I am pleased to be able to report that Polygon celebrated its fifteenth year investing on behalf of clients in 2018. For the year, we achieved an average return of 17.8% in our primary strategy, Global Growth, representing an outperformance of 1.6% against our benchmark of 70% global stocks and 30% US bonds. Since inception in 2003, our Global Growth composite has outperformed its benchmark by an average of almost 35 per year.
Diversification across asset classes and geography continues to be a mainstay of our investment process. With the dollar weakening against many currencies, for the first time in several years North America, was not the strongest performing region in the world in 2017. By comparison, Japan and Europe each grew by 24%, while emerging markets gained an impressive 38%. Given our global orientation, this environment resulted in improved, risk-adjusted performance across our portfolios.
Looking ahead, I believe the central problem we currently face as investors is how to maintain a reasonable level of equity market exposure (the main source of returns over time), while simultaneously limiting short-term, downward volatility. This concern is particularly acute in the U.S. given high market valuations and political risk, but the rest of the world is not immune from it. While diversification will certainly help, investing in non-correlated assets such as alternatives will be an area of increased emphasis as we go forward in 2018.
Overall, we are maintaining a defensive stance towards stocks, with equity weightings in our model portfolio in the 60%-65% range, depending on client objectives. Given its relative cheapness, and its more conservative characteristics, we are increasingly favoring value over growth in most markets. Globally, Mr. Trump’s recent lurches towards protectionism and the potential negative consequences for trade and global economic growth have further diminished our appetite for risk.
In the U.S., and to some extent globally, a critical issue for stock prices is the level of interest rates. Low rates, along with higher corporate earnings and the recent corporate tax cut, have propelled U.S. equity prices to record highs. However, comparing traditional valuation measures, such as price-to-earnings and price-to-book ratios, to historic data shows that current valuations are in the top 10% of all time, which suggests further advances will be difficult.
Upward pressure on rates is coming from a number of sources including the Federal Reserve (FED), which is worried both about inflation and about the need to have rates high enough so that cutting them will counter future recessionary tendencies. Further fueling these concerns is the potentially stimulative impact of the $1.5 trillion tax cut, which is coming at a time when the economy is already humming along nicely. Not only will this create a potential crowding out problem, as the government is forced to issue large amounts of debt to fund the deficit, but the FED may exacerbate the problem by dumping what is expected to be an average of $500 billion a year of Treasury securities into the bond market over the next few years as it whittles down its bloated balance sheet.
Positives for U.S. inflationary prospects, and stocks, include near record corporate profitability, relatively low capacity utilization, which at 77% remains subdued compared to its long term average of 80%, and the shrinking number of listed companies in the U.S., which has declined from almost 9,000 in 1997 to a little over 5,000 today. Tax reform and burgeoning consumer confidence are also propelling the economy forward. However, in our view, one of the main reasons for the buoyant state of the U.S. stock market is the lack of attractive alternative places to invest. If U.S. rates either rise, or are expected by the market to rise, above the 3% – 3.5% level we may reach a tipping point, which will bring equity prices down to earth. All of which is not to suggest that U.S. stocks are on the verge of a major decline. Nonetheless, the market appears vulnerable, and more volatility is likely. As a result we are currently underweight U.S. equities.
Several sectors in the U.S., and to some extent globally, are attractive, including finance, where banks are among the few industries that will benefit from higher interest rates. In the U.S. deregulation and lower taxes will also help. Energy related businesses look interesting, as oil demand has benefited from a growing global economy. Cash flow is improving as the major players have cut back on capital expenditures, which over time should lead to lower supply, thereby potentially putting upward pressure on prices. Although there is a lot of uncertainty around health care, the sector, currently trading at a 10% discount to the S&P, appears oversold. Aging populations in the developed world, improving systems and the development of new technology and treatments are all factors that should encourage positive returns in medical related businesses.
In Europe, valuations are less stretched and its economies are earlier in the economic cycle. This gives the European Central Bank more latitude as to when, and how, to raise interest rates, which remain considerably lower than in the U.S. Looser credit, continued strong GDP growth, and corporate earnings, expected to be approximately 10%, should provide a stable platform for European equities in 2018. However, political risk remains a concern, with both Brexit and the recent Italian election results having the potential to cause disruptions. For the moment, we are maintaining roughly a market weighting in European equities.
Japan looks more attractive, with the structural reforms implemented by the Abe government starting to have an effect. Share buybacks, once unknown in Japan, are starting to become commonplace, and are helping push the stock market forward much as they have done in the U.S. With earnings growth expected to be in the 15% range, valuations are undemanding by historic comparisons. Reflecting this, we are slightly overweight Japanese equities in our portfolios.
Despite their strong gains in 2017, emerging markets remain relatively cheap and are being driven more by growth than P/E expansion, as has often been the case in the West, especially the U.S., in recent years. Although one has to differentiate between individual emerging markets, in many ways Asia continues to be the most attractive region. With average earnings per share up over 20% in 2017, growth in Asia, excluding Japan, is expected to slightly slow, but is still projected to show an earnings-per-share growth rate in excess of 15% in 2018. China and India will lead the way, with earnings in each expected to grow by 18%. Consequently we intend to remain overweight emerging markets, which currently constitutes just over 10% of our model portfolio.
Even though foreign investors and mutual funds pumped over $55 billion into Asia last year, they are still significantly under exposed, with an almost 6% underweight position against the market cap index. Interestingly, foreign flows are less important to the local stock markets then they have been in the past, as domestic investors now account for more than half of total investment inflows.
Although expected returns from cash and bonds are not high, this asset class is useful both as a diversifier and as a defensive bulwark in case global markets decline. Given concerns about rising interest rates, almost all of our bond exposure tends to be in short term, or floating rate, instruments.
As noted above, we are seeking to increase our exposure to alternative investments and, in particular, to non-correlated assets. Commodities should provide some downside protection, and, as a real asset, they offer refuge in an inflationary environment. For the first time in many years, we have been buying gold and mining stocks, partly as a hedge, and partly to offset what we see as heightened political risk in world markets. Non U.S. real estate is a useful diversifier and remains attractively priced, while providing a useful source of current income.
I hope these brief comments will be of interest and look forward to your thoughts and comments, and would be delighted to try to answer any questions you might have.