Extreme Financial Games

 

A hedge fund that I oversee for my family office client had the following energizing comment in the fund's most recent quarterly letter:

There is no secret sauce for successful investing beyond a proven process and humility.

Certainly a number of hedge fund managers have been humbled recently by persistent underperformance against the S&P 500 as this unmanaged index marches ever higher.  For example, the Dow Jones Credit Suisse Long-Short Hedge Fund Index has gained only 4.3% year-to-date through September 30, 2017 compared to a total return of 14.1% for the S&P 500.  Despite the generally exorbitant compensation in the industry, I have some empathy for hedge fund managers that have consistently underperformed the S&P 500 because they've employed a risk mitigation, hedging discipline of shorting richly valued stocks (a bet that a stock price will go down) with flawed or failing business models and/or inferior management.  You lose money shorting a stock if it rises in price for speculative, technical, or other reasons despite its rich valuation and perceived poor fundamentals.  This year a broad swath of hedge fund managers' egos have been left dazed and confused by the irrationality of today's markets.

I believe the hedge fund manager's reference above to a "proven process" is a reference to the proving grounds of a sustainable investment approach of performance measured over a full market cycle - both bull and bear phases.  The rigor and discipline of an investment process is only truly tested in a period of bearish market volatility and declining prices.  Like great women and men, it is in the trial that an investor is made.  Just like precious metals in a furnace it takes intense heat and pressure to reveal the inherent beauty and shine of an investment process.

Since its founding in 2005, Servant Financial's primary investment objective has been to take a risk aware approach to preserve client capital and maintain the real value of portfolios while growing capital over the long-term.  Our investment strategy provides for the essential tenets of a fiduciary driven approach by providing broad diversification, low transaction costs, low portfolio turnover, and tax efficiency.

We achieve these investment objectives through risk-based asset allocation and a core passive index strategy.  We overlay active management elements through a relative value discipline among asset classes and employing select active fund and stock selections.

As we've written about frequently in the past, investors have generally been penalized for taking a global, broadly diversified investment approach.  Simply stated, with the benefit of hindsight investors would have significantly outperformed by being solely long U.S. equities over the last eight years.  This issue was explored in a recent article from PIMCO entitled "Are Diversifying Assets Up Next In The Return-Seeking Cycle?".  The article cites some stark comparisons of performance across asset classes:

Since the lows of the global financial crisis in March 2009, U.S. stocks (proxied by the S&P 500) have returned 270%, or 16.8% annualized, outpacing every other major market over that period.  Contributing to that outperformance were highly differentiated returns among asset classes, particularly in the three calendar years following the “taper tantrum” sparked by comments from then-Fed Chairman Ben Bernanke.  Starting in 2013 and through 2015, the S&P 500 Index gained 52% cumulatively, whereas core bonds returned 4% (proxied by the Bloomberg Barclays U.S. Aggregate Bond Index) and an equally weighted basket of diversifying assets actually lost value, returning −12%.  In other words, diversifiers lagged U.S. stocks by 64% for the 2013–2015 period.

Futurist and inventor Elon Musk's statement that "There's a one in billions chance we're in base reality" immediately came to mind.  In summary, Elon took game theory to the next level when he stated that he believes we are living in some advanced civilization's computer simulation.  Essentially, the world in which we live is the ultimate in fake news and our markets are a form of entertainment called extreme financial games.  When one looks at this issue through the lens of valuation, I think there is something to be said for Musk's argument that U.S. equity markets are some form of computer simulated entertainment.  

Within this realm of extreme financial gaming, Servant's investment process has been dynamic and interactive and has consistently included forward-looking expected return inputs to supplement the longstanding investment advisory practice of using past returns to forecast future returns.  Research Affiliates recently posted an article entitled, "The Most Dangerous (and Ubiquitous) Shortcut in Financial Planning" - using historical returns to forecast the future is the shortcut methodology.  I'm unsure who is the puppet master in this extreme financial game, but I'd like to use the rest of this feature article to update investors on S&P 500 valuations and expected future returns by summarizing the work of three investment research firms that we religiously follow that use forwarding-looking return forecast models.

The first research firm expected return forecasts we'll look at are from GMO.  GMO is a global investment leader with expertise in managing multi-asset class strategies as well as focused strategies in a number of specific asset classes.  GMO's investment approach seeks to identify asset classes and securities where investors are paid to take risk and utilizes a long-term investment horizon, a belief in the power of mean reversion, discipline, conviction, and a commitment to research (emphasis added).  As we've covered in the past, mean reversion is a key assumption in GMO's asset class forecasts. GMO assumes asset class valuations will revert to their historical mean valuation levels over a 7 year forecast period.  For the S&P 500 this approach implies that GMO expects that the current Shiller price to earnings (PE) of ratio 31.3 times at the 100th percentile of its historical valuation range would revert to approximately the 50th percentile over the next 7 years.  In other words, the lower valuation multiple applied to the S&P 500 over time is expected to result in mark to market valuation losses by GMO.

GMO recently published their 7-year asset class real return forecasts as of September 30, 2017.  As you can see from the chart below, GMO expects that investors will lose money over the next 7 years on a real basis (after inflation) for all asset classes except emerging market equities (+2.4%), emerging market debt (+0.4%), and cash (+0.1%).  U.S. large cap (-4.1%) is expected to be the worst performer over this forecast period.

 

 

The next body of valuation research we will look at is from Research Affiliates.  Research Affiliates is a global leader in smart beta and asset allocation.  Dedicated to creating value for investors, Research Affiliates seeks to significantly impact the global investment community through their insights and product innovations.  The scatter plot below shows Research Affiliates' 10-Year expectations of risk and real return for portfolios and asset classes.  Follow this link above to Research Affiliates' website where you can click each of the individual dots, or make selections from portfolio and asset lists to get more information about each portfolio or asset class.  The portfolios connected by the dashed line below represent efficient, highest return per unit of risk, portfolios.  These efficient portfolios are governed by a set of diversification standards which can be seen by clicking the "Efficient" label in the portfolio list at their website.

These expected returns are based on a set of routines which model both expected cash flows and changes in asset prices (reversion to the mean), and not by extrapolating returns of the past (pervasive short-cut approach used by most financial advisors).  You can learn more about Research Affiliates methodology for valuing assets here.

In general, I would characterize Research Affiliates' methodology as a more robust version of GMO's basic methodology described above.  Note that Research Affiliates projection period is 10 years versus GMO's 7 year forecast period.  There are obviously other significant differences in assumptions and methodology as you'll note for example that Research Affiliates has projected a 10 year real return for emerging market equities of 6.3% with volatility of 22.9% compared to GMO's 7 year expected real return of 2.4%.

 

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The third and final research firm's work we'll look at is Hussman Funds.  Hussman Funds was founded by John Hussman, an economist, stock market analyst, and mutual fund owner.  He publishes a weekly market commentary and is broadly known for his public criticism of the U.S. Treasury and the Federal Reserve policies and for predicting the 2008-2009 U.S. Recession.  He has written extensively about the extreme valuations of the S&P 500 and other asset classes precipitated by Fed monetary policies and, not surprisingly, is predicting another market crash and financial crisis.  

Like GMO and Research Affiliates, Hussman has performed extensive investment research and valuation analysis. In his latest weekly commentary dated October 9, 2017 is entitled "Why Market Valuations are Not Justified by Low Interest Rates."  Hussman describes how his team has back tested some 15 different valuation approaches and determined the methodologies that have the highest correlation and predictive value for future expected returns.  One of his favorite methodologies is Margin-adjusted CAPE (cyclically adjusted price earnings/Shiller PE).  Hussman's introduction to this method is as follows:

The chart below is based on (Hussman's) margin-adjusted variant of Robert Shiller’s cyclically-adjusted PE (CAPE). Specifically, the CAPE (calculated here as the ratio of the S&P 500 to the 10-year smoothing of inflation-adjusted earnings) is multiplied at each point in time by a factor equal to the 10-year smoothing of corporate after-tax profits to GDP, divided by the historical norm of 5.4%. The resulting measure is similar to the S&P 500 price/revenue multiple, the ratio of market capitalization to corporate gross value-added, and other measures that share a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

As expected, the (log) margin-adjusted CAPE acts as a “sufficient statistic” for actual subsequent S&P 500 total returns, particularly on horizons of 10-12 years (which is the point where deviations from historically normal valuations most reliably damp out). Also as expected, adding additional information about interest rates (green) does virtually nothing to improve the reliability of the resulting projections; a result that can be understood from our earlier valuation examples. If anything, low interest rates actually worsen expected future market returns here. If extreme valuations were not enough, depressed interest rates suggest the likelihood of below-average economic growth as well.

As you can tell by the green and blue lines in the bottom right corner, Hussman expects negative nominal returns for the S&P 500 over his 12 year forecast period.

