Tuesday April 7, 2015
Here Be Dragons?
As the U.S. economic recovery approaches its sixth anniversary, prognosticators may be well-advised to borrow from the practice of medieval mapmakers. To depict areas beyond established frontiers, mapmakers drew colorful illustrations of dragons and other mythological creatures. The message was one of caution: No one knows what lies there. While today’s economic landscape may not be fraught with the perils of a months-long ocean voyage on a wind-powered vessel navigating in uncharted waters, the challenges facing investors are real and the outcomes, like the receptions of distant people, are far from certain.
To be sure, there are many positive signs. Over the past year, the pace of the economic recovery in the U.S. has held relatively steady, the unemployment rate has continued to fall as new jobs have been created at a healthy clip, and most financial markets have stayed at elevated levels.
At the same time, many economies around the globe are still struggling, short-term interest rates continue to hover near zero, the prices of various commodities have declined, energy prices in particular have plummeted, and the dollar has gained sharply against other world currencies. In numerous respects, the current situation is unlike that of any prior period. Similar to the explorers of old, we may be poised to discover whether or not there are dragons lurking beyond the horizon.
On the surface, the waters appear relatively calm and the wind is at our backs. Most financial markets have continued to hold their values or trend upward, with little to suggest that measures of market psychology have deteriorated. Similarly, economic data in the U.S. generally indicate that we’re still in a period of slow but steady growth.
The unemployment rate has resumed its decline and is now at 5.5%, down from a peak of 10% in October 2009 and reaching its lowest point since May 2008. At 62.7%, the civilian labor force participation rate is somewhat concerning as it sits near its 37-year low. And new-job creation was disappointing in March. But for all of 2015, new jobs are expected to total more than three million, roughly the same as last year. All told, the improved employment picture is likely to result in slightly higher wages, which may slow the widening disparity in incomes between rich and poor.
Inflation is expected to remain low, given the huge assist from declining energy prices. While the Consumer Price Index will probably be higher than the sub 1% levels of the past few months, the rate is likely to stay below the U.S. Federal Reserve’s target of 2%. In addition, the housing market, despite recent weakness attributable to winter weather, is expected to finish the year strong with gains in housing starts, rising sales of existing homes and a resurgence of first-time buyers.
The economies of Europe and Japan are more problematic despite ongoing monetary stimulus. The real gross domestic product (GDP) growth rate for the euro area, though improving, remained anemic at 0.9% in 2014 and is forecast to be just 1.3% this year. Japan’s economy seems impervious to significant change. Neither Abenomics nor a deliberate devaluation of the Japanese yen has had the desired effect. Originally forecast to grow at a 3.6% annual rate in the fourth quarter of 2014 after two consecutive quarters of decline, actual fourth-quarter GDP growth in Japan was only 2.2%. On the other hand, China’s GDP growth looks impressive by comparison. Although many investors were unnerved by the deceleration to 7.4% growth in 2014 from 7.7% in 2013, China remains one of the fastest-growing countries in the world.
Beyond GDP growth rates, of all the economic factors that make investors pause, some of the most concerning to me are the levels of interest rates around the world. The yield on 10-year U.S. Treasury bonds is currently below 2%, which is down from about 4% five years ago. Three-year Treasury notes are currently yielding less than 1%, while one-year Treasury bills are yielding about 0.25%. As I’ve cautioned many times in the past, investors seeking higher yields today are taking on considerable principal risks. Even small rate increases could result in substantial principal losses for longer-term bonds.
What are less clear, but perhaps even more troubling, are the economic consequences of the sustained low-interest-rate environment that we’ve experienced. In all the time that interest rates have been recorded, there have rarely been periods in which rates have plunged to such low levels. And before you say that there isn’t much historical information for this sort of thing, it turns out that such information does exist going back almost 500 years!
Deutsche Bank, Global Financial Data, Inc. and Bloomberg Finance LLP have compiled data detailing the yield on 10-year Dutch government bonds starting in 1517. From the mid-16th century on, the 10-year Dutch yield fluctuated mostly above 3% with periodic upward spikes. Only in the last several years has the yield dropped significantly below the 3% threshold. More than 100 years of information for Switzerland tells a similar, if slightly more extreme, story. In fact, the 10-year Swiss government bond yield has recently turned negative. Likewise, over 140 years of data compiled by Robert Shiller and the U.S. Department of the Treasury shows the unprecedented nature of the sharp and prolonged decline in U.S. interest rates that has occurred during the past 30-plus years.
