Benchmark Returns through 12/31/2016
T-Bill 1 – 3mo (Cash): 0.26%
Barclay’s Aggregate Bond Index: 2.65%
Barclay’s Municipal Bond Index: 0.25 %
S&P 500: 11.96 %
Russell 2000: 21.31 %
MSCI EAFE (International Stocks): 1.00 %
MSCI Emerging Market Stocks: 11.19 %
Credit Suisse Hedge Fund Index: 0.28 %
Data provided by Orion
2016 RECAP & FINANCIAL MARKET PERFORMANCE
The New Year has arrived and 2016 has finally drawn to a close. The events of the previous year have been anything but boring, and some of the outcomes have surprised all but the most contrarian forecasters. The Brexit referendum and the election of Donald J. Trump were deemed by many individuals and pundits alike to be highly unlikely, and both events happened to surprise markets. The Federal Reserve also raised the benchmark Fed Funds by 25 bps to 0.50-0.75%, while communicating their intention to raise rates further in 2017. Interest rates began to rise in anticipation of the December press conference, causing the second half of the year to be tumultuous for many fixed income securities. Despite this, the Barclay’s Aggregate Bond Index still returned a profit of 2.65%. Equites also ended the year on a higher note as the US Presidential election spurred a rally in equities and other riskier assets. The U.S. dollar also gained against many major currencies as the market prices in the effects of higher interest rates. Inflationary pressures began to appear in 2016 both in economic reports and market-based measures.
A LOOK BACK ON THE EFFICACY OF MONETARY POLICY
Typically investments into fixed assets have been counted on to spur economic growth, as it is both a short term and long term catalyst when used appropriately. The focus of many extraordinary monetary policy tools used since the financial crisis were designed to lower global interest rates to allow companies that had excess leverage to service their debts more easily, and for companies to invest more in capital expenditures by creating an environment that offered cheaper financing. It appears that many economists underestimated the effects of how recent technological and organizational changes impacted the willingness for companies to use excess cash for investment in fixed assets. A significant amount of funds have been utilized for mergers, acquisitions, dividends, and share buybacks. These activities increase the value of financial assets, but the effect of each dollar spent on financial engineering has much less of an effect than funds used for productive assets generating real economic activity. The second factor that hasn’t garnered as much press is the ability of companies to stretch capacity utilization and operating leverage.
Many of the benefits coming from technology, research and development have a significantly higher amount of scalability when compared to previous innovations. This is particularly true of the services sector, though the benefits do spread across the larger economy. Software development that can increase the efficiency of an operating business can have the effect of increasing production capacity in a way that fixed asset investment traditionally has, however the dynamics of how these trends affect aggregate macro economy policy are uniquely different. Building or purchasing a software platform that can increase warehouse capacity has a similar effect on capacity for the company as building a new warehouse, though the follow-on effects on the broader economy are very different. While fixed investment is subject to the availability and cost of loanable funds, employment or hiring a company to develop a technology solution does not have the same relationship. Employment or hiring a company for a specific solution are both subject to the availability of specific groups of skilled labor rather than the ability to obtain a loan. The employment rate has reached a post-recessionary low of 4.6%, which is now causing wages to rise in many industries. While the easy availability of capital can be used to increase the pool of employees in a specific field, it is not a quick process. This entails a significant group of individuals deciding to obtain undergraduate or postgraduate education or training. Any mismatches in the labor force between an oversupply of less demanded jobs and a shortage of highly demanded jobs may take years to normalize. This suggests that the effect of the Federal Reserve’s Quantitative Easing program did not have the intended effect of boosting GDP growth through higher investment in the economy, but rather that it incentivized speculative pursuits by corporate managers that did less to boost the economy and more to simply raise prices of financial assets.
ENGINEERING CORPORATE PROFITS
We are present, once again, in the age of financial engineering and alchemy that could astonish even King Midas. As companies have taken advantage of the historically low interest rates to raise capital, they have not had the same necessity to raise capital expenditures as had been the case historically. Many companies have eschewed large capital expenditure projects in favor of increased shareholder distributions, large share repurchases, and Mergers & Acquisitions. This activity has created further dislocation between asset prices and real economic activity as equity valuations continue to be justified on the basis of decreasing share counts and the lack of investment alternatives offering a high total return in this historically low interest rate environment. The growth of debt in the S&P 500 companies has outpaced EBITDA growth while profit margins have already seemed to peak. EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization and it is an accounting measure meant to show the ability of the company to generate cash flow. While much of this debt issuance has boosted share prices, it has not necessarily placed the issuing companies in a stronger position for the future. Many companies have sacrificed a strong balance sheet in the pursuit of boosting share prices and revenue and profit growth began to slow slightly in 2014.
Repurchasing shares will boost earnings on a per share basis by reducing the number of shares entitled to each dollar of profit, though it does nothing to boost the growth of the company in any real manner. This type of financial engineering can place companies in a precarious position as they may struggle to refinance their debt, or pay the interest on the debt in the event of an economic downturn. It can also hinder further growth by placing the companies in a leveraged position that makes financing future growth projects substantially more expensive and risky as additional financing will likely be at a higher price. This has occurred as insider selling continues to rise, inferring that the management is not as optimistic about the future is stock valuations may suggest.ii Companies are likely to experience continued earnings growth in 2017, though the rate of growth is expected to be slower. The bull market that started in March 2009 has been relentlessly pushing through crisis after crisis. Though as positive economic news is released, it has not responded as eagerly.
