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Fireside Chat

Eric Freedman
CAPTRUST Chief Investment Officer

Hunter Brackett, CFA
Senior Manager | CAPTRUST Consulting Research Group

2014’s polar vortex, which extended from just east of the Rocky Mountains to parts of central Florida, represented the most severe cold snap in over 15 years. The chilly air prompted us to engage CAPTRUST Investment Committee members Eric Freedman and Hunter Brackett in a “fireside chat,” where we sorted through some of the more frequently asked client questions regarding the current economic, political, and capital market environments.

Q: After such a strong run in global stocks last year, what should my return expectations be
going forward?

A: We retain a favorable view on global stocks, particularly in the U.S., Japan, and parts of Europe, but believe that last year’s pace is unsustainable. Our longer-term capital market assumptions factor in a high single-digit return expectation for global stocks over a full market cycle, which historically has been a five- to seven-year period. We are more comfortable with a longer-term forecast than a shorter-term guesstimate, but we would not be surprised to see stocks 8–10 percent higher at the end of this year.

Q: What about bonds? Everyone talks about interest rates heading higher; doesn’t that mean bond prices have to go lower? Why should I still own them in my portfolio?

A: Bond prices and bond yields do move in opposite directions. However, just because bond yields increase does not mean that a bond portfolio will lose money. If interest rates move up at a measured pace, cash payments to bondholders can offset the negative impact that rising yields can have on a portfolio. Several time periods exist when bonds delivered positive total returns despite interest rate increases. CAPTRUST expects interest rates to gradually increase versus a sharp move higher.

The broad portfolio question is a timely one. It’s basketball season, so let’s use a team analogy. All of the asset classes in your portfolio serve different roles: some are there to score points in the form of primary total return drivers (equities and riskier parts of the bond market like high yield), while others are better at playing defense (traditional bond sectors like government bonds or cash). 

Bonds have traditionally benefited portfolios during periods of general economic stress, such as deflationary periods, weak gross domestic product and corporate earnings cycles, and other times when investors seek safety. Since no one rings a bell just before a risk event or period occurs, we always want to play some degree of portfolio defense. We recognize that interest rates are near historically low levels, so the right kind of bond market player should remain on the court. We have worked to incorporate bond strategies that can both provide defensive properties and not be overly susceptible to general interest rate movements. These are hard players to find in the current environment, but we have found several that have been helpful thus far, and we expect them to be in the future.

Q: How important will central bank activity be this year? Was that more of a 2013 story?

A: Central bank activity, particularly in U.S., Japan, and Europe, will remain the biggest market driver this year as governments seek to nudge growth higher but not create adverse side effects. Note that the major central banks have divergent intentions: the U.S. is paring back stimulus, Japan continues at a high level, and Europe remains more wait and see. While the U.S. Federal Reserve began its “tapering” process, or gradual slowdown to its bond buying program, it made clear (as clear as central bankers can be) that future Fed action is highly data driven, not on a preset or period-certain path. The U.S. economy has demonstrated recent strength, yet the Fed acknowledges that the recovery remains somewhat fragile. Japan continues to use unconventional methods to fight deflation, resulting in sharp movements in its stock market. The European Central Bank (ECB) has not committed to a formal asset purchase program to stoke growth, instead relying on low interest rates. Many analysts do not expect the ECB to stay on the sidelines for much longer. We see central banks retaining an accommodative stance as the year unfolds, a key tenet of why we favor global equities.

Q: Aren’t you worried about inflation if the Fed continues to provide stimulus? Weren’t low interest rates for too long a significant contributor to the 2008–09 financial crisis?