 

 

The last and perhaps most telling chart on current extreme valuations below is Hussman's margin-adjusted Shiller PE.  Since the current profit margins of the S&P 500 are well above the historical norm of 5.4%, Hussman estimates the Margin-adjusted Shiller PE is something like 44 times today or significantly in excess of the 40 times for the 1929 market bubble, the dot.com bubble of 2000 at 41 times, and the current Shiller PE of 31.3 (without making an adjustment to normalize margins).

By these metrics, we are clearly in an extreme financial game simulation or some other artificially created financial and market situation.  The question is are these "fake" markets of an alien origin or do they emanate from Fed monetary policies as Hussman and other market historians would vehemently argue?  My intuition is that it is Fed induced rather than E.T., the Extra-Terrestrial, playing an advanced video game.

 

 

The Charm And The Unknown Of Emerging Markets

 

In last month's blog feature we ventured into new media with the introduction of audible.com to describe some thoughts on summer readings.  This month I'd like to explore the media frontier of Trusted Insight and share a video from their 2017 Alpha Investment Conference with you.

Trusted Insight (TI) is the world’s biggest network of institutional investors.  Think of it as the LinkedIn of institutional investors.  The TI network allows lead investors to syndicate investment opportunities to family offices, qualified institutional buyers, and other institutional investors across asset classes such as Venture Capital, Private Equity/Buy-out, Real Estate, Infrastructure and others.  TI also manages its own platform fund(s) and acts as syndicate lead in seed stage venture capital funds.

With over 140,000 members on the platform controlling over $18 Trillion in assets, TI is one of the fastest growing and most trusted alternative asset syndication platforms.  Each week 30,000 institutional investors engage on the TI platform.  These institutional investors are actively investing in alternative assets, primarily private equity, hedge funds, real estate and private companies.

Founded by Alex Bangash, TI started in 2010 and is venture-funded and revenue producing. Its investors were the first investors or founders of Facebook, LinkedIn, Mint, Match.com, and Blackstone, among others. The company has offices in NYC and San Francisco.

TI hosted its first annual Alpha Investment Conference in San Francisco in June.  I was fortunate enough to participate as a panel member on Reassessing The Golden Age Of Private Equity with Dale Hunt, Managing Director - Private Equity at Ascension Investment Management, Josh Stern, Director - Private Markets at Robert Wood Johnson Foundation, and Tristram Perkins, Managing Director - Neuberger Berman.  Please click on the image below to hyperlink to a 14 minute video from this panel discussion entitled The Charm and Unknown of Emerging Markets by TI.

Although the discussion is primarily targeted to institutional investors, I think it provides helpful perspectives for individual investors as well, particularly in the complex investment landscape that investors find themselves in. TI prefaced the discussion as follows: "Emerging markets take a sizable chunk of institutional capital from developed countries.  But as domestic private equity has been providing steady returns, is the risk of going into emerging markets still worthwhile?  While some warn that investors should be careful betting on emerging markets, others argue investors need a little patience and a “buy-and-build” approach.

In part three of TI’s private equity panel, investors discuss their experience and observations on emerging market investing. The panelists also answered questions from the audience."

 

 

In the video, I reference a new book from Sam Zell. Please click the image below to a hyperlink to the audible site to listen to the book read by Sam. Enjoy. 

 

 

We've also been busy over the past year or so contemplating the establishment and progression of Servant Financial over the past 12 years and going through a refresh of our branding and marketing materials to ensure proper reflection of our founding mission, values. and raison d'être.  This journey started with a new corporate logo which you see below.  Please note the heraldic shield that forms the V in Servant.  We believe investment and wealth management is a noble profession.  The assets that we manage for clients represent their dreams for the future whether it be a college education for a son or daughter, vacation home, secure retirement, or eldercare for aging parents.  At the center of the shield is a key which represents our vision of providing better client solutions through experience, passion, and integrity represented by the three rings at the bottom of the key.  The mustard plants coming forth from the key symbolize our mission to serve clients and communities with good and faithful financial advice and cultivate the growth and fulfillment of their dreams.

 

 

Mexico Private Equity Day

 

In early June I attended the Mexico Private Equity Day conference in New York hosted by AMEXCAP, the association of Mexican private equity firms. The mission of AMEXCAP is the dissemination of information on industry opportunities, challenges, and trends for private equity investment in the country. Given President Trump's often inflammatory rhetoric during the campaign and since his election about building a wall at the Mexican border and renegotiating the North American Free Trade Agreement (NAFTA), I thought it would be beneficial to provide you with the Mexican perspectives on these and other matters.

From a macro perspective, the Mexican economy is accelerating with first quarter of 2017 GDP at 2.8% compared to 2.1% for the fourth quarter of 2016. Mexican micro-economic reforms to open up the energy and telecom sectors to private investment are beginning to bear fruit, particularly in the energy sector.

Mexican production is not simply low cost manufacturing, but rather highly complex, value-added production. The three countries of NAFTA are highly interdependent and integrated from a production standpoint and each party understands and appreciates its role in the supply chain. Imports and exports within the NAFTA block are expected to increase rather than decrease despite Trump's rhetoric. Many conference speakers held the view that Trump's preferences for U.S. strategic direction had met with institutional constraints by the Federal government which would result in compromise. For example, the U.S. withdrew from the nascent Trans-Pacific Partnership (TPP) but longstanding NAFTA is still on the books and progressive renegotiations are expected. Conference panelists generally expected the news flow on NAFTA would be relatively quiet until the 2018 Mexican presidential election process picks up steam.

In a speech on macroeconomic conditions, Gerardo Rodriquez a BlackRock emerging markets portfolio manager forecasted upside to GDP growth for developed market economies as we enter the final years of this expansionary cycle. This trend in turn is accelerating the emerging market economic expansion led by the manufacturing sector based on improving purchasing manager indicators (PMIs). As the BlackRock chart below depicts, Mexico and its LaTam peer Brazil are two of several emerging economies with PMIs that are in positive territory and improving.

 

 

As the chart below depicts, emerging market analysts are beginning to revise GDP growth forecasts for emerging markets upward. After bottoming out in 2015 at about 4.25% annual growth, emerging market economic growth as a whole is expected to accelerate to approximately 5.0% for 2018. Similarly, after several years of downward revisions, GDP growth forecasts for Mexico are likely to be revised upward for this year and next. The consensus GDP growth forecast for Mexico for 2017 is presently at 1.8% and very much in line with U.S. growth forecasts.

 

 

BlackRock's Rodriquez cited a common issue with growth forecasts in that analysts were consistently revising GDP growth forecasts down over time in years just after the 2008/09 crisis. In hindsight, analysts had anticipated quicker economic recoveries than what actually happened. This issue was universal across developed and emerging markets. He theorized that perhaps analysts are now being too conservative with growth forecasts after this period of being too optimistic on economic growth.

 

 

The Mexican private equity business is a growing and vibrant part of Mexico's economic development. In some respects the Mexican private equity market has recently jumped into the fast lane. According to a recent report by Bain Consulting on global private equity, the once nascent industry in Mexico reached a number of milestones in 2016 as the industry invested around government privatizations in the energy and telecom sectors. In terms of number of transactions, firms, and broad ecosystem, private equity in Mexico has a low penetration rate compared to Brazil and other emerging market peers, but the industry is experiencing robust growth in Mexico. For example, there were more private equity deals in Mexico in 2016 than in Brazil.

One significantly positive secular trend that will drive the Mexican private equity industry is legislation in the past decade that opened private equity investments to Mexican pension plans. The age of the average Mexican worker is only 42. This is much lower than the average pensioner in the U.S. and other developed economies. From an investment perspective the longer term nature of these pension liabilities for the average Mexican worker makes private equity an attractive asset allocation alternative for these theoretically more risk tolerant and less liquidity sensitive investors.

Others acknowledged that in this globally competitive world private equity investment is an international play. The broad capital needs for Mexico for private investment are competing for investment dollars with other developing nations like Turkey, India, and Indonesia. Broadly speaking the private equity asset class in Mexico is uniquely positioned to back the best entrepreneurial firms, but this was viewed as both a blessing and a curse as there is a "scarcity of top managers who think like owners." At this stage in the development of Mexico's private equity ecosystem, there is a clear shortage of successful operators that have experience creating successful entrepreneurial enterprises. Mexico's entrepreneurial class is still in its development phase.

We can see the development of an entrepreneurial class manifested in economic statistics. As the chart below depicts, Mexico's productivity growth has been one of the lowest in the world. Mexico's productivity growth from 1980 to 2010 was 0.25%. This compares to the leaders in productivity growth of 1.5% to 2.0% for Ireland, South Korea, and China. Meanwhile, the developed U.S. experienced productivity growth at twice the pace of Mexico at 0.5%.

 

 

There were several speakers who touched on the underlying factors driving Mexico's low productivity growth. The two most often cited factors were rule of law and control of corruption. Enhancement of rule of law will be an important aspect to continued development of the private equity market in Mexico. For example the Mexican government is moving forward with its goal of privatizing the energy sector. The government has been holding auctions on exploration and production opportunities in Mexico that would previously have been solely the domain of the state-owned energy company Pemex.

