by Eric Freedman
Explanations tidy up our lives. Assigning labels organizes everything from our garages to our computer files. Explanations provide justification, assign credit or blame, and help compartmentalize what causes certain events to occur.
When Jordan Spieth finished his first nine holes at Augusta National on April 10, he held a five-stroke lead. He bogeyed the next two holes. The second came on the hardest hole on the golf course, so the result seemed justified. But when Spieth, a professional golfer with two major championships under his belt, hit two shots into fabled Rae’s Creek on the par-three 12th hole, TV broadcasters, social media, patrons at Augusta, and living rooms around the globe sought explanations. After watching Spieth hit his second golf ball into the water, a dumbfounded three-time Masters-champion-turned-broadcaster Nick Faldo struggled to explain what he was witnessing, saying “[Spieth] turns and walks to the 10th tee … and we can hardly get our superlatives to mark this man’s incredible achievement, and then he goes bogey, bogey, and we don’t know what.”
Two of our kids play competitive golf, and I know from being a spectator and occasional caddie that many variables can affect a golf shot. Some are external to the golfer (e.g., temperature, wind, moisture, and elevation). Others are caused by the golfer (e.g., shot strategy, swing speed, club path, heart rate, and commitment to the shot). This cursory list only scratches the surface of what can impact results, but these variables interact with the laws of physics to produce outcomes, whether birdie, bogey, or the dreaded “other.” Even players themselves may not know definitively what causes an outcome.
Investment outcomes are also subject to these two conflicting forces: variable interaction and the need for explanatory narratives. Factors impacting a given asset class’s performance are nearly infinite. Take emerging market stocks, for example. A simplistic narrative that you may find in the headline of a popular publication may read something like “Emerging Market Stocks Decline on Currency Concerns.” While the headline satisfies our need for an explanation, it likely oversimplifies the cause. Emerging market stocks span many geographies, so a singular cause is unlikely. The reason currencies moved is also uncertain. They, too, are subject to interacting variables that a simple headline cannot capture. In a world of shortened attention spans and bite-sized content, we may be oversimplifying at the expense of true causal understanding.
In this Investment Strategy, we will explore what actually is — with little time spent on how we got here. So, first, let’s get the “how” out of the way.
Figure One: High, Low, and Current 10-Year Government Bond Yields (since 2012)
We have contended for several years that central banks’ desire to restrain borrowing costs to stoke economic activity and consumer spending has been a key market driver. We have shown the relationship between the U.S. equity market and the Federal Reserve’s balance sheet. We have also detailed how significant the Federal Reserve and other central banks have been in certain bond markets in which they are making purchases.
Irrespective of whether you accept this narrative, price trumps all. Comparable to the popular golf phrase “there are no pictures on scorecards,” market values reflect all the variables that surround them. Let’s first take a look at the bond market.
As you can see in Figure One, we have plotted current 10-year government bond yields from major economies and their ranges since the end of 2012 — almost three and a half years of data. Government bonds are considered the safest of yields, since they have lower credit risk than companies; governments have the power to tax whereas companies do not. They tend to be the starting point for many borrowing rates, like mortgage rates, so when central banks want to stimulate the economy, bond buying is a perceived effective tool.
Most importantly, government bonds are the cornerstone of modern finance. They are the building blocks for all other asset prices, with U.S. Treasury bonds crowned as the vaunted risk-free rate. The U.S. government’s payment to creditors is a near certainty since the U.S. has both taxation powers and the world’s strongest military. Asset prices move up in risk and expected return based on what government bonds, specifically those issued by the U.S., yield.
Two things stand out from Figure One. First, in and of themselves, global bond yields are extremely low. Lending to the U.S. government for 1.85 percent per annum for 10 years seems low. But that 1.85 percent appears juicy relative to Germany (0.15 percent) or the negative rates in Japan and Switzerland. Second, interest rates are either at or very close to their lowest levels, despite several years of economic healing since the financial crisis. Again, irrespective of the narrative behind how they arrived there, global interest rates are at historically low levels.
Analyzing global stock market scorecards is a little trickier. Major stock market indexes provide some information, but the best scorecard is corporate earnings. Stocks represent a claim on a company’s bottom line, and equity markets reflect what investors are willing to pay for those earnings. To be sure, stock prices can fluctuate (think of extremes during the dot-com era), but earnings are earnings. While many use forecast numbers, they represent expected earnings — not what will actually be posted. Earnings forecasts are just like expectations on the first tee: I think I may shoot a 75 today, but I will know for sure only after I play all 18 holes.
Figure Two shows actual earnings by month for four major equity indexes since March 2000, more than 16 years of data. The S&P 500 represents U.S. stocks, the MSCI EAFE index represents developed market international stocks (mainly Europe, the UK, and Japan), the MSCI EM Index represents emerging market equities, and the MSCI World is a proxy for all global stock markets.
Figure Two: Actual Earnings March 2000–May 2016 (in Dollars)
We see three key conclusions from this figure. First, earnings tend to trend in the same direction, emphasizing an interconnected global economy. Second, the only region that has reclaimed earnings levels achieved before the financial crisis is the U.S. Finally, earnings for all four indexes have been trending lower, not higher. Emerging and international developed markets show the steepest decline since their post-financial-crisis peaks. Note that for the U.S. equity market, dating back to the March 2009 equity market lows, the S&P 500 has rallied 232 percent over the past 87 months. Since 1928, bull markets have averaged 57 months in length and 165 percent in total return, so this equity market move has been bigger and longer than all but two others: the post-World War II period from 1949 to 1956 and 1990 to 2000, which ended with the dot-com bubble burst.
Setting aside the narratives for how we got here, markets reflect bond yields at all-time lows, stagnant or falling earnings, and at least one major market in a lengthy bull market with few pullbacks along the way. This is not the best setup for investors already frustrated by low returns over the past three years. I wish I could provide a more elegant synopsis, but looking at the scorecard offered by bond yields and earnings, the current challenging investment milieu is the inelegant truth.
While we continue to forecast a low-return environment, we do see some positives in the charts shown, particularly with respect to global equities. Japan’s demographic challenges will be hard to combat, but European and emerging market earnings have considerable room for improvement. In other words, companies’ better days are likely ahead of them, not behind them.
We respect the chance for a recession in coming years, but expect that the same central banks that have driven asset prices will remain accommodative. After several years of concerns about emerging markets, we are starting to see evidence of structural improvement. We also note that energy market disruption has led to opportunity in the high yield bond market. Attractive investment options exist, but we remain steadfast. Given low bond yields, investors must ratchet down their return expectations.
I have never had the pleasure of meeting Jordan Spieth, but as a golf parent and occasional caddie, I remain impressed with his poise and sportsmanship following that Sunday’s events. When asked about what happened, Spieth provided his own narrative, highlighting that he “just put a bad swing on it at the wrong time” and had a “lapse in concentration.” His willingness to speak with reporters immediately after the round, stay for the awards presentation, and give additional interviews provides a clinic in honesty, forthrightness, and dignity. The outcome was not what the old soul that is Jordan Spieth wanted, but his post-round character sets an example for all narratives; we can only hope to follow his lead.
To that end, while we wish the current capital market setting were more robust, we remain in an inelegant world with low expected returns. Nonetheless, we are seeing opportunities and working hard to find more, paying attention to risks and fees.