Fourth Quarter 2017 Research Q&A

Each quarter, we address questions from clients and advisors about our investment views, long-term strategy, and current positioning. Below, we discuss inflation, a curve-steepening fixed-income scenario, the U.S. dollar’s valuation, the effect of rising rates on arbitrage, and the recent performance of major equity factors and styles.

Inflation

In your scenario analysis framework, are you considering any sub-scenarios where inflation rises faster than the market expects? If so, does that scenario have enough weight in your minds to impact expected risks or returns or be explicitly modeled out?

It’s always critical to ask the question, what does the market expect? What is being discounted in current market prices? While it’s a key question, there’s never a simple answer. In terms of inflation, you can look at market-based measures of inflation expectations and see they have moved higher over the past few months. By market-based inflation expectations we mean metrics such as the 10-year break-even inflation rate, which is based on TIPS and Treasury yields, or five-year forward inflation expectations, which the Federal Reserve frequently refers to.

Those metrics now indicate inflation expectations of around 2% or maybe a slight bit higher. You can also look at survey-based measures of shorter-term inflation expectations (e.g., the University of Michigan survey of 12-month inflation expectations). Those have remained pretty stable at around 2.5%.

That type of 2% to 2.5% inflation expectation is consistent with our base case five-year scenario. But our assumption that the 10-year Treasury yield will end that period at around 4% is more important for our analysis than the inflation number. We’re baking in a pretty meaningful increase in Treasury yields from their current 2.5% to 2.6% level. Even with the fairly mild inflation expectations implicit in that scenario, we’re assuming real yields are going to increase from current levels. Now it may be the case that real yields don’t meaningfully increase, but instead inflation is higher and that could still lead to the 10-year yield rising to around that 4% range.

So, our base case scenario for bonds does incorporate a scenario where inflation is at least somewhat higher than the expected 2%, and this is reflected in our 10-year Treasury yield assumption of around 4%. Our bull case scenario assumes the 10-year Treasury yield ends the period in the ballpark of 6%. This scenario would also be consistent with a period of higher than expected inflation driving yields that much higher.

More broadly, it’s important to point out that our main focus in terms of managing our tactical active portfolios for inflation risk is via our tactical fixed-income positions. Those are the positions in absolute-return-oriented and flexible bond funds and our dedicated position in floating-rate loan funds, which together comprise about half of our overall fixed-income exposure. Those non-core bond positions would probably benefit in absolute terms from higher inflation, and they should definitely outperform core bonds in relative terms in that case. In addition, our alternative strategies holdings would likely benefit from or at least not be meaningfully harmed by rising inflation and rising interest rates.

And then on the equity side, we’d expect the reflationary environment to be a tailwind for many cyclical and more economically sensitive stocks, which are generally more heavily owned by our active, value-oriented managers. We saw this play out strongly in late 2016 after the Trump election. But that largely reversed last year.

On the other hand, the so-called bond-proxy stock sectors such as utilities, REITs, and consumer staples would be relative laggards in an inflationary environment. And, to generalize, those sectors and areas of the market are ones that most of our active managers do not find attractive right now, and they are typically underweight to them. So, an inflation environment should be more of a tailwind for our active managers in aggregate.

Finally, a reflationary environment could be relatively beneficial for emerging-market stocks and possibly European stocks, broadly speaking, compared to U.S. stocks, given these foreign markets tend to have more economically sensitive companies. While we would not be surprised to see inflation surprise the consensus at least somewhat on the upside, and we believe our portfolios would perform well if that did happen, we don’t see a meaningful risk of an outbreak of high inflation on the horizon. As we’ve discussed before, there are still a lot of structural longer-term disinflationary forces in the global economy, even if cyclical economic factors appear to be moving toward increasing inflationary pressure.

Our Portfolios in a Curve-Steepening Scenario

What do you envision happening to your investment portfolios in a curve-steepening scenario where the short end of the curve moves up as the Fed slowly increases rates, while the long end of the curve rises meaningfully?

