Topics: portfolio strategies that have performed well over multiple cycles as this one enters its latter stages; a Helsinki-inspired summer reading list
Despite projections of 20%+ S&P 500 earnings growth and 4% GDP growth in Q2, and good news from consumer/business surveys, jobs, housing and wages (see Appendix A), U.S. equity markets are only up ~6% this year. The reasons are clear to me: Fed tightening, the eventual fade in fiscal stimulus1 and market-unfriendly actions of the Administration. On the latter, it’s not just tariffs, which we’ve written about already,2 it’s also the practice of singling out companies for criticism and potential repercussions (Amazon, pharma companies, Harley Davidson, etc.). As JFK learned the hard way in 1962, market confidence is a risky thing to play around with.3
In any case, as the Fed brings its monetary stimulus experiment to an end (the first-ever extended period of negative real rates since 1830 that didn’t occur during wartime), investors hold the lowest portfolio allocations to cash on record. As interest rates rise, allocations to cash will likely rise as well. What about the rest of the portfolio? In this note, we walk through four investment strategies that have performed well over multiple cycles. As you know, past performance is past performance, but they’re worth reviewing, given the importance of region, sector and security selection as the cycle ages:
(and how skepticism on Europe and Japan is the gift that keeps on giving)
This strategy has yielded among the most consistent results of any I’ve seen in 30 years. In the chart, we show the benefit of a 10% equity overweight to the United States vs. Europe, combined with a 5% overweight to Emerging Markets vs. Japan.4 Other than during the doomed Southern European construction boom in 2004–2006, the strategy performed very well. In my view, there are many reasons why this strategy has worked (higher returns on equity in U.S. sectors vs. European counterparts, the migration of industrial production to the emerging world from the West, demographic pressures in Europe and Japan, etc.; see Appendix B). There are others, and of course there’s no way to know for sure. What we do know is this: In periods when Europe outperformed the United States, Emerging Markets delivered even higher returns than the developed world. That’s the simplest way of understanding the historical success of this approach.
This strategy has even delivered positive returns so far this year, despite the very poor performance of Emerging Markets like Brazil, Argentina and Turkey. Possible reasons include higher earnings growth in the United States vs. Europe, and the inflation relapse in Japan.
If you were looking for a combination of earnings growth and dividends to deliver outperformance in U.S. equities, one approach involved overweights to technology, healthcare and consumer staples. As shown below, a combined overweight to these three sectors delivered two sustained periods of outperformance since the early 1990s. During the 2003–2006 period, this strategy underperformed as a three-fold rise in oil prices combined with the housing boom led to substantial outperformance by the energy sector, financials and consumer discretionary. To be clear, technology has been doing the heavy lifting in this portfolio strategy for most of the last decade. As shown in the Appendix, tech margins increased from 10% in 2004 to 20% in 2017, while ex-tech margins are roughly flat over the same period.
Tech, healthcare and staples have also been strong performers outside the United States. In Europe and Japan, their outperformance roughly tracks the same contour as in the United States (see below, left). These sectors have also been substantial contributors to hedge fund returns. Long-short hedge funds focused on tech and healthcare have been among the best performers in the HFRI hedge fund universe over the last decade.
The first chart tends to shock people when they see it. According to S&P ratings analysis, around 50% of all bonds rated CCC default within 10 years. As a result, it shouldn’t be surprising that CCC-rated bonds are often not worth the aggravation for long-term investors. In the first year or two after a recession, CCC-rated bonds tend to deliver substantially positive returns, but you need to have the discipline to scale back once the cycle progresses.
Here’s a look at U.S. high yield returns by year and by rating, and at annualized return and volatility since 1995. BB-rated bonds have had the best returns, and experienced less volatility as well. And when spreads are as tight as they are now, BB-rated high bonds have outperformed CCC-rated bonds by an even wider margin (8.2% vs. 3.3%) over the next 12 months.
Through the Eurodollar forward curve, the market forecasts where LIBOR will be in the future. As shown below in the infamous “hair chart,” the market has done a pretty poor job: Every time the thin blue lines are above the thick red line, the forward market overestimated where LIBOR turned out to be. This has substantial implications for both investors in fixed income and for borrowers. For the latter, borrowing floating-rate debt has generally been a much better outcome than borrowing fixed.
The next chart looks specifically at the three-year time horizon, and compares predicted LIBOR levels with actual LIBOR levels. There are different ways for investors and borrowers to structure positions based on rate views: receiving/paying fixed rate swaps vs. LIBOR, interest rate caps and floors on floating-rate loans, and other products. The common successful theme among them would have been a preference for owning what the market thought rates would be, rather than what they turned out to be.
For the first time in a while, I think forward markets are more in sync with where actual short-term rates are headed.5 However, once the Fed is done tightening, I would not be surprised to see historical patterns of overestimation repeat themselves again.
Who says there’s no bipartisanship? The reaction to the Helsinki Summit looked pretty bipartisan to me.6 In any case, here’s a Helsinki-inspired summer reading list if you’re looking to brush up on some history:
George Washington’s Farewell Address. Particularly this part: “Against the insidious wiles of foreign influence, the jealousy of a free people ought to be constantly awake, since history and experience prove that foreign influence is one of the most baneful foes of republican government.” And also this part: “Real patriots who may resist the intrigues of the favorite are liable to become suspected and odious, while its tools and dupes usurp the applause and confidence of the people, to surrender their interests.”