A: The financial crisis was caused by lots of variables. Low interest rates certainly enabled excess lending and borrowing. However, while we agree that financial history has an uncanny habit of repeating itself, we are not yet seeing borrowing and lending trends at alarming levels. Some credit growth is a healthy and necessary agent to keep the economy expanding, and while some regions are seeing excess credit extension, like the Chinese residential property sector, Europe saw bank lending to corporations shrink at its fastest pace in history in late 2013.1 The U.S. has seen improvement in general consumer leverage trends, with many households improving their personal balance sheets. According to a 2013 Federal Reserve Bank of New York study, since 2008, households have trimmed almost $1 trillion of debt, showing some resolve in learning from past mistakes.2

Inflation remains, as we have termed it for almost six years, a “high-class problem.” Figure One graphically combines a gauge we use to assess investors’ inflation expectations with the Fed’s preferred tool for assessing actual consumer inflation. While inflationary expectations (blue line) have picked up since the 2008–09 financial crisis, they are currently below, but have trended near, the Fed’s long-term 2 percent inflationary target. Actual inflation (red line) increased to the Fed’s 2 percent comfort zone in late 2011/early 2012 but currently sits well below that target. We agree that low interest rates can contribute to inflationary pressures, but with major economies like the Eurozone, China, and Japan all growing well below their long-term trends, we are less concerned about inflation picking up for at least the next 12 months, which is when the U.S. Federal Reserve is expected to start raising interest rates to combat that very development.

Q: On the topics of China and emerging markets in general, emerging market stocks had been very strong performers for a long time but have been more disappointing lately. What do you think about them now, and why have they lagged?

A: Emerging market stocks have been the last 10 years’ star performer, returning almost 200 percent cumulatively since 2004 and 11.5 percent annualized, while U.S. large-cap and international developed stocks (as measured by the S&P 500 and MSCI EAFE indices, respectively) are up just over 100 percent. Despite a solid 2012, the last three years have been unkind to emerging market stocks. Valuation concerns, unstable currencies in the face of rising U.S. interest rates, policy makers unable to attract stickier foreign capital, and falling Chinese growth rates — reflecting that the “low-hanging fruit” attached to their shift from rural to urban areas has been realized —are all reasons for recent weakness.

We do find valuations becoming increasingly attractive in emerging markets, but our primary concern in the near term is that these assets have become increasingly sensitive to U.S. interest rates. When U.S. interest rates rose sharply last year from early May to early September, emerging market currencies, bonds, and stocks all fell. We don’t expect such a sharp interest-rate rise again this year, but even a gradual move higher may rattle investors despite attractive historical valuations.

Q: Having a diversified portfolio doesn’t seem to be working as it has in the past. Does diversification still work, or should I narrow my holdings to just a few asset classes?

A: That question reminds us of the old Warren Buffett quote, which goes something like “never ask a barber if you need a haircut.” Since we spend a lot of our time on asset allocation work (and enjoy our jobs), our natural inclination is to say definitively “yes.” Clearly the past few years have been very narrow in terms of what asset classes have worked, especially across larger and more liquid markets; meanwhile broad commodity and hedge fund indices have delivered disappointing absolute returns.

However, over longer periods of time, diversified portfolios have trumped narrower, domestic-only portfolios in delivering both better absolute and risk-adjusted returns. We are certain that one could counter that claim by showing an arbitrary period of time when it was not the case. But even over the last 10 years, when we have seen U.S. stocks rise by over 100 percent and U.S. bonds rise by over 50 percent, a diversified portfolio handily outperformed a 60/40 or 50/50 mix of U.S. stocks and bonds. A diversified portfolio also adds value by lowering return volatility: by dampening portfolio movement, a portfolio can compound more consistently, benefiting total returns.

Q: Finally, the two of you like rival ACC basketball teams, yet your offices are in close proximity to one another. How are tensions this time of year?

A: Eric: No tension. Very amicable relationship. I washed Hunter’s car yesterday as an olive branch.

Hunter: Ask me again in April. 

Sources:

1 http://www.ecb.europa.eu/press/pr/stats/md/html/index.en.html
2 http://www.newyorkfed.org/research/current_issues/ci19-2.html

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