Market Insights – Spring 2014
The S&P 500 Index finished the first quarter at a record high, returning 1.8% over the first three months of the year. The markets started on a weak note in January due to the harsh winter slowing down economic activity in the U.S. and the heightened geopolitical risk in Eastern Europe and Russia. The inclement weather in January led to below trend economic readings. The data reported toward the end of February and March showed a return to moderate economic growth. The economy added nearly two hundred thousand jobs in both February and March; additionally auto sales rebounded to a 16.4 million annualized rate, the second highest reading in the past seven years. By the end of the quarter, Russia annexed the Crimean Peninsula and the U.S. stock market had recovered the losses from January. The invasion of Crimea has led to capital flight from Russia which, combined with the enormous cost of Sochi and the threat of recession in Russia, will put significant pressure on Putin to focus on domestic issues.
In this piece, we highlight three important topics for investors: 1) increased investor risk appetite in U.S. markets; 2) vastly changed emerging market sentiment this decade; and, 3) our advice for navigating the current market environment.
Risk premia are approaching an unnaturally low level in the United States
We refer to risk premia as a measure of additional return that investors expect to receive for taking on more risk. As an example, the higher yield on a corporate bond relative to a bond backed by the U.S. Government should compensate an investor for the risk of the corporation defaulting. In the depths of the Great Recession of 2008, a ten-year bond guaranteed by Verizon offered a yield twice as high as a U.S. Government bond. Today, the difference is less than one percent. Over the past five years, the stock market has rallied, investors have become more comfortable taking on risk and risk premia have narrowed substantially as a result. Risk premia increase during recessions and decrease during periods of prosperity. As evidence of investors’ willingness to take on more risk, margin debt in the United States now stands at all-time highs ($465bn), surpassing the previous highs of 2000 and 2007 ($279bn and $378bn, respectively). The willingness of investors to take on more risk leads to higher prices and lower expected future returns on riskier assets.
Given the returns in the stock market over the past five years, many will be lured by the prospect of high returns continuing. The broad market remains reasonably valued, albeit with pockets of unreasonable valuations. Investors will be rewarded by staying disciplined and emphasizing quality over recent performance during this period of low risk premia.
Emerging Markets should be renamed
During the last decade, Emerging Markets were known as fast growing economies with a burgeoning middle class consumer and booming stock markets. The BRIC (Brazil, Russia, India, and China) nations were the cornerstone of the Emerging Markets, representing over two billion people and making a contribution to global growth that exceeded all of Europe and the U.S. combined. The investment industry widely promoted the Emerging Markets as high growth sources of opportunity based on faster economic growth. This decade has proven to be far different. Emerging market indices have been essentially flat while the U.S. stock market appreciated more than 60% over the past three years. The performance deviation has been remarkable as “emerging market” nations have seen economic growth slow, commodity prices decline, and ineffective governance cannibalize corporate profits. The dramatic underperformance changed the investment sentiment from “emerging” to “submerging” markets.
Greece was classified as an emerging market last year, leaving many wondering about the definition of an “emerging” market. Emerging markets were once termed “developing markets” and were known in the industry as countries that did not have all of the key components of a “developed market” (property rights, developed financial and legal systems, minimal political corruption, etc). These countries have the potential to grow faster than developed markets, but often stumble along the way. In the past year, Russia has violated international treaties, China has suppressed news dissemination, India has explicitly ignored patents, and Brazil has threatened the livelihood of the largest Brazilian corporations by forcing unprofitable investments and cutting electricity prices to control inflation. So where does this leave us on this major asset class? We believe that emerging markets are going to be high risk, high reward investments over the remainder of the decade. They are likely to outperform developed markets over the next five years, but will do so with considerably more volatility and periods of significant loss. Emerging markets now offer compelling valuations and higher growth opportunities than their developed market counterparts, which combined with weak investor sentiment, provide support for future returns.
What should investors do?
Looking past the first quarter, we see a prolonged economic cycle with low global inflation and accommodative central banks that are in a unique position to keep interest rates low at a later stage in the economic cycle. Inflation is low around the world, global growth is mildly accelerating, and there are few signs of economic overheating. Within the context of the global economy, the U.S. market is more expensive than most markets. The U.S. has been the star of this global economic cycle and has achieved commensurately strong market returns reflecting its leadership in the economic recovery. Europe is recovering from the sovereign debt crisis and valuations are fair. The Emerging Markets are relatively inexpensive on average and, while much of that discount is warranted, the return prospects for the future are promising from these levels.
We have said in the past that we expect this economic cycle to last longer than average. Thus, we highlight the reduction in risk premia as a 3-5 year issue, not a 2014 problem. We encourage investors to seek high quality investments and take a long-term perspective. Large cap companies will be less risky than small cap stocks over the intermediate term and will outperform during selloffs. We believe that equities will outperform traditional fixed income securities. High quality companies that have realistic or conservative assumptions built into their valuations should be favored over companies that are priced for perfection. With risk premia at the low point of this cycle, taking the time to focus on quality investments will be far more rewarding than chasing returns of the past five years.