To begin, we’ll note that over the past several years, we have reduced our portfolios’ duration by tactically reducing our longer-duration core fixed-income exposure, thereby reducing our risk to higher longer-term rates—the 10- to 30-year part of the curve. Most of the reallocation has been to shorter-duration, higher-yielding credit strategies such as short-dated high-yield and floating-rate loans, which are more impacted by changes in short to intermediate rates. We have also allocated to flexible bond funds that we have confidence can successfully navigate credit and interest-rate risks.

The piece of the portfolio that would be most impacted under the suggested scenario is our core bond exposure. But the core bond funds we own have slightly shorter durations, higher yields, or both.

So if long rates were to move up today, the overwhelming majority of our fixed-income exposure would not be greatly impacted, and we’d expect our portfolios to meaningfully outperform the Bloomberg Barclays U.S. Aggregate Bond Index. Lastly, while the core bond components of our portfolio could be negatively impacted by rising long-term rates, they do serve as ballast in the event of a risk-off environment, so they are key pieces of our portfolio construction.

THE U.S. DOLLAR AND OUR EUROPE OVERWEIGHT

Will you please share the team’s opinion on the U.S. dollar? Is there still an agnostic approach to the euro? Any thought of adding back your dollar-hedged European stock position?

Based on purchasing power parity (PPP), the dollar appears only slightly overvalued versus its six major trading partners’ currencies, according to Ned Davis Research. Using PPP versus the euro, which rose strongly against the U.S. dollar in 2017, the dollar is roughly around fair value. As such, we think the risks of the euro appreciating or depreciating versus the dollar are roughly equal from here. On the other hand, the British pound, the other major currency in Europe, looks slightly cheap versus the U.S. dollar. Overall, we do not see the need to hedge our currency exposure stemming from our overweight to Europe.

Our default position with the Europe fat pitch is to be unhedged, unless we see a material risk or high probability of the euro depreciating. We believed this risk to be material when we initiated our Europe relative fat pitch back in the spring of 2015, so we hedged half of the currency exposure we were getting from our European overweight. But in the summer of 2017, with the economic growth outlook improving, the euro’s then cheapness on a PPP basis, and the political/populist risks subsiding, we went fully unhedged.

Our timing in making this currency move was fortuitous and not something we expect to do consistently. We acted only after we saw the weight of the evidence suggesting the risk of a declining euro had subsided. To illustrate why we do not have confidence in making correct currency calls on a consistent basis, we’d point to last year. Hardly anyone expected the euro to appreciate, with some predicting it would go to parity with the U.S. dollar. Meanwhile, given the Fed was raising rates while the European Central Bank was staying put, most investors strongly believed the dollar would appreciate in 2017 given its attractive carry. But instead the dollar declined.

To reiterate, at this point we are not thinking of hedging our euro exposure, though it’s of course possible the euro may weaken and detract from returns in the short term. We expect this ebb and flow from currency exposure as a natural part of investing outside the United States, and it’s one of the factors in our decision to tactically overweight Europe. Over our five-year tactical horizon, we expect most of the outperformance versus the United States to come from local European equity returns, but we will not be surprised if we get some currency benefit too, because currencies can get out of sync with their long-term PPP valuations for long periods.

ARBITRAGE AND THE RISK-FREE RATE

As the risk-free rate rises with the FOMC hikes, do you expect a meaningful performance boost to the arbitrage strategies such that it could impact expected future returns in your bull case scenario? If not, is it because of very low starting levels, or just that it’s not a large factor on expected returns for the strategies? Also, what if M&A were to dry up but the risk-free rate kept increasing? How might that impact future expected returns?