Here are some noteworthy comments on this topic. One panelist shared a comment by a Houston-based energy CEO who indicated that she likes Mexican reservoirs but said that "it seemed like the Mexican government went around the world looking at energy concession contracts and picked the most complex and onerous provisions as requirements for the Mexican auction contracts." Another large energy investor raised questions about Mexican rule of law and the lack of separation of the judiciary branch of government.

BlackRock's Rodriquez stressed this issue as well. He indicated the rule of law and control of corruption continue to be the most significant challenges for LaTam. The World Bank ranks countries on these development factors as well as several other worldwide governance indicators.

The following table displays Mexico's percentile rank against all other countries on the World Bank's rule of law governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010 and 2015 rankings. Mexico lags Brazil and the region but perhaps even more telling its percentile rank in 2015 is below where it was in 2005.

 

 

This next table shows the World Bank's percentile rank of Mexico on its control of corruption governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010, and 2015 rankings. Once again Mexico's rankings lag the region and Brazil. Perhaps more disturbing is the precipitous drop in Mexico's ranking from 2005 to 2015.

 

 

BlackRock's Rodriquez noted that there are limited historical examples of emerging market countries piercing the ratio of 20% of U.S. GDP per capita. South Korea is one longer term example of a country that was able to continue on a steady path of wealth and prosperity for its people. China has just recently moved its GDP per capita to 25% of U.S. GDP per capita. Chile is a LaTam country that stands out as favorable player on this metric. Rodriquez cited that the reasons for the productivity lag in Latin America and the reason emerging market countries generally plateau around the ratio of 20% of U.S. GDP per capita is a) rule of law, b) control of corruption and c) failures in the education system. Research by Rodriquez indicates that GDP per capita is highly correlated to good scores on these three institutional development measures and the 20% ratio of U.S. GDP per capita threshold or ceiling reflects this dynamic.

This final chart below from Rodriquez's presentation depicts this phenomenon. The y-axis ranks countries on these three measures against the median percentile score represented at the zero horizontal line and the x-axis measures GDP per capita in U.S. dollar on a purchase price parity basis (PPP). Note that while Mexican GDP per capita has grown from 1996 (MEX'96) to 2015 (MEX'15), Mexico remains ranked below the median on these governance scores. Meanwhile, Chile (CHL) GDP per capita and governance rankings are both higher than Mexico and on par with South Korea (KOR). So in short, Mexico and other similarly situated developing countries could have higher GDP growth if they can meaningfully address their weak institutional oversight of rule of law and control of corruption.

 

 

In his recently published book "Am I Being Too Suble?: Straight Talk From A Business Rebel" billionaire and highly successful investor and entrepreneur Sam Zell wrote, "When you invest in emerging markets, you're trading rule of law for growth." Based on BlackRock's analysis by Rodriquez, the important corollary to this frictional cost of emerging market investing is that the leadership of emerging market countries, like Mexico, are sacrificing even higher GDP growth along with greater wealth and prosperity for their people by not addressing the meaningful productivity costs of weak institutional governance of rule of law and corruption.

China's Consumer Class

 

Over the past few years I've featured several articles on the favorable investment opportunity set in emerging market (EM) equities.  I've written about the attractive relative valuations and longer-term fundamental economic and demographic growth rates, particularly as compared to domestic equity markets that have garnered the lion's share of capital flow and investor attention.  Last December, 2016 just before the holidays I was with a group of investment professionals with an emerging market real estate focused private equity firm.  The group was in general agreement about the prospects for emerging market investments relative to developed market alternatives in the aftermath of corrections in EM public equity markets and currencies.  We debated the best investment opportunities for 2017 across the EM landscape.  We eventually white-boarded each individual's top EM investment idea as an official record and for group accountability.  

My emerging market "pick to click" was the Chinese consumer.  This selection was primarily driven by the favorable underlying trends I was seeing in certain Chinese consumer focused businesses within private equity funds I manage for a family office client.  The consumption data from these funds greatly contradicted the media coverage and conventional wisdom on China.  The contrarian nature of the selection was also evident in its stark contrast to the generally unfavorable consensus economic view of China for 2017 by the "experts."  Many brilliant hedge fund managers had been calling for a economic hard-landing for China and its currency, the renminbi.  This feature article will provide an overview of the Chinese economic performance so far in 2017 and an in-depth discussion on the rapidly expanding Chinese consumer class from a couple of different bodies of research followed by short cameos on two Chinese consumer focused private equity companies.

At a macro level, China’s gross domestic product (GDP) growth in the first quarter of 2017 was 6.9%, compared to 6.7% in the first quarter of 2016.  This growth rate was higher than market expectations and signaled that the Chinese economy was off to a good start in 2017.

Retail sales grew by 10.0% in the first quarter of 2017 while online retail sales grew by 32.1%, accounting for 12.4% of China’s total retail value, indicative of increasingly deeper penetration by online channels.

Real per capita disposable income, a key driver of personal consumption trends, maintained its high growth of 7.0% during 2016, with income of rural residents growing at 7.2% compared to urban resident’s growth rate of 6.3%, narrowing the gap between rural and urban populations.

These data elements suggest that China’s economy is off to strong start to 2017 with most major macro metrics meeting or exceeding expectations.  I view the macro environment in China as very favorable for long-term secular trends in increased consumer discretionary spending (consumerization) and a move towards more expensive premium products (premiumization).  These secular trends in China were expounded upon by reputable researchers at McKinsey and Goldman Sachs.

In a March, 2015 excerpt entitled "Why China’s consumers will continue to surprise the world" from the book One Hour China - Five Stories That Explain The Brutal Fight for One Billion Chinese Consumers authors Jeffrey Towson, a managing partner of the investment firm Towson Capital, and Jonathan Wetzel, a director in McKinsey’s Shanghai office, highlight that the most exciting aspect of Chinese consumption is the trend in rising discretionary spending.  The author's relay that "Chinese citizens are now moving beyond being able to only afford the basics of life, and their discretionary spending is taking off.  Growth in spending on annual discretionary categories in China is forecast to exceed 7 percent between 2010 and 2020, and growth of 6 to 7 percent annually is expected in a second category of “semi-necessities.”  Both of these categories are growing faster than spending on actual necessities, which are expected to grow around 5 percent a year, about the same as expected GDP growth."  Please see the chart below from this article (click on image to a link to the article and a larger image).

 

 

 

So too in Goldman Sachs’ latest macroeconomic insight report titled “The Rise of China’s New Consumer Class” wherein Goldman reports that "Across Asia, rising incomes are creating an enormous new class of consumers.  Much of that growth is coming from China, whose working population is larger than those of the U.S. and Europe combined.  As more Chinese consumers gain purchasing power, their needs and preferences will have a powerful effect on the global economy."  As the chart below depicts, China’s 770.4 million working population is a multiple of total workers of 146 million in the U.S.  Only 11% of China's population is considered middle class.  Rising incomes from the industrialization and urbanization of China are contributing significantly to the expansion of the middle class and the formation of a new hierarchy of consumer classes in China.  

 

 

The middle market bulge in China's working population is comprised of the Urban Middle and Urban Mass.  The Urban Middle class, defined by Goldman Sachs as families having an annual income of $11,733 per a capita, is depicted in the chart below.  This growing demographic of 146 million people (equivalent to total U.S. working population) consists of financially comfortable corporate office workers and those with government jobs on the public payroll.  This is the main focus of marketers as the middle class consumer tastes develop and incomes rise.  

 

 

The Urban Mass is made up of 236 million blue-collared workers and migrant workers with average annual income per capita of $5,858.   Income for this group has the biggest potential to rise in the next few years enabling them to incorporate discretionary spending into the mix along with basic non-discretionary consumption.  

 

 

Goldman concluded that even today nearly half of China’s consumption goes to more discretionary “needs” like clothing (looking more beautiful) and food (eating better).  The chart below shows the clear differences between China’s middle market consumption patterns with those of the US.  The comparison of an emerging working class with that of a developed economy shows that with rising wealth and income spending will shift over time from pure necessities to more discretionary items.

 

 

My oversight role of a portfolio of private equity funds includes a few with Chinese consumer focused portfolio companies where I was able to see the rise in China's consumer class beginning to play out in a big way in 2016.  Through attendance at fund advisory board and annual meetings and review of fund quarterly investor reports over the course of the year, my conviction increased that these Chinese consumer businesses were doing quite well and earning the high risk-adjusted returns an emerging market investor should expect to receive.  Many of the general partners involved in these Chinese companies have been consistently advising their investors that Western conventional wisdom on China was mostly wrong.  The Western view throughout 2016 was that all Chinese of means were anxiously seeking to get their money out of renminbi.  Admittedly wealthy Chinese were prudently diversifying their investments, but these funds saw firsthand important bullish indicators of Chinese company operating metrics.  Secondly, they took great comfort that their local Chinese partners were displaying longer term conviction by investing in China's future through increased investment in these businesses.  Let me highlight a couple of private company on a no names basis as examples of the rise of Chinese consumption for you.

