An Improving Outlook…
Many felt that 2017 would represent a continuation of the previous year’s excitement, tumult and unpredictability. However, perhaps the biggest surprise of the year was how little genuinely happened, at least compared to what some had expected. While many foresaw sweeping changes with the arrival of the Trump administration in Washington, shockingly little was accomplished, save of course for the tax reform bill at the end of the year. Others believed 2017 would mark further victories for populist politics, and while some symbolic wins were seen, the election of Emmanuel Macron in France and the reelection of Angela Merkel in Germany suggested that the establishment was less threatened than previously thought. Geopolitical risks were also seen as a potentially destabilizing force, and while there were certainly some unsettling situations, none were dramatic enough to weigh on markets for any length of time.
Indeed, though many had feared otherwise, this year proved to be a remarkable one for risk assets. U.S. equities posted their best gains since 2013, while indices in both developed and emerging markets posted impressive returns. Meanwhile, the Federal Reserve continued along its path towards normalizing monetary policy, raising rates three times, the most moves in any year since the financial crisis. The Bank of England raised rates for the first time in more than a decade, and the ECB, though leaving rates alone, did begin to reduce the scale of its quantitative easing program, suggesting a move towards tighter policy in the future. Such moves certainly made sense, given the reacceleration of global growth we encountered in this year. Though the recovery in the US has been steady for some time now, Europe finally saw a year in which the woes of the sovereign debt crisis did not show up in the headlines, and economic fundamentals actually showed signs of sustained improvement. Meanwhile, emerging markets recovered as commodity prices stabilized, and fears over a slowing Chinese economy abated. Against such a backdrop, one could easily make a very constructive case for risk assets going forward.
…In a More Fragile Environment
However, one must also recognize that this bull market has now lasted nearly nine years. In that time, there have been plenty of instances where we have expressed our concerns about stretched valuations, loose credit conditions and risks both macroeconomic and geopolitical in nature. While the Federal Reserve has continued to tighten monetary policy, and it seems other major central banks are not terribly far behind, not much changed this year to reduce our worries about the current environment.
While this year’s equity market gains were somewhat justified given improved macroeconomic fundamentals around the world, the fact remains that equity valuations, especially in U.S. markets, are elevated. These conditions have buoyed private markets as well, despite some public write-downs of high profile private companies by major institutional investors. On the credit side, lenders have continued to demonstrate a willingness to underwrite loans to risky sovereigns, corporates and individuals. All of this has occurred amidst an improving macro outlook globally, but one rife with geopolitical risk. While none of this represents much of a departure from recent years, we felt that the persistence of these trends provided grounds for further reflection when it came to managing risk.
As such, much of this year was spent seeking to take a more defensive positioning in client portfolios, concerned not only about one-off, macro or geopolitical events, but also about the increasing exuberance in markets we have referenced for some time. While in some cases, we explicitly reduced our allocation to equities in favor of other assets, we also actively made some decisions that sought to reduce the risk exposure of the specific equities themselves. Several of the names we own have received takeover bids, and while some of these transactions have advanced further along than others, we consider such positions to have somewhat lower market risk than normal. In addition, though we have lamented the dearth of compelling opportunities in equities (particularly in the U.S.) for some time, in the rare instances in which we were buyers this year, we elected to add to more defensive names, without compromising our diligence process in terms of identifying long term investment potential. Overall, while we sought to avoid an outright increase in our allocation to cash, we did feel this year marked a prudent time to reduce our risk exposure in a measured fashion.
Typically, such decisions can be rather painful in an environment like this. A move to a more guarded stance amidst rising equity markets usually results in a drag on performance and, psychologically, a feeling of missed opportunity. Yet surprisingly, these moves did not prove to create much of a headwind, if any, for client portfolios. While we would love to simply attribute this to our diligence when it comes to equity selection and asset allocation, we know that this is not the case. Though we remain confident in our investment methodology, we recognize that its inherent discipline will often come at a temporary price, in the form of relative underperformance during extreme market rallies. However, this year proved to be the exception to the rule, with our decisions to reduce portfolio risk proving far less costly than history, or intuition, would suggest. At first glance, one could consider this to be a “pleasant” surprise, the lack of consequence to our actions has given us reason for further pause.
As markets continue to move upward, and even more risk conscious investors such as ourselves enjoy impressive returns, we believe it may be time to recognize that the cycle may, finally, be reaching its later stages. Many of the typical indicators of such a period are making themselves apparent, especially in recent months. Though equities have moved higher for years now, these updrafts have been more pronounced as of late, and investor sentiment, especially on the retail side, has improved dramatically. On that note, there has certainly been increased interest on the part of the general public in this rising market. While equity indices have broken several records over the course of this bull market, there has certainly been an increased amount of media attention on these milestones lately, and whether looking to hard data or anecdotal evidence, the topic of the “stock market” seems to be coming up ever more frequently. If history is any indication, this renewed interest is likely a safe sign that markets may well be starting to show signs of age.
With that being said, while downside risks compound during this period, so too do upside risks. Quite often, towards the end of the cycle, increasingly irrational behavior can cause markets to experience dramatic moves upward, making an adherence towards discipline a rather tall order. However, given its rarity in such times, we believe discipline can be the most valuable asset of all. On the one hand, we feel that our portfolio continues to be well leveraged to more robust global growth, and should this persist, we believe we will stand to benefit. In addition, it is our intention to more actively seek out opportunities which lie outside of the U.S., given the more compelling valuations in both developed and emerging markets. Yet at the same time, we believe that it is important to continue to be mindful of the current elevated risks at this stage in the cycle, and as we have done over the past year, we intend to continue to assess our exposures with that in mind. While we would not, at least at this time, advocate for a flight to non-equity assets, much of our recent work has focused upon putting a plan in place for how best to navigate a potential dislocation. Periods such as these can be especially challenging, but we remain confident in our positioning, regardless of where markets may be heading.
No matter what this year has in store, we feel communication will be very important, and it is our intention to keep you apprised of any changes we see in this market environment, and how they relate to our strategy going forward. With that said, if you have any questions about the positioning of your portfolio, or wish to hear more about our views on this year and beyond, we strongly encourage you to get in touch and set up a time to talk.
As always, we thank you for your continued support and trust, and wish you all the best for 2018.