All things being equal, we would expect rate hikes to boost returns for arbitrage strategies since the risk-free rate is part of the driver for arbitrage strategies. However, merger spreads, for example, aren’t dramatically different. A major part of that is due to the continued ultra-low volatility environment that’s working in the opposite direction, keeping spreads tighter than they might otherwise be and valuations high for almost all assets. We’ve been among many who have said that this low volatility environment can’t last forever, but we obviously don’t know what the catalyst will be for it to change. When it does change, it could change dramatically and rapidly, as many of the strategies that have been implicitly or explicitly shorting volatility will choose to or be forced to reverse course. That wouldn’t feel good as it happens, but it would be helpful in setting the stage for a healthier pricing of risk and allowing managers that had been positioned conservatively to take advantage of a more “normal” environment, including wider spreads. In the meantime, as arbitrage manager Water Island has recently observed, there are some advantages to a continuing bull market in terms of reduced downside to deal breaks if the market and sector have gained significantly between deal announcement and deal break, which allows arbitrageurs to be slightly more aggressive in their positioning. There’s also the increased potential for topping bids or activists pushing for higher prices if a sector has run up significantly enough that original deal terms don’t make sense on a relative value basis for the shareholders of target companies.

To answer the second part of the question, obviously M&A drying up is a negative for arbitrage, while rates rising (at a controlled pace) is on balance generally good, although it has the potential to impact financing cost and availability, which could make acquirers less aggressive in the price they can pay. And then you have the issue of volatility and general risk appetite in the market, which in the short term can swamp all the other factors. So it’s hard to say without knowing more about what the environment looks like, but more M&A is better of course.

EQUITY STYLE AND FACTOR TRENDS

As you pointed out in your year-end commentary, growth or momentum continues to trounce value from a style perspective and from a size factor, large outperformed small. Do you or any of the active managers you speak with see these trends being reversed due to fiscal stimulus, tax reform in the United States, or any other reasons?

We haven’t gotten any comments specifically on this from our active managers, so we don’t have anything to say on that point in terms of their view. There’s certainly a reasonable narrative that says, broadly speaking, small-cap companies stand to benefit more from the corporate tax cuts than large-cap companies because smaller companies currently have higher effective tax rates, so the tax cut will be more meaningful for small caps’ after-tax profits. Ned Davis Research estimated that tax cuts might cause roughly an 11% increase in earnings per share for the S&P 500 Index in 2018. And they estimated roughly a 30% increase for the S&P SmallCap 600 Index. There is clearly a meaningful difference there.

In terms of value versus growth stocks, we made the point earlier that a reflationary, higher GDP growth environment is generally more favorable for cyclical and economically sensitive stocks, all else equal, and those types of stocks tend to be more widely held in value indexes and by value-oriented investors. So, there’s a potential for that thesis to play out, but the earnings growth for those types of companies will ultimately have to come through to justify any stock price increases. We aren’t betting on either of those things playing out for small caps or value stocks. And while the thesis and narrative seems logical and makes sense, the market isn’t supporting it so far this year, with value and small-cap stock indexes still underperforming.

The other part of the question was about a possible fat pitch in value versus growth. The current environment is unlike the late 1990s or early 2000s, when we had a significant underweight to growth stocks and were overweight to value and small-cap stocks, REITs, and more yield-oriented stocks. That was a market where there was an extreme bifurcation. Anything tech was outrageously overvalued, far beyond what current valuations are. Anything bricks and mortar was hated. Then, certain areas were, to our analysis, clearly undervalued, while others were ridiculously overvalued. Right now, regardless of the disparities and differences between styles, the market overall looks expensive. We’ve talked about median price-to-earnings ratios being at all-time highs or near all-time highs, but there’s not such a clear “out of whack” disparity between value and growth from a valuation perspective.

In addition, in our actively managed portfolios, we’re seeing our value managers own “growth stocks,” names like Amazon.com, Netflix, Apple. So, neither we nor our managers think of value and growth in the black and white terms with which the Russell 1000 Index defines them.

Those are some of the factors that go into the reason that we’re not looking at value as a fat pitch right now, even if we think value’s probably due for a relative run of outperformance. Lastly, we’ll reiterate the point that we already have a value bias in our active portfolios based on the types of managers that we own. So we should benefit from that as it is, without making a tactical shift.

—Litman Gregory Research Team (1/29/18)

 

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