 

 

The first noteworthy business is the master franchisee in mainland China (PRC) of a western market quick service restaurant (QSR).  The company’s master franchise agreement grants it the exclusive right to develop, operate, and sub-franchise this brand's restaurants in the PRC until June 2032.  At the time of investment, this business had about 60 system-wide restaurants.  Consistent with the research outlined above, the private equity firm's original investment thesis in 2012 was to capitalize on growing middle-class demand for convenience foods with a proximate goal to open 600 restaurants over the next 5 years.  Now five years into it, the QSR business has exceeded their store growth target while the profitability of the business is very strong and improving.  The platform has capitalized on its operating leverage and has had excellent consumer response to its tailored, innovative menu offering.  For 2016 the company exceeded its revenue and EBITDA budgets by wide margins by sustaining high comparable sales growth of over 15% for the past couple of years.  The company has successfully grown system-wide restaurant count to over 650 stores, or more than 10 times the footprint at investment.  Having clearly demonstrated successful execution in operations, the private equity firm has recently been able to secure increased borrowing capacity from local Chinese banks on favorable terms that will enable continued capital-efficient growth.  The PE firm has begun exploring strategic options for the fund's holding.

 

 

The other highly successful Chinese consumer business owned by another private equity fund is a low cost producer and distributor of high end wallpaper for homeowners.  The fund's thesis was that China's consumer markets will follow the same general market development pattern that occurred in the U.S. and other developed markets as they industrialized.  The fund partnered with one of its longstanding Chinese partners with which the fund had invested earlier in a consumer paper products business - paper towels and toilet paper.  With only a 3% penetration rate for wallpaper in China at the time of investment, the fund looked forward to successfully growing the business rapidly given its huge total potential addressable market.  The fund's equity capital was primarily used to purchase capital equipment for the production of wallpaper which the PE firm believed established a reasonable downside for the venture at the liquidation value of the production equipment.  The firm's high end wallpaper offering is highly similar to the best European wallpapers in design and quality but can be sold at a much lower price point given local labor rate savings and substantial shipping cost advantages.   In just a couple of years, the wallpaper business has grown into the world's largest wallpaper producer.  The private equity firm currently expects to sell the business to its Chinese partner now that the business is through its business development phase.  Its founder would like to consolidate the profitable and rapidly growing wallpaper business with its other listed consumer paper products businesses.  

Prompted by these insights on fundamental Chinese consumption trends, we endeavored to identify whether or not there was a liquid, publicly traded exchange traded fund (ETF) to ride the wave of rising consumption by China's massive middle and urban mass populations.  We quickly identified the Global X China Consumer ETF (symbol: CHIQ) featured below. CHIQ has a price return through June 20, 2017 of 29.2% compared to 12.4% the broader iShares China Large-Cap ETF (FXI).   Unfortunately, we have not yet added CHIQ to client portfolios because its assets under management (AUM) of $80 million does not yet meet our $100 million minimum threshold.  However, we believe that we are in the early innings of this Chinese consumerization trend and will continue to monitor the performance and growth in AUM of CHIQ and expect to add the position to client portfolios at some point in the future.

 

 

The Global X China Consumer ETF (CHIQ) is based on the Solactive China Consumer Index.  This index is designed to reflect the performance of the consumer sector in China.  It is comprised of selected companies which have their main business operations in the consumer sector and are domiciled in China or are domiciled elsewhere but have their main business operations in China.  The fund invests at least 80% of its total assets in the securities of the underlying index and in American Depositary Receipts ("ADRs") and Global Depositary Receipts ("GDRs") based on the securities in the underlying Solactive index.  Sell side analysts' forecasts of the underlying companies roll-up to ETF level revenue and earnings growth projections of 12% and 20%, respectively, in 2017 followed by 16% and 19%, respectively, in 2018. The following table provides summary valuation metrics and historical view on CHIQ's price to earnings (P/E) ratio based on data compiled by the ETF Research Center (subscription required).

 

 

The chart below summarizes the consumer sub-sector exposure of CHIQ (click image to go to Fact Sheet and larger image). You can see that CHIQ is keenly focused on more on areas of consumer discretionary spending.

 

 

Barron's recently summarized a longer China research report by Morgan Stanley strategists Laura Wang, Jonathan Garner and Charles Clavel entitled, "What Morgan Stanley Expects for China Stocks."  These strategist assessment was wholly consistent with the boots on the ground reports from the Chinese private equity firms.  Morgan's principal conclusion reads: “We expect China to avoid a financial shock and achieve high income status by 2027.  Our view is that moving to higher value-added activities will propel the economy forward and drive the continued medium-term outperformance of MSCI China versus MSCI EM, providing significant investment opportunities”.  As relates CHIQ, the Morgan strategist recommended five thematic sectors for investment: a) Healthcare, b) Mass-market consumption; 3) Environmental protection; 4) Technology/High-end manufacturing; and 5) Defense/Aerospace.

 Of note, The Wall Street Journal reported earlier today that MSCI agreed to include China A-Share locally traded shares to its indices.  This decision follows three straight years of rejections and opens up the Chinese market to more foreign investment.

Socially Responsible ETF Choices

 

Since the dawn of time, man has been given the gift of choice.  This concept is reflected in the ancient wisdom literature and the words of great philosophers.  The wisdom of Deutoronomy 11:26 written around 1400 BC imparts, "Look, today I am giving you the choice between a blessing and a curse!"  The classical Greek philosopher Plato pronounced around 400 BC, "Let each one of us leave every other kind of knowledge and seek and follow one thing only, if peradventure he may be able to learn and find some one who will make him able to learn and discern between good and evil, and so to choose always and everywhere the better life as he has the opportunity."

Every facet of life seemingly has this Platonic element of choosing the better life or the righteous path over the alternative.  In the investment realm, the element of doing good through investment choices is called socially responsible investing (SRI).  SRI is any investment strategy which seeks to consider both a financial return and the promotion of a social good through a combination of financial support and advocacy for social change.  As you would expect, religious organizations have generally taken the lead on this topic.  Perhaps the earliest modern day organization to formally encourage socially responsible investment policies was the United States Conference of Catholic Bishops.  In 1971, the Catholic Bishops openly challenged U.S. corporations on the issue of apartheid in South Africa.  In 1986, the USCCB issued its first formal set of guidelines for socially responsible investing.  USCCB ethical investment guidelines seek to: 1) do no harm (like the hippocratic oath) by avoiding participation in harmful activities, 2) to use its role as stockholder for social stewardship, and 3) to promote the common good and social justice.

These goals generally comport with today's evolving SRI mindset which broadly seeks to encourage corporate practices on environmental stewardship, consumer protection, human rights, and diversity.  For example, some common negative SRI screening criteria include avoiding businesses involved in alcohol, tobacco, fast food, gambling, pornography, weapons, contraception/abortion, fossil fuel production, and military products.  Areas of social advocacy recognized by SRI practitioners are often summarized under the alternative heading of ESG - environment, social justice, and corporate governance.

US-SIF - The Forum for Sustainable and Responsible Investing issued a Report on Sustainable and Responsible Investing Trends in the United States that identified $8.72 trillion in total assets under management at the end of 2015 that used one or more sustainable, responsible, or impact investing strategy.  This balance represents approximately 22% of the total assets under professional management in the United States as tracked by Cerulli Associates.  US-SIF reports that from 2014 to 2016, SRI enjoyed a growth rate of more than 33 percent, increasing from $6.57 trillion in 2014.  The chart below summarizes the scope of SRI activities in the United States (click chart for link to larger image).  

 

 

The vast majority of the foregoing assets are professionally managed for institutional investors.  Current assets under management for retail investors represent a much lower market share than the institutionally weighted 22% reported by US-SIF.  Within the ETF (exchange traded funds) market which is Servant Financial's investment vehicle of choice, there are 32 funds with social investment mandates with $2.4 billion of assets under management (AUM).  This compares to total AUM in ETFs of $3.4 trillion.  This suggests that SRI ETFs represent only about 1/10 of 1% of the ETF market.  Furthermore, total AUM of the more mature mutual fund industry is $15.7 trillion.  While AUM of $22 billion of the top 5 SRI focused mutual funds is more than 7 times larger than SRI ETF AUM at $22 billion, it still only represents around that same 1/10 of 1% of the mutual fund market.  

Despite these statistically low rates of market penetration, there may be some pent up demand for SRI investment solutions among retail investors.  A recent survey of retail investors' wealth management preferences by FactSet and Scorpio Partnership of over 1,000 high net worth individuals found that SRI was a particularly hot button for both millennials under 35 and Generation X adults between 35 and 54 years of age.  

When asked, "To what extent do you agree that your portfolio should be managed and allocated in a socially responsible manner?," sixty-one percent of respondents under age 35 said they expected their wealth managers to screen investments based on ESG factors.  Preferences for SRI were also high in the 35-54 age group with fifty-three percent of Generation X respondents in favor of some type of ESG screening. See the chart below (click chart for link to larger image).

