2015: Meeting Expectations?
It seems that, as each year comes to a close, investors everywhere want to discuss what they believe lies ahead of them after the stroke of midnight on December 31. Generally speaking, these predictions rarely match the realities of the coming year. The events we expect to move markets have less impact then we expect, and are eclipsed by unforeseen developments as the year progresses. This past year proved somewhat of an exception, with many predicted events going more or less as planned. Economic data in the US reflected continued economic strength, leading the Federal Reserve to finally raise rates, while the Eurozone and Japan continued regimes of loose monetary policy in an attempt to bolster growth. Meanwhile, many emerging markets faced headwinds due to falling commodity prices, the impending US rate rise and concerns over slowing Chinese growth. Overall, the overarching theme of “divergence” played out largely according to early forecasts in 2015.
A number of worries presented themselves early on in the year as markets agonized over everything from geopolitical concerns to extreme weather to central bank policy. Crude oil prices fluctuated throughout the quarter, and a stronger dollar raised fears about the fate of US exporters. While many of these worries were part of the consensus view for the year, they nevertheless had an impact. In the Eurozone, the election of the anti-austerity Syriza party in Greece led to new negotiations over Greece’s debt, with a long-term solution proving elusive. This spooked European markets somewhat, but the impact was significantly blunted by the European Central Bank’s announcement of a €60 billion per month quantitative easing campaign. Though many had anticipated this would be Draghi & Company’s course of action for some time, the package was much larger than expected, raising confidence it could jump-start the moribund Eurozone economy. While this drove European bourses markedly higher early on in the year, it quickly became clear that Europe was a long way from declaring any type of victory.
Much of Europe’s good fortune reversed as the year progressed and Greece again had the Eurozone staring into the abyss, and in the process roiling markets around the world. After defaulting on a €1.55 billion loan payment to the IMF, Greece proposed a debt restructuring plan that its creditors, namely the European Commission, the ECB and the IMF, quickly rejected. The Troika’s counteroffer, which included a number of reforms to the Greek economy, was put to referendum and firmly rejected by Greek voters in June. Seen by many as a referendum on Greece’s continued membership in the Eurozone, an emergency summit was called in Brussels as the EU made a last ditch attempt to avoid a “Grexit”. After contentious negotiations, a deal was finally reached in which Greece would receive its third bailout in five years in exchange for implementing new economic reforms and austerity measures.
Fears over Greece’s fate, combined with an ongoing rout in global commodity prices, did much to weigh on global markets over the course of the summer. However, it was not long after the resolution of the Greek drama markets were again roiled, this time driven by events in China. In early August, the People’s Bank of China moved to devalue the renminbi three times in as many days, a move markets interpreted as an official confirmation of slowing Chinese growth. Risk assets around the world were impacted, with volatility reaching levels not seen since the summer of 2011. While many have expressed concern over the state of the Chinese economy in recent years, this was seemingly the first time markets meaningfully reflected the implications this could have on the global economy.
Naturally, emerging markets were hit hard by the prospect of slowing growth in China, already attempting to cope with softer commodity markets. For some countries, like Brazil, these events ultimately led to sovereign ratings downgrades this year when combined with structural headwinds. What’s more, emerging markets also had to contend with geopolitical concerns and the timing of a US rate hike, overall making this year a particularly challenging one for EM investors. Developed markets, though faring better than EM, were still impacted by China. With Western multinationals deriving an increasing share of their revenue from the developing world, fears of contagion drove US and European indices downward. While August’s market gyrations taught us little about the health of the Chinese economy, they did demonstrate the linkages between developed and emerging markets have never been stronger.
These linkages appeared to end up influencing Federal Reserve policy, with the US central bank ultimately choosing to defer raising short term rates in the face of global market instability. Up until this point, inaction by the Fed was celebrated by markets. However this time, the Fed’s decision to stand pat unnerved investors, interpreted to mean the global economy was so weak that it could not handle an even slight tightening of US monetary policy. Though some at the time believed that this could mean a delay until 2016, a series of strong jobs reports led the Fed to finally increase the key interest rate in December. While this was a rather small rate hike, it was nevertheless seen as historic given that it was the first move upward in rates since 2006. Markets welcomed the move, as it reflected newfound confidence in the strength of the US economy, and the Fed was quite clear that it intends to raise rates at a gradual pace going forward.