It’s fascinating to note that in all three countries, 10-year government bond yields peaked around the 1980s and have been trending sharply lower ever since, the result of the most-significant bull market in bonds ever. Though many observers, including myself, have largely attributed the recent low rates to the policies of the U.S. Federal Reserve (Fed) and other leading central banks, there may be other factors in play as well.
So are we headed for another period of financial stress? That’s the question many investors are asking. While current stock valuations are elevated, I don’t see an obvious economic parallel to the situation leading up to the global financial crisis that began in 2007. For example, in 2007, it was strange that you could get a mortgage with no money down. It was also obviously problematic. It violated centuries of economic wisdom about the importance of “skin in the game.” Not surprisingly, no-money-down mortgages led to high rates of default.
Today, it’s strange that interest rates are at their lowest levels in almost 500 years. And the consequences are highly uncertain.
During the global financial crisis of 2007 to 2009, not only did the stock market suffer, but the entire economy was teetering. As a result, central bankers and policymakers appropriately came to the rescue. Today, in contrast, I feel that the global economy is on reasonably sound footing — despite the slow growth around the world. But it’s important to note that investors can experience losses even when the economy is relatively resilient. For example, during the tech bear market of 2000 to 2002, stock prices generally fell despite the fact that quarterly GDP growth was positive in 10 out of 12 quarters.
My main point is that we’re in a “high-degree-of-difficulty” environment. There are no easy answers. Take oil, for example, which recently fell below $50 per barrel in a fast and furious decline. For those who think they know where oil is headed next, I’d ask how well they predicted oil’s price action in 2008 and 2009. Back then, oil had an even-more dramatic decline — only to recoup about two-thirds of its losses in relatively short order.
The same can be said about our ability to predict the consequences of the other phenomena I’ve discussed in this message: Low, even negative, interest rates throughout the world. New rounds of quantitative easing by the European Central Bank and the Bank of Japan. A rise in the value of the U.S. dollar that’s been more significant than at any time in the last decade. An intentional, prolonged depreciation of the Japanese yen. And slow economic growth contributing to fears of deflation. Can all of these occur without a major disruption down the road? Maybe. So I’m looking at these phenomena more with a sense of wonderment, rather than with any dire predictions. But it wouldn’t be surprising if the economy did indeed encounter some dragons in the coming years.
Another quarter, another gain. Seemingly in defiance of the slow-growth economy, and in the face of potentially higher interest rates from the Federal Reserve, most stocks continued their advance during the first quarter of 2015. For the ninth straight quarter, the S&P 500® Index posted a positive return, this time rising a modest 0.95%. Repeating the pattern of the previous quarter, small caps, as measured by the Russell 2000® Index, performed even better as they moved up 4.32%. For the first time since the dot-com bubble burst in 2000, the Nasdaq Composite Index advanced past the 5,000 level, although the Index settled a bit lower by the end of the quarter.
As is par for the course, gains in the markets didn’t come without hiccups along the way. Many investors were speculating that a correction was just around the corner. The markets were generally volatile in January, up sharply in February and volatile again in March.
Nevertheless, the quarter’s gains were broad-based as most sectors, market-cap ranges and style categories were in positive territory. Not wanting to be left out, bond markets advanced with the intermediate-term Barclays Capital U.S. Aggregate Bond Index gaining 1.61% and the long-term Barclays U.S. 20+ Year Treasury Bond Index rising 4.19%.
Overseas, European and Japanese stocks also posted strong gains for the most part. Emerging markets performed with less consistency — China, India, Korea and Taiwan generally did well, while Latin America struggled. The strengthening U.S. dollar has had a mixed impact internationally — boosting trade, but making dollar-denominated debt more expensive. The debt issue is less of a problem today, however, because emerging-market bonds are increasingly being denominated in local currencies.
After several years of sharply rising stock prices and slow economic growth, there’s no question that valuations on most U.S. companies are high. Nor is there any denying that this situation is making the job of portfolio management more challenging. As described earlier, we’re now in a high-degree-of-difficulty environment. The easy money has already been made.
Consider these examples at two ends of the investment spectrum: An investor could buy a U.S. tech company with a strong, consistent growth rate at an expensive price-to-earnings multiple. Or the investor could buy a Russian oil company with an attractive dividend yield and a low price-to-book value. Which would you choose? Do you prefer the predictability of the U.S. tech company with the high valuation, or the substantial dividend income from the Russian oil company that’s exposed to significant geopolitical risks?
