Broad US equity indices are once again hitting all-time highs, but based on the lack of enthusiasm surrounding their performance and future prospects, an investor could almost be forgiven for failing to notice. The US equity market rally of the past several years has frequently been called “the most hated rally of all-time,” and we’d be hard-pressed to disagree. Retail investors have continued to flee the asset class, and broad measures of market sentiment remain poor.
In years past, equity market performance and American optimism went hand-in-hand. In fact, the stock market could be used as a reliable predictor of presidential elections—when stocks did well, the incumbent party was reelected, as the table on the left shows. However, the peculiar circumstances of a stock market at all-time highs amidst an absence of euphoria suggest that the relationship between stocks and presidential elections may have lost some of its predictive strength.
One of the hallmarks of the skepticism surrounding the equity rally is the odd correlation between US stock and bond markets, suggesting that one must be “wrong.” Bond markets tend to be more rational, so many investors conclude equities will have to “catch down” to where bonds suggest they should be. Plunging bond yields, the argument goes, signal weak future economic growth, the threat of persistent de/disinflation, and a lack of confidence among investors, all of which should be negative for equity valuations. Valid as these concerns may be, they miss the central point: plunging bond yields themselves drive higher equity valuations. Absolute valuations provide historical context, but relative valuations (shown below) drive performance.
If an investor accepts this premise, then he must assess the sustainability of current equity valuations based on his outlook for the sustainability of low bond yields. We have argued that long-term demographic trends and the maturity of a 40 year credit expansion (often referred to as a “debt supercycle”) have been the primary factors pushing interest rates lower, not central bank policy. These factors are not transitory, suggesting to us that a major drop in US equities is not imminent. However, with little room left for further expansion of credit, we will likely see an increase in interest rate volatility as we edge towards the end of the 35 year bull market in bonds, a dynamic we recently discussed in our Fixed Income White Paper.
Overall, our portfolios are broadly diversified and our equity exposure focuses on high quality companies. Our fixed income holdings provide us with exposure to all major markets as well as direct currency exposure to developed markets. Targeting longer duration holdings has enabled us to benefit from the continued fall in global bond yields. Our equity exposure avoids cyclical sectors in order to lower volatility and focus on companies with stable earnings. We favor international equities slightly over US, and have not hedged any of our foreign currency exposure in order to benefit from a weaker US dollar. Additionally, our portfolios own gold, whose status as an alternative currency should enable it to benefit from increasingly aggressive monetary policies around the world.
Our portfolios’ domestic fixed income consists of long-duration US treasuries, corporate bonds, and preferred stock. This gives us exposure to long-duration and high quality companies, while avoiding low qualities issues and the securitized market. Our international fixed income consists of international inflation protected bonds (international TIPS), international high yield bonds, and dollar-denominated emerging market sovereign bonds.
Despite our conviction in the sustainability of low bond yields at least in the intermediate-term, extreme monetary policies around the world threaten higher interest rate volatility. As a result, tactical allocation in an investor’s fixed income allocation is more important than ever. Currently, there is a risk that global bond yields may increase in the short-term, erasing some of the decline they have made this year. There are two major reasons for this. First, because the move downward in bond yields has occurred so quickly, it has attracted many short-term investors to long-duration assets creating a “crowded trade.” Second, and more importantly, we are likely at the beginning of a period of increasing fiscal stimulus around the world. Canada, Australia, and Japan have already unveiled stimulus measures this year, Europe appears to be moving in that direction, and the US will join them following November’s elections. This will increase the supply of bonds and inflation expectations, both putting upward pressure on interest rates. We have therefore reduced our portfolios’ sensitivity to interest rates by reducing our exposure to long duration US treasuries. In addition, we have initiated a position in international TIPS.
Our equity exposure is diversified across both developed and emerging markets, and we have not hedged any of our foreign currency exposure. This gives us broadly diversified exposure to global equities and currencies. We have also focused the majority of our exposure on low volatility and high dividend companies. As economic policy uncertainty continues to increase, investors benefit by targeting companies with stables earnings.
We also hold a position in Australia. This gives us some exposure to commodity producers, while avoiding oil to a large extent, which we feel still has some risk to the downside. In addition, Australia has initiated a significant fiscal stimulus plan which will boost domestic demand and support earnings.
Following the UK’s historic Brexit vote, we initiated a position in European financials, as we viewed the negative market reaction to the vote to be excessive. This view has been supported by recent equity market performance, with global stocks surpassing their pre-Brexit levels. However, renewed concerns surrounding Italian banks have weighed on stock prices and brought into question future performance. We have therefore exited the position for a profit.
We continue to hold a position in gold. Its status as an alternative currency should support it as global central banks continue to pursue extremely aggressive policies. Furthermore, as an asset with low correlations to most others, it helps lower overall portfolio volatility.
Our Global Tactical Income Portfolio uses the same global macro framework as our other three Global Tactical Portfolios, but due to its income and capital preservation investment goals, its holdings differ to some degree. It does not participate in some equity allocations, and owns some additional fixed income holdings.
Currently, GTI owns Build America bonds and US High Yield bonds in addition to the fixed income holdings common across all four portfolios. These holdings help increase portfolio yield, while increasing diversification and limiting concentration. All of its equity holdings are low volatility stocks, and it does not have any exposure to Australia or emerging markets, which helps reduce volatility.
We have raised cash in our Global Tactical Income Portfolio. Due to the short-term risk of an increase in interest rates, it was prudent to raise cash levels in our Income and Conservative portfolios because they carry higher sensitivity to interest rate movements.
**Individual account allocations may differ slightly from model allocations.
Past performance is no guarantee of future results. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. Returns can vary dramatically in separately managed accounts as such factors as point of entry, style range and varying execution costs at different broker/dealers can play a role. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts are inherently limited and should not be relied upon as an indicator of future results. There is no guarantee that these investment strategies will work under all market conditions, and each advisor should evaluate their ability to invest client funds for the long-term, especially during periods of downturn in the market.
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