Now that the dust is beginning to settle from the results of the U.S. election, I thought it would be a propitious time to take a step back and review the recent past, as well as to take a look ahead. 2016 marked the fourth consecutive year during which U.S. equities out performed the rest of the world. With the dollar appreciating to near record levels against other currencies, and Europe continuing to struggle, these trends were a headwind for internationally diversified investors such as ourselves. Of course, the corollary is that U.S. assets have become increasingly expensive compared to the rest of the world, which suggests that, going forward, there will be ample opportunities for globally oriented investors.
In our core strategy, Global Growth, results for the year were in the 5%-7% range, comfortably outstripping the return of our benchmark (70% global Stocks 30% U.S. bonds), though we lagged the U.S. equity market. As noted above, this was primarily due to our global diversification, which itself is risk averse, but also partly due to our conservatism across asset classes. While I make no apologies for the latter, with hindsight we could perhaps have been more U.S.-centric as regards the former.
The good news is that we are off to a terrific start to 2017, with returns YTD roughly equal to the gains of all last year. We continue to be true to our long term approach, with our asset allocation diversified across both asset classes and geography. On a risk adjusted basis, this strategy has proved the most efficient and has rewarded both us, and our investors. Currently, weightings in our model portfolio are 67% equities (of which slightly over half are U.S.), 15% fixed income (almost all either floating rate or short term) and 18% alternatives.
Looking ahead, global markets face a number of significant challenges. In the U.S., we are in the eighth year of an economic recovery, which has seen the stock market almost triple in value. While there are some potential economic benefits from the ideas being put forward by the new administration—which include tax changes, measures such as a tax holiday for the repatriation of corporate funds held offshore, and increased infrastructure spending—given Mr. Trump’s declining political capital there are many uncertainties regarding the likelihood and timing of their passage. In particular, I think it is an open question as to whether congressional republicans will support the deficit spending measures proposed by the president.
Given these uncertainties, I think we need to primarily base our forward-looking assessment on the current market environment, rather than projecting that a cornucopia of corporate reforms are about to be unleashed, as the market seems to be doing. At the end of the day, stock prices are determined by corporate earnings, not anticipated political events—though the latter certainly have to be taken into account. Or, to paraphrase one of my favorite Warren Buffet quotes, “In the short term the market is a voting machine, but in the long term it is a weighing machine.”
At the moment, the Wall Street consensus is for U.S. earnings to rise on the order of 10% in 2017. If the proposed corporate tax reforms are enacted, this could add an additional 10% to per share earnings. On a valuation basis, U.S. stocks are currently trading at a price to earnings ratio of over 20, putting them in the 90th percentile of their historic range. In other words, only 10% of the time have they been this expensive. Price to book ratios are similarly dear. In short, even if the reforms are passed, as the market seems to believe, the U.S. market looks pricey.
One of the key issues overhanging the U.S. market is the threat of higher inflation and the potential for interest rate increases. Low interest rates and the expansion of the FED’s balance sheet have clearly been an important component in the market’s long rally. However, expectations are for several rate increases this year, which will not only begin to make fixed income investments more attractive compared to equities, but, at this advanced stage in the economic cycle, could cause corporates to begin slowing their plans for expansion.
Trade is another area of concern. Here, I think Mr. Trump needs to carefully assess the geopolitical landscape. Trade represents close to 50% of global GDP and for many years has been its fastest growing component. Despite his heated campaign rhetoric, the U.S. is no longer the solitary super power it may have been in the past. The economic growth of China, in particular, coupled with a growing sense of isolation in this country, bodes poorly for our ability to impose our economic will on others. It is worth reminding ourselves that China only exports about 15% of its manufacturing to the U.S., and that any tariff barriers we slap on them will more than likely be reciprocated, in both cases potentially having a significant economic cost to the U.S. consumer.
Speaking of the U.S. consumer—which, as many of you know, accounts for 70% of the economy—the post election mood has thus far been a positive. The assumption is that the proposed Trump tax cuts will unleash pent up animal spirits and spur spending. While this psychology has helped U.S. stocks to soar since the elections, the uncertainties, and possible future missteps, of a Trump Administration may eventually diminish the upward trajectory of this trend.