The reality is that we aren’t faced with just two alternatives. But the examples show the types of complicated risk/reward trade-offs that exist in the current market environment. In addition, the bull run in the S&P 500 Index has gone on without a correction of 10% or more for about three and a half years, which is two years longer than the average bull market. As a result, I believe now is a time for caution.
While I don’t think that most investors can effectively move in and out of the markets, a somewhat higher-than-normal cash position might be warranted for more-conservative investors. And in an era in which markets are often dominated by speculative trend-following, I think it’s especially important for portfolio managers to really understand the companies in which they’re invested. This has always been our focus at Wasatch Advisors.
Regarding interest rates, I’ve said before that mild increases in rates would help people at or near retirement who are currently unable to generate reasonable levels of income on their lower-risk investments. In addition, higher interest rates would encourage a healthier credit environment in which more borrowers would have access to capital and lenders would have the potential to receive fair returns.
Now that the Fed has signaled a rate hike for later this year, my outlook is for a reversion to normalcy. My hope is that this reversion to normalcy will come gradually, which may allow us to work off the excesses in the stock and bond markets without major downturns. But again, the endgame is especially difficult to predict because we haven’t been here before and we don’t know the nature of the dragons that may appear.
Wasatch is celebrating its 40th anniversary this year. In some ways, today’s environment couldn’t be more different from when I founded the firm in 1975. Back then, 10-year U.S. Treasury bonds were yielding about 8%. Inflation was running at approximately 9%. Oil prices were spiking upward. And stock prices were low coming off of the 1973 to 1974 bear market.
What hasn’t changed is our focus on seeking to exploit opportunities in less-efficient areas of the markets. From the 1970s through the 1990s, most of our efforts were dedicated to researching U.S. small-cap companies that were able to rapidly grow their returns on capital. In 2000, we applied the same philosophy and process to international markets and launched our first international investment vehicle.
Five years later, in 2005, we started the Wasatch International Micro Cap strategy to focus on international (non-U.S.) micro-cap stocks, which are defined as those with market capitalizations of less than $1 billion at the time of purchase. The typical market-cap range for the portfolios’ holdings is $300 million to $1.5 billion.
For investors who have most of their assets allocated to U.S. equities and to large- and mid-cap stocks, the International Micro Cap strategy offers the potential of significant diversification benefits. With the ability to invest in developed countries, emerging markets and even some frontier markets, and the freedom to invest across all sectors and industries, the strategy has a large investment universe — more than 7,000 companies — and goes where we believe the best opportunities lie.
We’ve just published a white paper that discusses the International Micro Cap strategy and our investment process in great detail. If you’d like a copy of the white paper, please contact us.
With sincere thanks for your continued investment and for your trust,
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
CFA® is a trademark owned by CFA Institute.
© 2015 Wasatch Advisors, Inc. All rights reserved.
Abenomics refers to the economic policies advocated by Japanese prime minister Shinzo Abe after his December 2012 re-election to the post he last held in 2007. His aim was to revive the sluggish economy with “three arrows”— a massive fiscal stimulus, more aggressive monetary easing from the Bank of Japan, and structural reforms to boost Japan’s competitiveness.
A bear market is generally defined as a drop of 20% or more in stock prices over at least a two-month period.
A bull market is defined as a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as the result of an economic recovery, an economic boom or investor psychology.
The Consumer Price Index (CPI), also called the cost-of-living index, is an inflationary indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The CPI is published monthly.
Dividend yield is a company’s annual dividend payments divided by its market capitalization, or the dividend per share divided by the price per share. For example, a company whose stock sells for $30 per share that pays an annual dividend of $3 per share has a dividend yield of 10%.
Gross domestic product (GDP) is a basic measure of a country’s economic performance, and is the market value of all final goods and services made within the borders of a country in a year.
The price-to-book ratio is used to compare a company’s book value to its current market price. Book value is the total net asset value of a company minus intangible assets and goodwill.
The price-to-earnings (P/E) multiple, also known as the P/E ratio, is the price of a stock divided by its earnings per share.
Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Valuation is the process of determining the current worth of an asset or company.
The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged, but is a commonly used measure of common stock total-return performance.
The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks.
The Barclays Capital U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market, including government and corporate securities, agency mortgage pass-through securities, and asset-backed securities.
The Barclays U.S. 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.
The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the Index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The Nasdaq was created by the National Association of Securities Dealers (NASD) to enable investors to trade securities on a computerized, speedy and transparent system, and commenced operations on February 8, 1971.
You cannot invest directly in these or any indices.