 

 

When asked, "In the next five years, how do expect your allocations to socially responsible investments to change?," a whopping 90% of millennials said they expect their SRI allocations to increase either a little (45%) to a lot (45%).  Generation X individuals similarly expected SRI allocations to increase a little (46%) to a lot (26%).  See the chart below (click chart for link to larger image).

 

 

The two primary criticisms against SRI have historically been that 1) the screening processes (both negative and positive) required to identify qualified companies are costly to undertake and 2) the selection criteria in and of themselves will penalize investment performance.  The perception of this double whammy to net investment returns (after fund investment management fees) appears to be an artifact of history.  A decade or so earlier, the typical SRI mutual fund likely sported an expense ratio in excess of the average mutual fund expense ratio of 1.5%.  However, the construction of passive SRI indexes together with technological innovations that allow the broad sharing of screening methodologies from one to many have been driving these frictional costs lower for SRI conscious investors.  

A number of passive SRI indexes have been developed based on environmental and social criteria or religious-based criteria (Catholic and Islamic Indexes).  The oldest SRI Index is the Domini 400 Social Index, which started in 1990. The Calvert Social Index started in 2000, and the FTSE4Good Indexes dates from 2005. Currently index mutual funds and ETFs are available that track the Domini 400 Social Index, the FTSE4Good Select Index, and the MSCI US ESG Broad Market and ESG Select Social Indexes.  MSCI has created a series of social indexes which cover the entire US market and discrete segments of the market based upon market capitalization.

US-SIF publishes a list of over 200 SRI mutual funds.  Expense ratios for retail investor share classes among these funds range from 0.44% for a blended fixed income and equity product to 2.4% or more for global, emerging market focused or sector specific strategies.  SRI can be executed much more cheaply in more transparent and competitive domestic fixed income and large capitalization equity markets (S&P 500 or Russell 3000) than in international markets or global sector funds.

In 2016, TIAA Global Asset Management released Responsible Investing: Delivering Competitive Performance which argued against the misconception that responsible investment (RI) screens penalize investment performance.  In the report, TIAA concluded its "analysis of leading RI equity indexes over the long term found no statistical difference in returns compared to broad market benchmarks, suggesting the absence of any systematic performance penalty.  Moreover, incorporating environmental, social and governance (ESG) criteria in security selection did not entail additional risk. RI indexes and their broad market counterparts had similar risk profiles, based on Sharpe ratios and standard deviation measures."

The table below summarizes TIAA's findings (click table for link to larger image within research paper). Note: all of the index performance figures in the table are before (or gross of) fund management fees.

 

 

Servant Financial's preferred approach to build globally diversified portfolios for clients is to use low cost, tax efficient ETFs as much as possible.  The market development of SRI ETFs is still in its infancy.  Whereas there are over 200 SRI mutual funds with over $22 billion in AUM, there are only 32 SRI ETFs at about 10% of the size of the SRI mutual fund AUM.

The largest SRI ETF is iShares MSCI KLD 400 Social ETF (symbol DSI) with $748 million in AUM. This ETF has an expense ratio of 0.50%.  It was the second SRI ETF offering when it hit the market in November, 2006.  Launched in May 1990, the MSCI KLD 400 Social Index is one of the first SRI indexes.

The MSCI KLD 400 Social Index is designed to provide exposure to companies with high MSCI ESG Ratings while excluding companies whose products may have negative social or environmental impacts.  It consists of 400 companies selected from the MSCI USA IMI Index, which includes large-, mid- and small-cap US companies.  DSI aims to select companies with the highest ESG Ratings in each sector and maintain sector weights similar to those of the parent MSCI USA IMI index.  In addition, DSI excludes companies incompatible with a common set of values screens: alcohol, tobacco, gambling, civilian firearms, military weapons, nuclear power, adult entertainment and genetically modified organisms.  The following table summarizes some key facts and the top ten holdings of DSI (click chart for link to larger image).

 

 

The oldest SRI ETF is iShares MSCI USA ESG Select ETF (KLD) which was issued in January, 2005.  KLD is the second largest SRI ETF with $513 million in AUM.  This ETF has an expense ratio of 0.50%.  The MSCI USA ESG Select Index is designed to maximize exposure to positive environmental, social and governance (ESG) factors while exhibiting risk and return characteristics similar to those of the MSCI USA Index.  KLD is comprised of 100 or more large- and mid-cap stocks and is optimized to be sector diversified, targeting companies with high MSCI ESG ratings in each sector.  KLD uses far fewer negative screens than the MSCI KLD 400 Social Index as it only excludes tobacco.  Relative to the MSCI USA Index, the MSCI USA ESG Select Index tends to over-weight companies with high ESG ratings and under-weight companies with low ratings.  The Index is a benchmark for investors who seek an investment opportunity set with a very high ESG score and controlled risk.  Constituent selection is based on data from MSCI ESG Research.

The following table summarizes some key facts and the top ten holdings of KLD (click chart for link to larger image).  Note only two of the KLD top ten holdings are also included in DSI.

 

 

There are only two other ETFs with more than $250 million in AUM worth mentioning.  These ETFs have much more narrow social screens but interestingly both have lower expense ratios of 0.20%.  

The iShares MSCI ACWI Low Carbon Target ETF (symbol CRBN) seeks to track the investment results of an index composed of large and mid-capitalization developed and emerging market equities with a lower carbon exposure than that of the broad market.  CRBN has $314 million of AUM and seeks to support companies less dependent on fossil fuels by overweighting their stocks relative to higher carbon-emitting peers.  This ETF's holdings make it look like a quasi-financial, technology, and consumer focused fund as these three sectors represent 51% of the asset allocation.

The SPDR SSGA Gender Diversity Index ETF (symbol SHE) seeks to provide investment results that correspond generally to the total return performance of the SSGA Gender Diversity Index.  The SSGA Gender Diversity Index is designed to measure the performance of U.S. large capitalization companies that are "gender diverse," which are defined as companies that exhibit gender diversity in their senior leadership positions.  This ETF has $285 million in AUM and was seeded with $250 million by CalSTRS, the large California pension plan.  This ETF is much more diversified than CRBN. Further, academic research shows that firms run by women perform slightly better than their counterparts in return on equity.  Companies with strong female leadership sported 10.1% returns on equity compared to 7.4% for companies without a critical mass of woman at the top.  This explains SSGA's "Better Together" slogan.

Although the market share for SRI among retail investors appears rather low at less than 1% of mutual fund and ETF assets under management, surveys indicate that SRI is a clear aspirational goal among Millennials and Generation X investors.  The ETF industry appears to be in the early stages of developing low cost, tax efficient products around passive SRI indices to address these unmet retail investor needs.  Both parties are also operating under a certain set of economic criteria while they endeavor to find a better way or more righteous path to achieve their objectives.  We believe there is potentially a budding Platonic relationship here and will continue to monitor socially responsible ETF choices on behalf of our clients.

Entering The Inflation Labyrinth

 

A labyrinth is not a maze.  It is unicursal (one line) and has only one path to the center and back out.  The labyrinth has no dead ends or blind alleys like a maze.  It is a circular path to a sole destination. The path often twists and turns back on itself many times before reaching its center.  Once at the center, there is only one way back out. The same path in the opposite direction.

The labyrinth often symbolizes a journey to a predetermined destination such as a pilgrimage to a holy site.  For example, the best known labyrinth is the beautifully preserved pavement labyrinth in Chartres Cathedral, France (pictured below). The cathedral was constructed during the second decade of the 13th century.  The labyrinth is 12.9 meters (42.3 feet) in diameter and fills the width of the nave or center of the church.  While much has been written about the purpose of this labyrinth, little contemporary documentation has survived.  It is known that labyrinths in the French cathedrals were the scene of Easter dances carried out by clergy.  It is also popularly assumed that the labyrinth is a symbol of the long tortuous path that Medieval pilgrims endured to visit Chartres and other sacred places.

This month's feature article will focus on another labyrinth - the Federal Reserve's long torturous path to inflationary conditions.

 

A white paper from the Congressional Research Service entitled Monetary Policy and the Federal Reserve: Current Policy and Conditions by Marc Laborite, a specialist in macroeconomic policy, dated February 7, 2017, summarizes the current state of the Federal Open Market Committee's (FOMC or Fed) monetary policy conditions:

"The Fed anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”  Thus, although rates are being raised, the Fed plans to maintain an unusually stimulative monetary policy for the time being.  In terms of its mandate, the Fed believes that unemployment has reached the rate that it considers consistent with maximum employment (although other labor market indicators suggest some slack remains), but inflation has remained below the Fed’s 2% goal since 2013 by the Fed’s preferred measure.  Debate is currently focused on how quickly the Fed should raise rates. Some contend the greater risk is that raising rates too slowly will cause inflation to become too high or cause financial instability, whereas others contend that raising rates too quickly will cause inflation to remain too low and choke off the expansion."

Recent inflationary data suggests that inflation is on the rise across the globe particularly in the world's two largest economies.  According to Trading Economic's global macro models and analysts' expectations, the inflation rate in the United States is expected to be 2.50 percent by the end of the first quarter of 2017.  In January 2017, consumer price inflation (CPI) on a year over year basis (YoY) reached their forecasted level of 2.50 percent.  Core CPI YoY (excludes volatile energy and food prices) rose 2.3% in January.