While all of this was encouraging, another story developing in bond markets proved less so: the exodus from junk bonds. Though high yield bonds had a rather weak showing for the entirety of 2015, this accelerated significantly in the final quarter of the year as worries about issuers in the energy sector, among other factors, led to a selloff. This highlighted concerns about liquidity in junk bonds, especially following the closure of Third Avenue’s Focused Credit fund in December. While credit spreads have widened noticeably in 2015, whether this is merely a reflection of diminished investor risk appetite or a sign of a shift in the business cycle remains to be seen.
Though economic risks were on the minds of many as the year drew to a close, so too were geopolitical risks. In particular, the situation in Syria and Iraq deteriorated further as the Islamic State expanded their sphere of influence, and forced thousands to flee their homes, leading to what has become the largest refugee crisis in Europe since World War II. While this story had been developing throughout the year, it was not until the Paris terrorist attacks in November that it seemed to finally enter the public discourse. With the attacks perpetrated by young men who grew up in the West, a plethora of questions have since been raised not only about security, but also immigration and integration in Europe and the United States. As the debate continues and refugees continue to pour in, it seems there will be a great many challenges related to this crisis in the years ahead.
Ultimately, 2015 proved to be a year where volatility returned to markets as economies around the world found themselves in different stages of the business cycle. The “divergence” everyone spoke of at the beginning of the year was quite visible in economic data, in central bank policy and in market returns. While developed markets were flat, emerging markets and commodities saw significant losses for the year. In spite of a year of marked volatility, US equities ultimately finished slightly in the black, with the S&P returning 1.4%. While a decent performance for the year when compared to other major asset classes, it certainly was a far cry from the double digit returns we have seen from US equities in recent years. Many investors, regardless of their portfolio strategy, found this year to be a disappointing one. Returns were muted, and, in spite of a great deal of market volatility, markets yielded fewer bargains than value oriented investors would have hoped.
Though US equity returns were slightly positive, the distribution of performance was quite skewed, with the preponderance of the S&P 500’s return generated by a select few companies in the technology space. Owning these companies required accepting valuations that could be described as “frothy” at best, and it was virtually impossible to generate a positive return in US equities for the year without owning them. In a year where volatility was noticeably higher, this seems counterintuitive. Nevertheless, it stands as yet another example of the confusing, often contradictory signals we are seeing from markets. As 2016 begins, many wonder if the picture will become clearer.
2016 Outlook
While making a conjecture on the path of global markets is never an easy task (or a practical one for that matter), doing so in today’s environment is particularly challenging. The “divergence” that we saw play out last year made for conflicting signals about market risk appetites and the drivers of growth. The nearly seven year old bull market is clearly showing signs of aging, as evidenced by the increased volatility and lackluster returns of 2015. For some time now, many have been expecting the US recovery to shift into a higher gear, yet this “escape velocity” remains elusive. What’s more, it seems that concerns about global growth may produce further headwinds.
We believe that the divergence story so many market pundits envisioned last year is likely to extend into 2016, at least as far as central bank policy goes. So long as US economic data continues to look fairly good, we expect the Federal Reserve will keep raising rates, albeit slowly. The UK may start down this path as well, but this is highly data dependent and nowhere near assured. Meanwhile, both the Eurozone and Japan will continue with accommodative monetary policy as they try and stimulate growth and inflation. While central bank policy will still be important to global markets in 2016, we believe that it will no longer be as dominant a factor as in the recent past.
Instead, we believe that investors will spend more time focusing on valuations as well as on the business and credit cycles. Like many value investors, we feel this is long overdue. At this point, it is difficult to argue that protracted easy monetary policy has not distorted asset prices in a number of corners of the market. Though recent bouts of market turmoil have allowed us to make some compelling additions to portfolios, we still feel that our opportunity remains a bit limited as a result of elevated valuations. If what we have seen so far this year is any indication, 2016 may be the year where that changes.
However, that transition is not necessarily a pretty one. We believe that market volatility is likely to be a fact of life this year as market shocks are no longer muted by easy monetary policy. With this volatility comes the usual media sensationalism, and investors are frequently overtaken by fear and frenzy. In times like this, markets tend to exhibit acute myopia, so concerned with the impact current events may have on the next month or quarter, rather than year or decade. For the long term investor, these are the times that can be the most fruitful, as compelling opportunities are thrown out with the market’s proverbial bathwater, but we are the first ones to admit it is often not easy to tune out the noise.
