The Latin phrase "omne trium perfectum" translates to "everything that comes in threes is perfect." Closely related to this dictum is the "rule of three" writing principle which holds that things that come in threes are funnier, more satisfying, or more effective than other numbers of things. Who hasn't heard of the Three Musketeers, or The Three Stooges - Moe, Larry and Curly? Do you recall the public service message to "Stop, Drop and Roll" if your clothing catches fire?
This writing principle was even used by Charles Dickens in A Christmas Carol In Prose, Being A Ghost-Story of Christmas published on December 19, 1843. You'll recall that the protagonist of the novella Ebenezer Scrooge was visited by three spirits - The Ghost of Christmas Past, Present, and Yet To Come. With that as an introduction, we'll be covering three investment related topics on threes this month - hat tricks, third pillar, and three time Charlie.
When it comes to hat tricks or scoring three goals in one hockey game, no one accomplished this scarce feat more often than "The Great One" Wayne Gretzky. Gretzky holds the NHL record for most career hat tricks with 50 over his 20 year career. Mario Lemieux ("The Magnificent One") is in second place with 40 hat tricks over his 17 year career. In celebration of this rare event, hockey fans will typically throw their hats onto the ice after the third goal.
Gretzky also has an often repeated quote that describes how he played the game of hockey. This great one from The Great One was used by investment legend and "Oracle of Omaha" Warren Buffet in the aftermath of the global financial crisis in 2008 when he encouraged investors to buy equities in the market meltdown: "In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: ‘I skate to where the puck is going to be, not to where it has been.’ “
We're doing our best to follow The Oracle and The Great One's investment advice in these highly unusual times for global markets. You may recall that in last month's blog post "The Mortal Comedy," we highlighted a relative value opportunity in global equities and debt by recommending investors "maintain robust portfolios comprised of globally diversified baskets of assets with a sufficiently meaningful position in emerging market and developed international equities." Our recommendation was supported in part by Global Asset Classes: 10 Year Expected Returns from Research Affiliates.
It came as little surprise when Research Affiliates published an article shortly thereafter from Rob Arnott and Brandon Kunz on December 15, 2016, entitled "The Emerging Markets Hat Trick: Time to Throw Your Hat In?" The three factors supportive of the authors' bullishness on emerging market equities are summarized below in the closing paragraph of their piece.
"Most investors believe the best time to invest is when uncertainty is low and valuations are attractive. But these conditions rarely coincide with each other. Most investors opt for “less uncertainty” over “attractive valuations,” and end up chasing past performance along the way. We’ve often said bargains don’t exist in the absence of fear, and that fear is usually amply justified. For this reason, we believe the better approach is to invest in attractively valued assets while fear and uncertainty, although elevated, are beginning to fall. Such opportunities don’t present themselves very often. Today’s historically attractive valuations, deeply depressed currencies, and positive momentum—both price and economic—compose a very rare hat trick for emerging market equities, local bonds, and currencies, adding up to a region with strong potential for long-term outperformance. We’ve thrown our hat into the rink. Will you? (emphasis added)"
We believe that last month's blog article adequately covered the first "goal" of historically attractive valuations for emerging market equities. The chart below from the Research Affiliates' article demonstrates the second "goal" of deeply depressed currencies. Based on Research Affiliates' Purchase Price Parity (PPP) model, emerging market currencies are trading 19% below fair value with the U.S. dollar. PPP is an economic theory that compares different countries' currencies through a market "basket of goods" approach. Note from the chart that emerging market currencies, represented by the JP Morgan Emerging Local Markets Index Plus, continue to trade at discounts not seen since the 1997 "Asian Contagion" and 1998 Russian debt default.
Some experts have argued that these emerging market currency discounts will only widen with the U.S. Federal Reserve solidly in an interest rate normalization phase of monetary policy. Research Affiliates together with their partner PIMCO asset management recently looked at this issue and in their December 2016 commentary for the PIMCO All Asset All Access Fund stated that "We have several instances of rising interest rates since the 1994 tequila crisis. When we examine the historical relationship between U.S. interest rates and EM currencies, we find that modest rises to U.S. rates have been accompanied by stronger economic growth, declining volatility and rising FX rates, resulting in higher total returns to EM currencies (see Figure 1)."
Moreover, "As evidenced by Figure 2, the U.S. dollar has consistently depreciated versus an equally weighted basket of eight representative EM currencies in the months after the first hike of a monetary policy tightening cycle. The average exchange rate depreciation of the U.S. dollar versus EM currencies in the six months following an initial rate hike has been 4.5%."
