Commentary

Key Takeaways

• The global economy is in a long process of moving from an unsustainable to a sustainable foundation.
• An unwind of a multi-year period of crowded trades in defensive and low volatility stocks accelerated following the U.S. election, with outperformance by cyclical value stocks.
• Rising interest rates tend to accompany periods of strength for value, small cap and emerging market shares and a recovery in active manager relative performance.

The Shift From Inflating Assets to Supporting Growth

Last year will likely be remembered as a time of large divides among both people and financial markets. Differences in political, economic and religious beliefs rose to the surface in the broader context of a sense that the world was being run by elites who were disconnected from the condition of the average citizen. A number of global leaders, along with pollsters and the popular media, misjudged the strong desire to move away from the status quo and were removed from power including the Prime Ministers of the United Kingdom and Italy, the President of Brazil and the Democratic Party candidate for the U.S. presidency. Leadership in financial assets also shifted materially as many of the historically wide gaps in relative performance and valuations surprised most investors by reversing violently in the latter half of 2016.  

We view these changes within the framework of our long held and somewhat optimistic view that the global economy is in a long process of moving from an unsustainable to a sustainable foundation. While resisted by central bankers and most policy makers, the period of mal-consumption and mal-investment fueled by the single-minded focus to subsidize debt accumulation is in the process of ending. Post the 1998 Long Term Capital Management bailout of the Nobel Laureates, every crisis became a “systemic” threat and we entered a period that could be termed “The Great Distortion.” When cheap money and more debt did not produce strong economic growth, the response was to add more debt and even cheaper money. Monetary policy shifted from ZIRP (zero interest rates) to NIRP (negative interest rates) and the new tool of quantitative easing was introduced to fund the entire annual borrowing needs of the developed world with printed money.

Exhibit 1: Historical Interest Rates for 10-Year U.S. Treasury Note

Source: Bloomberg.

The effect on global investment markets was to create a series of inflated asset bubbles that temporarily supported a boom in the real economy. We experienced the tech wreck of 2000, housing collapse of 2008 and commodity/emerging markets bust after 2011. The popular labels of “super-cycle” and “the Great Moderation” faded into the pessimistic resignation of “secular stagnation” and “the new normal.” By the middle of last year, this was reflected in many historic extremes in both equity and credit markets. Most striking were sovereign debt values where $13 trillion in bonds were priced at negative nominal interest rates. This is unprecedented in the long history of interest rates going back about 4,000 years and as succinctly put by Gavekal’s Anatole Kaletsky, “likely represents one of the greatest asset bubbles we have ever witnessed.”

This long and potentially ending one-way move in bond prices (Exhibit 1) also had a powerful impact on equity markets. Given that central bank policies tended to inflate asset prices while creating a more volatile and slower growing real economy, investors favored companies with bond-like characteristics. This created an environment that rewarded factor exposures found more in passive than active investment strategies. In a recent comprehensive study by Empirical Research Partners they found that passive ownership of large cap U.S. stocks has risen seven-fold in the past 15 years. The characteristics of passive stock holdings tended to be higher yielding, stable earning firms with a high correlation to Treasury bond returns. Quantitative solutions that target low volatility, momentum and high dividends have also dominated fund flows in the past decade. Back tests of these factors along with high passive ownership show a self-reinforcing loop of excess returns. The risk is that this backward looking performance was driven by the direction of interest rates and could reverse if the great bond bull market is over. Interestingly, the Empirical researchers have noted that since the middle of last year, stocks in the highest quintile of passive ownership have begun to underperform.

Our intention is not a broad rant against passive and quantitative investing but to point out the fundamentally crowded, overvalued and extended nature of the favored assets of the past decade. The most significant relationships to highlight are value vs. growth, U.S. vs. non-U.S., cyclicals vs. defensives, emerging markets vs. developed and the broad underperformance of financial stocks. We witnessed a sharp unwind of crowded trades that accelerated following the U.S. election with outperformance by high beta, low quality, poor momentum and cyclical value stocks. The change was dramatic with a 14 percentage point move (from 5.7% behind to 8.4% ahead) in favor of value relative to growth on a trailing one-year basis between the third and fourth quarter (Exhibit 2). While this represented a four standard deviation event, a higher level of volatility is not unusual in the initial stage of a style reversal.

 

Exhibit 2: Closing the Value vs. Growth Gap

Source: Bloomberg.

We believe a material shift in relative performance is supported by a blend of cyclical and structural economic, policy, regional, sector and company valuation dynamics. Politicians tend to be more keenly sensitive to their own unemployment than to the job prospects of their citizens and this led to a change in economic policy focus in 2016. After relying on central banks for bailouts and free money with little success, global leaders are now proposing a blend of supply side and Keynesian stimulus. Tax cuts, regulatory reforms and infrastructure spending were met with approval by central bankers promising to fund these efforts with “permanent monetization” and allow for an “overshoot” of inflation before meaningfully tightening monetary policy. Japanese, European and U.S. central bankers announced plans to taper bond purchases while communicating the desire to now manage their respective yield curves. This led to a record $1.7 trillion fall in the value of global bonds in the month of November alone. These actions were undertaken in the context of a global economy that was climbing out of a sharp slowdown with signs that deflationary pressures had peaked. As the year ended, 85% of global purchasing managers’ surveys were in expansion territory.