Even amidst all of the tumult we are seeing in markets, we believe this could be an interesting year for US growth. Though expected to occur gradually, continued rate rises are ultimately a sign that the Fed has confidence in the economy. While data has generally been good, especially from a labor market perspective, we believe that the US could begin to finally see the type of inflation numbers it’s been seeking, whether in the context of wages or CPI. What’s more, lower energy costs could translate into increased spending not only by consumers, but also corporate America, with capex creating another tailwind for the economy. Though such a situation has been forecast in past years, only to disappoint, one should not discount the possibility of a US economic surprise to the upside.
With that being said, there are some important risks to consider. As the US economic recovery approaches its seventh year, some have pointed to indicators that it may be peaking. Credit markets, generally seen as a useful "canary in the coal mine" when it comes to measuring the health of the economy, could potentially support this view. As of late, high yield spreads have widened significantly, driven primarily by concerns in the energy sector. Though now trading at generally healthy levels, further deterioration in the high yield market, especially outside of energy, would likely imply that we are heading towards the end of the US credit cycle. Should this be the case, we could be in the early stages of a contraction. While we intend to follow credit markets closely this year, we recognize that, like many economic indicators, this would not be the first time they have generated a false positive.
Meanwhile, fears about China have already taken tangible form. Yet another devaluation of the yuan roiled markets earlier this year, taken as further evidence that a deceleration in the world's second largest economy will be bumpier than expected. While we have pointed to softness in China as a concern for some time, we believe that the key risk going forward is the extent to which the global economy has leveraged itself to unrealistic expectations of this "new normal", regardless of whether it is a "hard" or "soft" landing. Given the pain we have already seen in commodity driven corporates and sovereigns, this has already played out to some degree. However, should we find this extends to other sectors, this could prove problematic for the global economy. Though an imperfect (and admittedly, an overused one as of late), we could see a scenario play out similar to the one we saw during the 1997 Asian financial crisis. That said, a key, unsettling difference from that situation is the increased interconnectedness we see today between economies both developed and emerging. We believe the picture will become clear as the year progresses, and certainly see validity in an argument where a Chinese "soft landing" may not prove as damaging to global growth as feared. Nevertheless, we feel vigilance is certainly necessary here.
Moving Forward: Our Direction for 2016
Undoubtedly, there are plenty of things to be worried about in 2016: economies and central banks around the world are taking increasingly divergent paths, the US expansion may be peaking, and the model for global growth may be changing before our eyes. A good deal of our time this year will certainly be spent monitoring these developments. In particular, our focus here is to avoid situations where we own assets that could face enduring structural headwinds. While market gyrations and investor panic may create short term losses, we believe these are less important factors to focus on. Rather, we believe it more important to regularly test whether our original long term investment thesis still holds water, and the management at the helm is still creating tangible value for investors. When both are the case, we feel it is essential to have the resolve to endure volatile markets, along with the courage to enter them.
Indeed, while managing risk is central to our investment process, so too is our desire to identify opportunities in markets. In particular, we seek to find well run companies that are levered to secular global trends, especially when markets fail to see their inherent value. Should market volatility continue to persist this year, we believe that our opportunity set should expand significantly. That being said, we do intend to remain disciplined; short term price fluctuations will not be our guide. The bargain hunt that is our investment style is labor intensive and can take time, but one that ultimately rewards those willing to adhere to it for the long term. We are the first to admit that our relative performance has not been acceptable over the past two years. However, with a turn in the market environment potentially upon us, we believe assets could reprice in manner more in line with our views on quality and risk. Regardless of what the markets have in store, over the course of 2016 we intend to make continued improvements and additions to our investment due diligence and risk management processes.
In addition, it is our goal this year to provide you with better insight into our investment process, our views on the markets and the trends we feel are driving the global economy. It is important that you understand exactly why we have chosen a company or investment product in order to make it easier to tune out what will likely be a fair amount of market “noise” this year. To that end, if you are interested in learning more, please do not hesitate to get in touch, and we will set up a time to talk. As always, we thank you for your continued support and trust, and wish you all the best for 2016.
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