Looking forward, Trading Economics estimates the inflation rate in the United States will remain at 2.50 percent for twelve months.  In the long-term, the U. S. inflation rate is projected to trend around 2.50 percent to 2020.  The chart below summarizes Trading Economic's inflation forecasts for the United States.  Note the nice upward sloping pattern indicative of rising inflation.

 

 

Trading Economics forecasts the inflation rate in the world's second largest economy of China to be 2.60 percent by the end of the first quarter of 2017.  China has also recently experienced a dramatic turn in inflationary metrics. China's January producer price index (PPI) posted a stronger-than-expected 6.9% YoY increase.  A year ago in January 2016, Chinese PPI was a negative (5.3%) YoY. China's remarkable one-year inflationary turnaround was not isolated to producer prices.  China's CPI has also increased 2.5 percent YoY up from a year ago CPI of 1.8 percent, well within earshot of Trading Economics forecast of 2.6 percent inflation by the end of the first quarter of 2017.  

Looking forward, Trading Economics estimates the inflation rate in China to stand at 3.00 percent in 12 months time.  In the long-term, the China inflation rate is projected to trend around 4.50 percent in 2020.  Again the chart for China shows a nice upward sloping inflationary pattern.

 

 

As outlined in the white paper Monetary Policy and the Federal Reserve: Current Policy and Conditions, the difficulty for the FOMC is properly timing their monetary actions to act soon enough to prevent incipient inflationary pressures from taking hold while not tightening monetary policy too quickly and choking off economic growth.  An additional policy wild card is the impact of Trump administration actions on economic activity.  Most experts view Trump's policies as favorable and expect his administration's policy initiatives to enhance overall economic growth prospects in the United States.  However, minutes from the Federal Reserve's January meeting released last week indicate that policymakers are highly uncertain about the impact of Trump's fiscal plan on the U.S. economy.  The following are some quotes from the Fed's January minutes addressing fiscal policy and inflation:

"Participants again emphasized their considerable uncertainty about the prospects for changes in fiscal and other government policies as well as about the timing and magnitude of the net effects of such changes on economic activity."

"Regarding the outlook for inflation, some participants continued to be concerned that faster-than-expected economic growth or a substantial undershooting of the longer-run normal unemployment rate posed upside risks to inflation."

The following chart from Advisor Perspectives summarizes the components of the consumer price index (CPI) to provide perspective on assessing inflation. Please note that the largest category is housing representing 42% of CPI followed by transportation and food and beverage components which both represent about 15% of CPI. These three components together represent approximately 72% of CPI.

 

 

Given the lengthy period of accommodative monetary policy since the Great Recession of 2008/9, it is not surprising that we are finally beginning to see an uptick of inflationary trends impact these three key components of CPI.  Most noteworthy is the rebound in commodity prices from the late 2014 to early 2016 correction which are essential inputs to the transportation and housing construction components.  West Texas Intermediate oil prices are up 63% year over year.  Industrial metal prices also saw large increases in 2016. Copper prices advanced 27% in 2016 and are up 10% so far in 2017.  Over the last twelve months, copper is up 28%, nickel is up 27%, silver is up 19%, and gold is up 2%.  Meanwhile indices of home prices show a continued inflationary trend as home prices rose 6.2% year over year in December 2016, as institutional/landlord ownership of single family homes increased to 37% in 2016, the highest percentage in over a decade.  These factors show how dynamic and resilient the U.S. economy has been as capital and supply have rapidly adjusted to aggregate demand and prices.

One of the more visible aspects of Trump's policies on economic growth and inflation is immigration.  Some experts suggest that less immigration would inhibit U.S. economic growth given poor underlying demographic trends.  U.S. fertility rates are falling, leading to a natural population growth rate of 0.4%, the lowest level since the founding of our nation.  Fertility is perhaps more of a longer term than immediate issue as relates to near term inflation monitoring.  Experts suggest that immigration - legal or unauthorized - is necessary to meet the economic growth requirements in the labor force and that absent robust immigration trends, particularly lower paying, less skilled employment, we would see a pick-up in inflationary pressures as wages are increased to attract needed productive labor capacity.

The following chart from Pew Research Center suggests that based upon the most recently available census data for the period from 2009 to 2014, that unauthorized immigration declined over this period and therefore was not a significant factor in the growth in the U.S. labor force during this time period.

 

 

In 2014, the nation’s civilian labor force of 160.4 million people consisted of about 132.8 million U.S.-born workers (83% of the total and up 1.6% from 2009), 19.5 million lawful immigrant workers (12% of total and up 7.8% from 2009 ) and 8.0 million unauthorized immigrant workers (5% of total and down 100K).  The numbers of U.S.-born members of the workforce and lawful immigrant members of the workforce both increased from 2009 to 2014, while the number of unauthorized immigrant workers did not.  As depicted in the chart below, the estimated number of unauthorized immigrants in the labor force plateaued in 2005 and has essentially flatlined since.

 

 

So while legal immigration has been a significant positive contributor to labor force growth over the relevant period, unauthorized immigration has not been a significant factor.  Arguably, a continuation of policies that promote legal immigration would have a continued positive effect on labor force growth and government tax revenues while policy actions to discourage unauthorized immigration would have negligible or minimal impact on the overall U.S. labor force and economy.  The table below sets forth the U.S. industries and occupations that employ the highest share of unauthorized immigrant workers.

 

 

Although unauthorized immigrants work throughout the U.S. economy, they are particularly concentrated in some sectors, according to the Pew Research Center analysis.  Compared with their 5% share of the civilian workforce, they were overrepresented in the agriculture (17%) and construction (13%) sectors, as well as in the leisure and hospitality industry (9%).  They were underrepresented in some sectors such as the educational and health services sector and the financial and information industries.

By occupation, unauthorized immigrants held a higher share of U.S. farming jobs (26%) in 2014 than would be expected given their share of the workforce.  They also held a disproportionate share of construction jobs (15%). By contrast, unauthorized immigrants held a lower share of maintenance, management, professional, sales and office support jobs than their share of the workforce overall.

Although the foregoing data suggests Trump immigration policies would likely have minimal overall impact on the U.S. labor force and economy, aggressive policy actions could result in labor force disruptions and spark inflationary pressures in specific sub-sectors such as agricultural/food and beverage and construction/housing sector where unauthorized immigration labor is a key production input.

Based upon the more hawkish tone of its policy statements, it would appear that the FOMC is much closer to the center of the inflation labyrinth than they would otherwise publicly admit for fear of being seen as behind the curve.  Even before the impacts of Trump fiscal policies, current CPI readings are running above the FOMC's 2% inflation target.  In addition, two key components of CPI - housing (42% of CPI) and transportation (15% of CPI) - are already on an uptrend.  Moreover, there is considerable data supporting the view that aggressive immigration policy actions could be highly disruptive to the labor cost inputs in the important agricultural and construction sectors of the U.S. economy.  As President Trump would say it could be "yuge." 

Bread of Presence

 

The new year of 2017 has started with incredible optimism and exuberant risk taking in liquid securities markets. Through January 24, 2017, the S&P 500 was up 2.4% on a total return basis while the technology heavy NASDAQ was up 4.8%. The four horseman of "gratification", better know as the FANGs, sped out of the starting gate with Facebook's (FB) price up 10.7%, Amazon (AMZN, +9.1%), Netflix (NFLX, +9.9%), and Google (GOOG, +4.8%). For the last twelve months through January 24th, the S&P 500 was up an astounding 24.9% and the NASDAQ up 26.6%.

Contrast the start of this year with January 2016 when fear held sway and we experienced the exact opposite market movements. Has all that much changed in one year's time? Certainly, we have a new administration ensconced in the White House and a Republican controlled House and Senate to boot, but will that in and of itself end Washington gridlock, particularly with a polarizing President Donald J. Trump with adolescent-like readiness to Tweet anything at anytime. With markets this ebullient, this is an opportune time to feast on the bread of presence, to ponder the current geopolicital situation, and to take stock of market fundamentals.

We mostly see the same yeast for loaves of instability we saw a year ago. First and foremost is the long fermenting yeast of monetary policy. Unprecedented monetary disorder of the past 8 plus years has been leavened by the global central bankers for so long that what were once considered "extraordinary" measures pass for normal and acceptable monetary policy. We have rising populism across the developed markets of Europe and America sowing the seeds of social and democratic instability. Our pugnacious President has no fear of publicly attacking his opposition as in his mind the ends justify the means. Those abhorred by his methods and beliefs tend to escalate the juvenile verbal warfare. For example, pop star Madonna had this to say at Women's March on Washington rally according to Business Insider, "Yes, I am outraged. Yes, I have thought an awful lot about blowing up the White House ... but I choose love," Madonna said from the main stage area near the National Mall. If you read the venomous words quoted in the linked article, it is quite clear that this pop star turned would be terrorist is speaking from a heart of stone. If there was any love in her words and actions, it was self-promotional love.