Research Affiliates' conservatively estimates the potential value of this second "goal" for emerging market equity investors. "If EM currencies’ relative valuations strengthen just halfway back to historical norms, such a move would translate into a near 1.0% tailwind to yearly returns over the next decade." That per annum pickup is quite substantial in today's low return environment.
The third "goal" of this emerging market equity hat trick of positive momentum - both price and economic - is portrayed in the following chart. Research Affiliatess' "business-cycle slowdown probabilities for emerging market economies shows a 68% correlation with recent price momentum. As the probability of an economic slowdown falls, equity prices tend to rise and vice versa, suggesting the markets gauge future economic prospects as, or even before, they materialize." Emerging market economic slowdown probabilities have fallen from 2015 highs of 67% to a just above neutral reading of 54% in November, 2016.
We think this hat trick of favorable emerging market equity indicators highlighted by Research Affiliates is highly suggestive that the puck of global capital flows will soon be heading to the open ice of emerging market economies. The open ice is where The Great One scored.
Ever since the wildcard election of Donald J. Trump as our nation's 45th President we've been pondering and researching the potential impacts of his likely policy initiatives on the global economy and markets. Investors have made their initial bets on the impact of a Trump administration even before he has set foot into the Oval Office by bidding up domestic large-, mid- and small-cap equities with a clear tilt towards pro-growth/cyclical sectors. We believe a second derivative and perhaps a secular trend of a Trump Administration is the risk of rising inflation triggered by higher fiscal spending and protective trade policies. This potential inflationary backdrop has led us to research various asset classes that provide protection as inflation hedges - U.S. Treasury Inflation Protection Securities (TIPs), commodities, real estate investment trusts (REITs), floating rate senior bank loans (where interest rates are reset every 30 to 60 days), emerging market equities, debt (local and U.S. dollar based), and currencies.
Predictably, we ran across Rob Arnott again in our research and discovered that Arnott had previously referred to asset classes that provide inflation protection as the Third Pillar of investment portfolios. In a 2011 interview with Morningstar, Arnott described this Third Pillar asset class as follows:
"Investors should assemble a diversified portfolio of inflation hedges to provide a third pillar to their traditional allocations to stocks and bonds. The fixed-income markets offer a wide array of inflation hedging asset classes beyond the obvious foundation of inflation-linked government bonds. Short duration credit, floating-rate bonds, high yield, and bank loans all provide inflation protection. Local currency emerging-market bonds and commodities provide protection against both inflation and dollar depreciation."
In our initial research, we found that shorter maturity TIPs correlate more strongly with changes in inflation. In addition, compared to other inflation protection assets (gold, REITs, commodities, etc.) short-term TIPs have less volatility/risk while providing similar or higher inflation protection. We recently added iShares 0-5 Year TIPS Bond ETF (STIP) to Servant Financial model portfolios. In the meantime, we continue to conduct additional research on the potential open ice of Third Pillar asset classes.
Three Time Charlie
The third installment of this article is about three time Charlie, a young aspiring author of 24 who incredibly was able sell his first novel not once, not twice, but three times. The young author's name is Charlie Dickens the aforementioned author of A Christmas Carol. Charlie's first novel was The Posthumous Papers of the Pickwick Club (also known as The Pickwick Papers) published in 1846. Mr. Pickwick is shown chasing his hat in the original illustration above and this is the short story of young Charlie's hat trick.
The largely unproven young Charlie convinced his publisher to issue his first novel The Pickwick Papers in monthly series for a shilling each series. The book was completed in 20 parts with the last monthly issue a double series with two concluding parts, The shilling per issue price is equivalent to $100 or more for the entire novel in today's prices.
While the first three monthly parts sold only a few hundred copies, Charlie's final installments sold approximately 40,000 copies. Every Londoner seemed to be reading this young publishing sensation of the century. Immediately after the novel was completed, Charlie’s publishers issued the complete book in a cloth case-binding so that true Dickens' aficionados could prominently display The Pickwick Papers on their book shelves.
Charlie and his publisher quickly discovered that the first editions in the original series issue were in great demand by rabid Dickens' collectors so they began to repurchase the individual 20 part first edition series. Next, they charmed connoisseurs of this scintillating writer of comic prose with a splendid repackaging of the original 20 series edition in a smartly bound leather Collector's Edition of The Pickwick Papers for their third sale. And that my friends is the story behind "three time Charlie" and his legendary "hat trick."