Looking across the major sectors of the U.S. market, although they have climbed significantly, we believe financial institutions will continue to be one of the beneficiaries of the new regime. Not only are regulatory burdens likely to decline, but higher interest rates should provide a tail wind. Furthermore, valuations for bank stocks remain cheap by historic standards, in both the U.S. and overseas. Longer term, energy stocks are poised to benefit, not just because of Mr. Trump’s stance on the environment, but also because of falls in investment by the major oil companies. Over time, the lack of capital expenditure should cause energy supplies to diminish, even as demand increases. This imbalance could result in higher prices a year or two down the road.
In contrast, if higher tariff barriers are imposed, and reciprocated, U.S. exporters will be among the losers. Rising interest rates in the U.S. are likely to help push the dollar higher, compounding the problem, although companies which primarily sell to a domestic audience may benefit. Tech companies will also suffer if visas for non-U.S. workers become more difficult to procure. In addition, the negative tone of Trump’s statements on immigration may be an issue in terms of attracting skilled workers from overseas. Lastly, the competitive position of major tech firms like Apple, which are dependent on cheap imported components, could be affected if higher tariffs are imposed.
While higher U.S. interest rates, and tariff barriers, will be headwinds for non-U.S. markets, many of these markets remain attractive on a valuation basis. Europe, where price to earnings ratios continue to languish below historic norms, is cheap compared to the U.S. For instance, price to book ratios are currently 1.7 in Europe vs 2.9 in the States. While it is true that these ratios have historically tended to be lower in Europe, a large part of the discrepancy has been because of varying perceptions of political risk. However, in light of the uncertainties in the U.S. at the moment, I am not sure the gap is justified. Furthermore, Europe remains at an earlier stage in the economic cycle, with the central bank still in expansive, low interest rate mode. Lastly, European exporters are poised to benefit from the weakness of their currency, and the multinationals among them are less vulnerable to tariff barriers than their global competitors, because many of them have production facilities inside America.
Similarly, Japan looks relatively interesting, and certainly not over priced. Though cultural change is hard to achieve, some of the reforms introduced by Mr. Abe are starting to have an effect. For instance, corporate share buys backs are running at four times the rate of 2012, as companies seek to return to investors some of the mountain of cash they have been sitting on. Japan is also less susceptible to the potential negative impact of tariff barriers than many of its Asian competitors, with Goldman Sachs estimating the impact on GDP growth rates to be roughly half that of Korea or Taiwan.
Globally, emerging markets appear to be among the more promising regions for investors. Not only are they inexpensive—both in comparison to other regions, and to the past—but, at 6%, their forecasted GDP growth rates for 2017 are among the highest in the world. While these markets do tend to be volatile, they are better positioned to withstand economic dislocation than they have been in the past. As a group, their currency reserves are high and their external debt is relatively low. Of course, they are by no means completely homogenous, although markets sometimes tend to treat them that way. While commodities continue to be important for many of these markets, we now see many more listed high tech companies in the group than has historically been the case. India stands out as among the most attractive, with very high growth rates, surging corporate profitability and a relatively low export dependency on the U.S.
Turning briefly to other asset classes. Bonds continue to look over priced, and will struggle if rates in the U.S. increase, though they may some downside protection if equities tumble. However, given the potential for higher interest rates to cause substantial falls in long maturity bonds, we have kept most of our bond exposure short term or in adjustable rate instruments. These securities are particularly useful in a rising rate environment since their interest rates can adjust upward, thereby protecting the principal value of the bond.
Given the high valuations and the many uncertainties both stock and bond markets face, alternatives—including non-correlated assets such as market neutral strategies, commodities and real estate—look increasingly attractive. In this over heated environment, we are clearly looking to play more defense than offense. Cash is, of course, in many ways the ultimate defensive weapon, and as a result we have been keeping 5%-10% of our powder dry. Going forward, we intend to increase allocations to alternative strategies as opportunities arise.
I hope this brief summary will provide some insight into our strategy and outlook. Please let us know if you have any questions or comments.