We also have calls for renegotiations of major trade agreements (BREXIT from the European Union and NAFTA), proposals for protectionist trade policies, and accusations of currency manipulation acting as a fungal culture for economic and market instability. No matter how you cut it the present moment in market history is not a time to be complacent. In fact perhaps it is time to be paranoid, very paranoid.

Andy Grove, founder and former Chairman and CEO of Intel, wrote a seminal book in 1996 that addressed this issue entitled, Only the Paranoid Survive: How to Exploit the Crisis Points That Challenge Every Company. Mr. Grove gave a speech in 1998 at the Intel Academy of Management, Annual Meeting that summarized his book and thoughts on how the paranoid survive Strategic Inflection Points.

He described Strategic Inflection Points as:

"...what happens to a business when a major change takes place in its competitive environment. A major change due to introduction of new technologies. A major change due to the introduction of a different regulatory environment. The major change can be simply a change in the customers' values, a change in what customers prefer. Almost always it hits the corporation in such a way that those of us in senior management are among the last ones to notice... But what is common to all of them and what is key is that they require a fundamental change in business strategy, and that's almost a definition of a strategic inflection point. A strategic inflection point is that which causes you to make a fundamental change in business strategy. Nothing less is sufficient. (emphasis added)"

Groves goes on to cite examples of Strategic Inflection Points in the telecom industry with the regulatory actions that broke up the Bell System in 1984 and more recently the Strategic Inflection Point in the bookseller industry with Barnes & Noble writing the final chapter on local booksellers followed shortly thereafter by Amazon.com shredding Border's and Barnes & Noble's business models.

He continues.

"One of the empirical observations with companies that are dealing with Strategic Inflection Points, or are in the middle of them, is that there is a growing divergence, a dissonance if you will, between the strategy statements of those companies and the strategy actions."

"It is extremely important to be able to listen to the people who bring you bad news and who are typically divided. In the system that I described to you, these people tend to be lower level people. They have to bring you bad news and be Cassandras against the senior management, against the fear of management of repercussions. Unless you deal with this fear, unless you live this fear you will never hear from those helpful Cassandras and you are going to be late in responding to the Strategic Inflection Points. (emphasis added)"

If you ponder the current geopolitical environment, don't the foregoing explanations and signs point to a Strategic Inflection Point in America that led to the populist ascendancy of Donald J. Trump to our Nation's 45th President? Haven't the Main Street and middle class voters assumed the role of the "helpful Cassandras" and brought the bad news of a Strategic Inflection Point to the senior management team in Washington? Didn't the voters just tell the Washington establishment that they are no longer "buying" the sub-standard institutional products and services the government is providing this Nation? And didn't the citizenry just fire the old CEO and management team and replace them a new CEO and leadership team who have the common sense to acknowledge that our Nation is at a Strategic Inflection Point that requires a fundamental change in strategy? Rather than the usual indifference of a kleptocratic politician, President Donald J. Trump is instead zealously paranoid about Making America Great Again and he is rapidly deploying plans to exploit crisis points in our Nation's resources of capital, industry and labor.

In his book, Only The Paranoid Survive, Groves opined that once a Strategic Inflection Point has been identified the next two phases that a business must go through is to first Let Chaos Reign (Chapter 7), "Resolution comes through experimentation. Only stepping out of the out old ruts will bring new insights." And so the Donald President Trump is now sifting through the wheat and chaff of government regulations, programs, and priorities and realigning the business of government to his strategic initiatives. In the first two days in office Trump has taken the following actions accordingly to PBS - 1) rollback Obamacare, aka Affordable Care Act, 2) freeze all in process regulation until it can be reviewed by him or his agency appointees, 3) no Federal money to support abortion, 4) United States withdrawal from the Trans-Pacific Partnership trade agreement, 5) Federal hiring freeze, 6) & 7) speed up approval for the Dakota Access and Keystone Oil Pipelines, 8) speed up environmental reviews for critical infrastructure projects, 9) direct Secretary of Commerce to draft regulations that provide that American steel is used for pipeline projects to the "maximum extent possible", 10) comprehensive review of American manufacturing regulations by the Secretary of Commerce, 11) deportations and sanctuary cities - speed up deportation process of criminals, hire more Immigration and Customs agents, and ordered the Attorney General and Secretary of Homeland Security to block Federal grants to sanctuary cities, and 12) build the Southern Border Wall.

There no longer seems to be cognitive dissonance between the strategic action of American leadership and the strategic statements of its new CEO Donald J. Trump. This speaks to Grove's next phase of fundamental strategic transformation Reign in Chaos (Chapter 8), "Clarity of direction, which includes describing what we are going after as well as well as what we will not be going after, is exceedingly important at the late stage of a strategic transformation." The Trump administration has compressed Grove's two phases into one potentially chaotic national transformation plan. These bold executive actions are wholly consistent with President Trump's strategic plan as most recently articulated in his inauguration address on January 20th. The following excerpts of Trump's inauguration address are consonant with the theory that Trump is using Grove's Only The Paranoid Survive playbook:

"We, the citizens of America, are now joined in a great national effort to rebuild our country and to restore its promise for all of our people."

"This is your day. This is your celebration. And this, the United States of America, is your country. What truly matters is not which party controls our government, but whether our government is controlled by the people."

"At the center of this movement is a crucial conviction: that a nation exists to serve its citizens."

"We will follow two simple rules: Buy American and Hire American. We will seek friendship and goodwill with the nations of the world – but we do so with the understanding that it is the right of all nations to put their own interests first."

"At the bedrock of our politics will be a total allegiance to the United States of America, and through our loyalty to our country, we will rediscover our loyalty to each other."

 

Moreover, Andy Grove's strategic spirit also seems to be influencing President Trump's policy on U.S. employment and job creation. Mr. Groves wrote a marvelous op ed in July 2010 for Bloomberg entitled "How America Can Create Jobs." Groves immigrated to America in 1956. He fled Soviet bloc Hungary where he "witnessed first hand the perils of both government overreach and a stratified population."

Groves felt strongly that employment growth depended on American companies' ability or willingness to scale up within the U.S. As Intel CEO, he worked to keep Intel's manufacturing in the U.S., with the company having 90,000 employees in 2010. He explained the causes and effects of many business's growth plans:

"Each company, ruggedly individualistic, does its best to expand efficiently and improve its own profitability. However, our pursuit of our individual businesses, which often involves transferring manufacturing and a great deal of engineering out of the country, has hindered our ability to bring innovations to scale at home. Without scaling, we don't just lose jobs—we lose our hold on new technologies. Losing the ability to scale will ultimately damage our capacity to innovate."

To remedy the problem, he strongly believed that "job creation" should become America's number 1 objective, much as it is in Asian nations. Among the methods he felt were worth considering was the imposition of a tax on imported products, a strategic tool now at the forefront of the Trump administration trade policies.

"The first task is to rebuild our industrial commons. We should develop a system of financial incentives: Levy an extra tax on the product of offshored labor. (If the result is a trade war, treat it like other wars—fight to win.) Keep that money separate. Deposit it in the coffers of what we might call the Scaling Bank of the U.S. and make these sums available to companies that will scale their American operations. Such a system would be a daily reminder that while pursuing our company goals, all of us in business have a responsibility to maintain the industrial base on which we depend and the society whose adaptability—and stability—we may have taken for granted."

In his closing sentence Grove clearly acknowledged back in 2010 his belief that our Nation was facing a Strategic Inflection Point, "If we want to remain a leading economy, we change on our own, or change will continue to be forced upon us."

Paradoxically, we see Trump's strategic initiatives as further fermenting short-term economic and market instability while advancing his long term strategic plan of allowing every American citizen the opportunity to put bread on their family table. Isn't this the same bread of presence or Promised Land that our Founding Fathers spoke of in the preamble to the U.S. Constitution?

We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.

Omne Trium Perfectum

 

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.

Hat Tricks

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.

 

 

Third Pillar

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."

The Mortal Comedy

 

The Comedy Illuminating Florence featured above is the most famous fresco by Domenico di Michelino, located on the west wall of the Cathedral of Saint Mary of the Flowers in Florence.  The canvas is divided, like Dante Aligheri's The Divine Comedy, into three parts: Inferno (Hell), Purgatorio (Purgatory), and Paradiso (Paradise or Heaven).  Dante is in the center of the fresco wearing a red robe and holding a volume of his poem The Divine Comedy.  With his right hand Dante points to a procession of sinners being led down through the nine circles of Hell.  Behind Dante in the center are the seven levels of the Mount of Purgatory, with Adam and Eve at the top standing in the Earthly Paradise. Above them, the sun and moon and seven planets represent the Heavenly Paradise.  On the right is Dante’s home city of Florence illuminated by rays emanating from his poem, hence the title - The Comedy Illuminating Florence.