Venona: Decoding Soviet Espionage in America, Yale University Press, Klehr and Haynes, 2000. This book describes the long-secret U.S. intelligence team that decoded thousands of Soviet messages sent in the 1940s, uncovering an enormous range of espionage activities: the actions of convicted spy Alger Hiss, proof of Soviet infiltration of the U.S. Manhattan Project to build the atomic bomb, evidence that spies had reached the highest levels of the U.S. State and Treasury Departments, and indications that more than 300 Americans assisted in the Soviet theft of American industrial, scientific, military and diplomatic secrets.7 Stealing technical and political secrets from the United States has been a priority for Russia ever since.
Comrade J: Untold Secrets of Russia’s Master Spy in America After the End of the Cold War, GP Putnam, 2008. Author/Washington Post journalist Pete Earley reveals the extent of Russian spying in the United States after the Cold War ended. His source: KGB defector Sergei Tretyakov, who ran Russia’s espionage operations in NYC from 1995 to 2000. Tretyakov describes his memoir as a “warning to Americans…Russia’s Foreign Intelligence Service is trying to destroy the U.S. even today” through espionage and disinformation, and claims that Russian operatives are more active in the United States now than during the Cold War.
APT28: A window into Russia’s cyber espionage operations? A 2010 report by cybersecurity firm FireEye analyzed a longstanding espionage effort and concluded that based on its malware style, data theft techniques and targeted organizations, that it was likely sponsored by Russia’s government.
Deception: Spies, Lies and How Russia Dupes the West, 2012. Edward Lucas. Self-explanatory.
March 2017 Senate testimony by Clint Watts from the Foreign Policy Research Institute on Russia’s Active Measures strategy of disinformation and disruption in the digital age (including attacks on Western financial markets), and why this campaign is more successful than the Soviet era version.
The good news…rising business surveys, stock buybacks and earnings:
But…are tariffs already boosting U.S. producer prices and depressing indicators aligned with global trade (capital spending and industrial commodity prices)?
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1 The stimulative impact of fiscal policy and financial conditions (short rates, long rates, spreads, the dollar and equities) is still positive but expected to decline to zero by year-end.
2 J.P. Morgan estimates a direct negative impact from tariffs on earnings of 3% at the high end, but this may not capture second-order effects and related global shocks. The rollover in industrial metals, rising U.S. producer prices and slower growth in G3 capital goods orders suggest tariffs may already be having an impact (see Appendix A).
3 In April 1962, JFK accused steel companies of inappropriate price hikes, citing “pursuit of power and profits exceeding their sense of public responsibility,” “utter contempt” and “unjustifiable and irresponsible defiance of the public interest.” Steel companies were threatened with audits and rollback of depreciation rules; Attorney General Robert Kennedy sent FBI agents to homes of steel executives. Steel companies caved in to the President’s demands. At the time, markets had recovered from the 1960–61 recession, employment was rising and there was little reason for a correction. Even so, after JFK’s attacks on steel, a 20% bear market set in (worst decline from 1942 to 1974) as investors lost confidence in the corporate sector’s ability to chart its own course. Months later, JFK responded to market weakness with new depreciation allowances, an investment tax credit and a tax cut…but the damage was done.
4 The United States and Europe have larger weights than Emerging Markets and Japan in the MSCI World Equity Index, which is why our U.S. overweight is larger than our EM overweight. Japan’s weight is now just 8% in the MSCI World Index (it was 31% in 1990), limiting the degree to which it can be underweighted vs. EM.
5 What I’ve been reading: research from New York Fed President John Williams on the equilibrium real Fed Funds rate over time, and why, for a variety of reasons, it may have declined to just 0.5% from 2.0% in the 1980s, 1990s and early 2000s. If so, market expectations for just three to four more Fed hikes might be spot on.
6 After the summit, there were critical quotes from some in the GOP: Lindsey Graham, Paul Ryan, Ben Sasse, Bob Corker, John McCain, Liz Cheney, Orrin Hatch, Susan Collins, Trey Gowdy, Abigail Huntsman, John Cornyn, Mitt Romney, Joe Straus and Newt Gingrich (who described the Summit as the “worst mistake in Trump’s Presidency”). By the way, in 2012, Romney described Russia as the major geopolitical foe of the United States, given its various actions contrary to U.S. interests. He was roundly criticized by Secretary of State Hillary Clinton for “backward-looking” and “dated” views; Vice President Joe Biden said, “Romney acts like he thinks the Cold War’s still on, Russia is still our major adversary. I don't know where he’s been. This is not 1956.” Will someone please tell that to the Russians?
7 I had an interesting discussion with Emory University’s Harvey Klehr, author of the Venona book:
• As Venona and related KGB archival materials were released over the last 20 years (the latter often through defectors), the espionage activities of senior U.S. officials, presidential aides and private citizens such as Alger Hiss, Julius Rosenberg, Duncan Lee, Elizabeth Bentley, Harry Dexter White, Lauchlin Currie and Larry Duggan were finally confirmed, destroying the myth that it was all just Red Scare prosecutorial overreach. The government had substantial evidence of their activities at the time, but couldn’t present their full scope without compromising Venona counterintelligence operations. General Omar Bradley was so concerned about intelligence leaks from the Truman White House that he did not disclose the Venona program to Truman at all
• Russian interference in U.S. elections dates back to 1936 and 1948
• Trump could do enormous damage to the U.S. intelligence community in the two years remaining in his term, depending on his public statements and behind-the-scenes directives
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