"Just as most experts concluded that the evidence for secular stagnation was overwhelming, economically-sensitive sectors staged a powerful rally. "

Inflation in Germany spiked to the highest level in over three years in December with export prices heading up in China for the first time since 2011. Industrial commodity prices and shipping rates moved strongly higher in the second half of last year, bolstered by demand from improving growth in the U.S., China, Japan and Europe. Wage increases also accelerated in the major developed economies. Most importantly, the contraction in global nominal GDP in dollar terms ended. The fall in this dollar-based measure, to a greater degree than 2009, represented a hidden recession and weighed heavily on the earnings of cyclically-related and financial services companies. The upturn in worldwide nominal GDP is already improving the profits in the economically sensitive and banking sectors. Global earnings have been in decline for the past six years but are now rising due to a recovery in these industries and led by gains in non-U.S. regions. This is likely to continue into 2017 given that analyst earnings estimate revisions are strongest in Japan, Europe and Asia within the energy, materials, industrials, tech hardware and financial sectors.

The main theme in 2016 driving country, sector and style/factor performance was a powerful reversal at mid-year. Just as most experts concluded that the evidence for secular stagnation and deflation was overwhelming, the long suffering economically-sensitive sectors staged a powerful rally  (Exhibit 3). Gains for the year were led by energy, materials and industrials shares. Financial stocks also rose strongly in the second half, resulting in outperformance for the year. Technology firms ended a somewhat volatile year with solid relative gains, helped by the performance of semiconductor and electronic component makers. As sentiment towards the global economy improved, both defensive and income-oriented equities significantly underperformed. Bond-correlated utility and telecom shares were hardest hit and posted losses for the year. Consumer-related sectors also lagged, driven by declines in auto, housing and retailing companies. While confidence measures improved in December, this did not fully offset concerns about the impact of rising rates on debt-funded durable goods purchases and consumption.

 

Exhibit 3: Sharp Reversal in International Sector Performance 

Source: Bloomberg

From a country standpoint, the post-election rally in U.S. shares and the dollar led to another year of outperformance of American equities. Emerging markets rebounded from losses of the previous three years and posted strong relative gains led by stocks in Brazil, Russia, Hungary, Thailand, Peru, South Africa and Indonesia. Europe underperformed as political uncertainty and continued weakness in the banking sector led to losses in Italy, Spain and Ireland. Sweden, Switzerland, Finland, Denmark and Belgium also registered declines, weighed down by the falling health care, retail, telecom and utility sectors. In the UK, a sharp rally in share prices after the June Brexit-related plunge was more than offset by a 16% decline in the British pound relative to the U.S. dollar. Japan was nearly flat for the year despite an 8% rebound in the last six months of 2016 as exporters were bolstered by the weakening yen and banks by the shift away from the central banks’ negative interest rate policy. Asian markets experienced modest overall gains with strong performance from Australia, Korea, New Zealand and Thailand. India, China, Hong Kong, Malaysia and Singapore underperformed due to both policy and economic concerns.

Despite generally improving global economic conditions, continued loose monetary policies are being augmented with expansionary fiscal spending to create an “overshoot” in both growth and inflation. Given the record high amount of debt in the world at over $200 trillion, much of which needs to be refinanced in the next two years, central bankers face a difficult balancing act. The only way out from underneath these crushing liabilities is through growth and debasement but too rapid a move risks alienating bond buyers. Debt investors are already somewhat unsettled after record losses in the fourth quarter along with the main price supporter, the monetary authorities, discussing “tapering” of their purchases in 2017. After a 35-year downtrend in global interest rates, this environment is becoming unfriendly to fixed income assets and more beneficial to real economic activity. In short, the shift away from outperformance of stocks that are the most bond correlated that began in late 2016 is likely to continue well into this year. Conversely, rising interest rates tend to accompany periods of strong relative performance for value, small capitalization, emerging market and cyclically-oriented shares. Also, as noted in a recent note by Nomura Research entitled “Peak Passive,” these are also the conditions in which the cyclical downturn in active manager relative performance recovers.

As author Matt Ridley points out in his book, The Evolution of Everything, significant new ideas tend to emerge just at the right time and appear to be both unexpected and spontaneous. Steady, smaller, bottom up forces tend to eventually overwhelm larger, centrally planned solutions and drive economic and human progress. In this context, the movement to address the great imbalances built up over the past two decades, while fraught with uncertainty, can be seen as positive. While we must remain watchful for any unhelpful policy and economic developments, the shift towards global growth based upon rising incomes, investment and productivity is likely to support a recovery in asset prices tied most closely to the real economy. As a disciplined value manager we are well positioned for this environment and end of the “Great Distortion.”