Global stock markets generally fell in the third quarter. In the U.S., larger-company stocks dominated, with the S&P 500 gaining +1.1% while smaller-company stocks were down -7.4%. Year to date, large-cap stocks have gained +8.2% versus a decline of -4.3% for the small-cap benchmark. Our view has been that while U.S. stocks, broadly speaking, are not cheap relative to companies’ earning potential, small caps have been slightly overvalued and are more vulnerable in market sell-offs.
The quarter’s financial market results were set against a now familiar backdrop of macroeconomic and geopolitical concerns. Increasingly, we are seeing divergent economic outlooks around the globe: the U.S. is seemingly on a path of modest recovery; Europe is facing stalled growth and potential deflation; and China continues to seek a balance between maintaining sufficient economic growth on the one hand versus slowing credit creation and implementing economic reform on the other. Geopolitical issues, including the recent escalation of U.S. military action in the Middle East, give investors additional outcomes to consider.
The statements and actions of global central bankers continue to exert a powerful influence on financial markets. As a result, we have found ourselves more attuned to monetary policy in recent years than in times past. Monetary policy remains one of the largest unknowns and risk factors as we look forward.
At their latest meeting in mid-September, the Fed continued on its course of ending quantitative easing bond purchases in October, as expected. The Fed also did nothing to dispel market expectations that they are likely to start raising the federal funds rate around mid-2015, given the current trajectory of economic growth and unemployment. However, Federal Reserve Board Chair Janet Yellen again reiterated that all of their decisions will be data dependent, not calendar driven. While the market and the Fed are now in line in terms of the likely timing of the first rate hike, the market still does not expect the pace of rate hikes to be as aggressive as current Fed forecasts imply, using the median forecast of the FOMC members. So the potential for a market surprise in terms of higher and sooner rate increases exists.
The news from the European Central Bank during the quarter was perhaps more meaningful and highlighted the divergence among global central bank policies. In early September, ECB president Mario Draghi announced additional stimulative monetary policy actions in response to worsening eurozone economic data and deflationary indicators. The ECB not only cut rates but also announced its plans to buy private sector asset-backed securities and certain types of bonds backed by loans from banks, with the aim of increasing the flow of credit to the real economy (particularly to small- to medium-sized businesses). More broadly, Draghi said the “aim is to steer, significantly steer, the size of our [ECB] balance sheet towards the dimensions it used to have at the beginning of 2012.” This could imply roughly one trillion euros of additional asset purchases over the next 12 months.
The ECB will essentially “print euros” to buy the securities, so it’s similar to QE (where the Fed bought government bonds) but on a much smaller scale. In theory, buying the securities from banks will free up capital enabling banks to make new loans to businesses, stimulating growth. But the actual magnitude of these purchases remains to be seen. There are reasons to be skeptical it will have much impact given the small size of the ABS market, and that the ECB will only be buying the highest-quality tiers of the securities at this point.
If the ECB’s latest steps don’t do enough to move the economic needle, it may ultimately have to engage in large-scale QE—as the Fed, Bank of England, and Bank of Japan have done—in order to try to prevent deflation from taking hold in the eurozone. Deflation in Europe could obviously have very negative consequences for the global economy and equity markets. On the other hand, a strong shot of QE liquidity from the ECB could give a boost to global stock markets just as the Fed is starting to tighten U.S. monetary policy.
As we noted at the outset of this commentary, our macro view has not changed over the course of the quarter. We continue to see the U.S. on a slow path of recovery with very gradual improvement in growth and employment. Much of the developed world is in worse shape, facing slower growth, higher unemployment, and worrisome deflationary trends. The role of monetary policy—specifically the timing and impact of the Fed’s gradual winding down of its stimulative policies—is a major unknown. In addition, we continue to monitor the risk of a greater slowdown in China’s economic growth, a risk factor that also hasn’t changed meaningfully over the past three months.
INVESTMENT STRATEGY & OUTLOOK
In the absence of major market developments, our outlook for individual asset classes has not changed materially from last quarter. The overall environment still seems supportive of higher equity prices due to mild but positive economic growth, low inflation, accommodative Fed policy, and weak “competition” for stocks from bonds and other asset classes. This may continue to be the case in the near term. Should we see a change in the market environment (i.e. volatility) that presents compelling opportunities, we are poised to adjust exposures. However, given the current risk/return dynamics in place, we remain patient.
We acknowledge that upward stock market trends may continue in the near-term and, based on our longer-term analysis and focus on downside risk management, we may not be positioned to fully benefit from these trends. But we are unwilling to violate our discipline by throwing in the towel just because everyone else is “playing that game.” That is not long-term investing, and is certainly not appropriate for investors who have entrusted us with preserving their capital across varying market environments.
Given market valuations and an uncertain economic backdrop, we have maintained our allocations to alternative strategies to provide client portfolios with hedged exposure to equities and bonds. Our fixed income exposure remains diversified across flexible absolute return-oriented fixed income strategies that have higher return potential in a rising-rate environment, while still maintaining some core bond exposure for portfolio risk management purposes in the event of an unpredictable recessionary shock. Overall, our fixed income positioning has benefited our clients’ portfolios over the roughly five-year period in which it has been in place, and we are confident it will continue to do so when rates inevitably begin to rise.
Ultimately, in our investment analysis and decision making we try to focus on what is knowable with a reasonable degree of certainty or within a reasonable range of outcomes and probabilities. There are times when what we determine is right for our clients’ long-term benefit is at odds with what the markets are doing in the short term. However, we believe our discipline in adhering to our circle of competence—our expertise as asset class analysts, fund manager analysts, and portfolio (risk) managers—gives us an edge that has enabled us to meet our clients’ investment objectives over time.
We appreciate your confidence and trust in us. As always, please feel free to contact us with any specific questions about this letter or any of the investments that we manage on your behalf.
This material is provided for informational purposes only and does not constitute an offer or solicitation by HFS, or its subsidiaries or affiliates, to invest in these indices or their constituent products. The data contained herein are from referenced sources which HFS believes to be reliable. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. The views expressed are those of HFS. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investing involves a high degree of risk, and all investors should carefully consider their investment objectives and the suitability of any investment. Past performance is not necessarily indicative of future results.