, we are looking for oil to stabilize and the dollar’s recent relative strength to slow, alleviating the two major headwinds that have held corporate earnings back since the start of 2015. We also expect the Federal Reserve to continue to slowly raise interest rates. While this is a new dynamic, those first tentative interest rates moves are unlikely to snuff out growth in 2016 and history suggests that investors typically become comfortable with that understanding relatively quickly after a new rate cycle begins. Finally, while China’s slowing growth rate and continued devaluation of its currency will remain a headline discussion this year, we expect their economic progress to continue far into the future – and for a reasonable economic equilibrium to present itself in the year to come.
While there is always room to do better and to improve any aspect of our craft, we are committed to staying disciplined to our core investment philosophy: maintaining a globally diverse investment portfolio, investing for the long-term, and rebalancing those portfolios along the way as opportunities present themselves. While the environment for diversified portfolios has been challenging, we stayed true to our investment discipline and rebalanced into the market’s autumn storm, taking advantage of the emotional state of the markets in support of your long-term investment horizons and our forward outlook.
So although the economy looks set for more of the same in the New Year, we think this year’s sequel may ultimately be better received by the markets. After all, just as we had to accept we were watching an admirable remake of the first Star Wars movie produced nearly 40 years ago; investors need to accept that while this particular market environment comes with certain limitations and occasional disappointments, it can still be a rewarding long-term experience.
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