The investment strategy’s focus is to consistently provide the most rational and disciplined exposure to a diversified group of assets that can achieve the investor’s objectives while navigating the inevitable periods of volatility. Valuation should be used amongst a group of other tools to monitor the portfolio’s risks and to manage return expectations. However valuation is not a timing tool. At the close of 1997, the S&P 500 was trading at a price multiple just shy of 25 times reported earningsiii. Before that point, valuations that reached 25 reverted to a lower average. This valuation level was reached in 1991, but robust earnings growth quickly followed causing valuations to fall as the price continued steadily higher. If an investor became nervous and at the end of 1997 decided not to invest in a simple portfolio that was rebalanced annually consisting of a 60% allocation to the S&P 500 Index and a 40% allocation to the Barclay’s Aggregate Bond Index, they would have correctly anticipated the crash almost three years early, but they would not have outperformed inflation. From the highest close price marked in September 2000, and the low reached in October 2002, the S&P total return recorded a drawdown of 47.4%.iv The previously mentioned portfolio that would have been purchased at the time the valuation of S&P 500 was trading at an all-time high would have experienced a return of approximately 11.9% before fees at the end of September 2002, when the S&P was down 47% from its highs. Inflation over that same period was approximately 11.7%. This simple portfolio showed a 10 year cumulative return, gross of fees, of 85.3%, far outpacing the total inflation of 30.68% over that 10 year period. This simple example was meant to show that investors are not rewarded from trying to time markets, but by adhering to a disciplined investment plan that considers both the risk tolerance and return goals of the client.
THE STUBBORN END OF THE BOND BULL MARKET
The total ownership of U.S. Treasury bonds by domestic commercial banks had increased substantially from September 2013 to November 2016. As the effects of new banking regulation emerged, namely Basel 3, banks became required to hold a larger segment of assets in high quality assets that could be liquidated quickly in the event of a bank run. The legislation was meant to prevent the types of large overnight funding that caused a significant amount of stress in the financial system during the crisis. This regulation, when combined with the QE programs, caused many financial institutions to purchase more Treasury bonds. Based on the fact that as their asset base grew through Quantitative Easing programs, they boosted their holdings of Treasury bonds as increased regulation punished other assets that did not receive preferential treatment and as loan activity had been slow to recover. This boost in U.S. Treasury holdings placed downward pressure on interest rates through the middle of 2016, as large volumes were accumulated by commercial banks. At this point, loan activity had picked up and many commercial banks already purchased the Treasuries required to comply with the current Basel 3 regulations. The effects of China’s currency policy began to have a much larger effect during the latter half of 2016 as the People’s Bank of China sold U.S. Treasury bonds to stabilize the Chinese Yuan. The sale of U.S. Treasury bonds from China’s foreign exchange reserves should continue as the Federal Reserve continues to communicate a desire to raise interest rates, causing the dollar to rise against other currencies such as the Chinese Yuan. The effect of China’s sale of U.S. Treasuries, along with rising inflation expectations, has caused interest rates during the second half of 2016. These trends are expected to continue over the next few years with the risk for higher interest rates being a key focus. This can be mitigated by taking less interest rate risk through shorter maturity bonds, and areas of the marketplace that still offer value after the recent selloff in the second half of the year.
STEPPING FORWARD INTO 2017
The past year appears to have marked a few large scale trend shifts. Inflation appears to finally be headed towards the 2% target of the Federal Reserve. The Federal Open Market Committee of the Board of Governors of the Federal Reserve has communicated their intention to increase the pace of interest rate hikes slightly, and to arrive at the neutral interest rate level of approximately 3% by 2019 or 2020.v This will be a difficult task as GDP growth remains below trend and inflation slowly rises. If the Fed increases rates too quickly, it could slow economic growth further, but if it hikes too slow it may risk generating inflation above the 2% target. This difficulty is compounded by the uncertainty around the Trump White House. Ambiguity still exists around the President-Elect’s agenda, and the ability of his office to deliver on it. Estimates for the S&P 500’s 2017 earnings suggest that the analysts aren’t finding many reasons to be cautious. They tend towards optimism, which is hardly the most celebrated trait of a seasoned investor. Fixed Income markets are unlikely to be as rosy over the next few years. The role of fixed income in a portfolio is to provide steady income, offer diversification, and lower the portfolio’s overall volatility. This role has not changed. The change has occurred in the process of constructing a bond portfolio to provide investors with the same experience that could have been achieved previously in a much simpler portfolio. Buying and holding bond indices that once seemed bulletproof now exposes clients to more risk than may be appropriate. Further diversification can mitigate some of these risks, and the proprietary process Newport Advisory uses to manage client portfolios gives us the confidence to navigate the evolving risks and opportunities the future holds.
iv Data from YCharts
These are the opinions of Newport Advisory, not necessarily those of Cambridge, and are for informational purposes only. They should not be construed or acted upon as
individualized investment advice. Diversification and asset allocation strategies do not assure profit or protect against loss. Indices mentioned are unmanaged and cannot be
invested into directly. Past performance is not a guarantee of future results.