The Divine Comedy tells the allegory of Dante's journey through these three realms of the dead, lasting from the night before Good Friday to the Wednesday after Easter in the spring of 1300.  Conscious of his self-destructive behavior and feeling that he has fallen into a "low place" (basso loco), Dante is rescued by the Roman poet Virgil author of Aeneid and Trojan Horse legend.  Virgil guides Dante through Hell and Purgatory and sends him on his to Paradise.

All hope abandon, ye who enter here! Dante Alighieri

In its third quarter of 2016 Quarterly Newsletter, investment management firm GMO's Ben Inker describes the torturous parallel of the "mortal comedy" of investment management today in his article entitled, "Hellish Choices: What's An Asset Owner To Do?" Inker somberly explains the dilemma investors face with today's loathsome investment opportunity set:

Given today’s low yields and high valuations across almost all asset classes, there are no particularly good outcomes available for investors.  We believe that either valuations will revert to historically normal levels and near-term returns will be very bad (Purgatory scenario), or valuations will remain elevated relative to history (Hell scenario).  If valuations remain elevated indefinitely, near-term returns will be less bad but still insufficient for for investors to achieve their goals.  Furthermore, given elevated valuations in the long term, long-term returns will also be insufficient for investors to achieve their goals.

It would be very handy to know which scenario will play out, as the reversion (Purgatory) versus no reversion scenarios (Hell) have important implications both for the appropriate portfolio to run today and critical institution-level decisions that investors will be forced to make in the future.  Unfortunately, we believe there is no certainty as to which scenario will play out.  As a result, we believe it is prudent for investors to try to build portfolios that are robust to either outcome and start contingency planning for the possibility that long-term returns will be meaningfully lower than what is necessary for their current saving/ contribution and spending plans to be sustainable. (explanations/emphasis added)

In the Purgatory scenario that Inker outlines we'll obtain the "salvation" of future higher risk-adjusted investment returns only if we "purge" today's high valuations. With the Hell scenario, there is no saving grace from a redemptive correction in valuations. We'll remain in this high valuation and tormentingly low risk-adjusted return environment potentially for the rest of our mortal existence.

The chart below highlights GMO's view of Purgatory and Hell scenarios over their seven year forecast period (click image to link to article and larger image). GMO's standard forecasting approach in the Purgatory scenario is that high valuations will gradually dissipate such that seven years from now valuations will have reverted to historical norms. GMO's Hell scenario assumes valuations do not mean revert but instead remain at historically elevated levels. Inker states:

Our standard assumptions for long-term asset class returns are that equities deliver 5.5 - 6.0% above inflation in the long run, bonds 2.5 - 3.0% above inflation, and cash 1 - 1.5% above inflation...  The assumptions for Hell are 1.25% lower equilibrium returns across the board.  In other words, in Hell the equilibrium return on cash is 0% real and risk premia are otherwise left unchanged.

 

 

The second chart below depicts GMO's mean variance optimized portfolios for the Purgatory scenario (left column) and Hell scenario (right column).  Note the marked differences in asset allocation depending on whether you expect a valuation purge or not.  There is a substantially lower weighting in risk assets (equities) in a Purgatory forecast with cash representing 50% of assets while the Hell forecast has 58% weighting in risk assets because there is no dread of a valuation purge.  Also note that Emerging Market (EM) equities carry a 17% weight in both the Purgatory and Hell scenarios given the asset class has GMO's highest expected real return in either scenario.  Inker states in a footnote to the article that he "put limits on asset classes."  We believe he has likely constrained emerging market equities to 17% of the portfolio in both scenarios.

 

 

The third GMO chart below presents the Purgatory Portfolio and Hell Portfolio under two scenarios - Purgatory (a purging to normal valuations occurs within the seven year forecast period), and Hell scenario (no purging).  Inker summarizes the differences in expected investment outcomes:

And while the two portfolios have similar expected returns if Purgatory turns out to be the correct forecast, the difference between the two in Hell is 1.3% per year for seven years.  Another way to look at it is if you pick the Purgatory portfolio and it turns out we are in Hell, you will only break even with a more traditional 60% stock/40% bond portfolio.  If you run the Hell portfolio and it turns out we are in Purgatory, you are taking almost twice the volatility and expected loss in a depression, and almost three times the portfolio duration for no benefit in expected return.

 

 

Inker concludes his investment article by stating that

...we believe the basic point is that from today's valuation levels, there are no good outcomes for investors....  we can hope that valuations fall to historically normal levels, because only if that happens will the institutional business models and savings and investing heuristics that institutions and savers have built still be valid.

Given Inker's sober investment outlook one must ponder whether there are any alternative paths for long term investors.  Perhaps Dante's trials in Purgatory may provide useful allusions for today's investor. Purgatory is the second part of Dante's The Divine Comedy.  Dante and Virgil ascend out of the depths of Hell to the Mountain of Purgatory on the far side of the world.  The Mountain is on an island that is the only land in the Southern Hemisphere.  This aspect of the poem has a distinct emerging market angle as we see in this global map below with Organization of Economic Corporation and Development (OECD) countries in blue and non-OECD or developing countries in gray and mostly in the Southern Hemisphere.

 

 

In addition, Dante's Purgatory Mountain has seven terraces rising one above the other which correspond to the seven deadly sins - Lust, Gluttony, Greed, Sloth, Anger, Envy, and Pride.  The terraces are inhabited by souls doing penance as expiation for their sins - the conversion of the soul from the sorrow and misery of sin to the state of grace.  One could imagine Dante finding a slothful soul running a penitential marathon while shouting with zeal, "Go Cubs Go" as if the Chicago Cub would ever have a snowball's chance in hell of winning a World Series.  This aspect of the story suggests taking a contrarian view as well as a longer term perspective (up to 108 years for a Cub fan's salvation).  These literary allusions led us to consider whether one possible asset class to enhance portfolio returns for investors was emerging market equities and debt (securities akin to some investors as lovable losers like the Cubs).

We found some potentially confirmatory views of higher expected returns for emerging market equities in the Purgatory scenario in recent forecasts of 10 year real returns by Research Affiliates as of October 31, 2016.  Much like GMO, Research Affiliates' standard return forecast approach assumes that today's high valuations will mean revert to normal valuations at some point over the course of their projection period of 10 years (compared to GMO's 7 year forecast period).

As depicted in the following chart, Research Affiliates forecast 10 year real annual returns of 7.3% for emerging market equities compared to GMO 7 year Purgatory return of 3.7%. Research Affiliates' expected return is comprised of 2.7% from yield, 1.3% growth, 1.5% valuation, and 1.8% foreign exchange (weaker dollar).  In addition, Research Affiliates' forecasts higher real returns for emerging market debt in local currencies of 3.8% over 10 years compared to GMO's 0.3% over 7 years.  Lastly, Research Affiliates' forecasts higher real annual returns for international developed EAFE equities of 5.9% compared to GMO 7 year Purgatory return of 0.5%. Research Affiliates' return is comprised of 3.4% from yield, 1.3% growth, 0.0% valuation, and 1.2% foreign exchange (weaker dollar). Research Affiliates approach to foreign currency forecasts is summarized here.  For the month of November, the U.S. dollar appreciated about 3% compared to a trade weighted basket of other major currencies.

 

Worldly fame is but a breath of wind that blows now this way, and now that, and changes name as it changes direction. Dante Alighieri

As we've stated in previous postings, there is no free lunch with emerging market equities or debt.  Both asset classes are very volatile and prices are subject to rapid movement in global capital flows in and out of these much more thinly capitalized and less liquid markets.  Emerging market equities were all the rage in the 2001 to 2007 period in the aftermath of the BRIC acronym (Brazil, Russia, India, and China) coined in 2001 by Jim O'Neill from investment bank Goldman Sachs in a paper entitled "Building Better Global Economic BRICs." Emerging market economies and equities enjoyed robust foreign capital flows and exuberant psychological tailwinds.

The winds of global capital flows changed subsequent to the global financial crisis and it has generally been a struggle for the former BRIC darlings.  Emerging market equities have performed poorly on an absolute and relative basis over the trailing five and ten year periods.  The emerging market asset class has disappointed investors so often many of its fans have adopted a Cub's like attitude, "Wait until next year."  Meanwhile, S&P 500 large cap equities have become the Bronx Bombers of asset classes - winning return championship year after year through 2015.  Through October 2016, the winds of global capital flows were in favor of the much maligned emerging markets only to abruptly reverse direction to U.S. shores with the wildcard Trump election.

We suspect that the global winds of capital flows will continue to change and as GMO's Inker has suggested portfolios must be robust to a possible purging of valuations, of which domestic markets are the richest.  Portfolios also need to be responsive to changes in long term global capital flows, relative values, demographics, and economic conditions.  A recent meeting with a China focused private equity firm provides some relevant anecdotes that suggest Western conventional wisdom on China is mostly wrong.  China is making good progress in transitioning to a domestic consumption led economy with services accounting for 53% of GDP.  China GDP growth was 6.7% for the first nine months of 2016.  China's non-performing loan problem and corporate debt levels are manageable relative to the size of their economy.

The private equity firm's pending exits are mostly through sales to their local Chinese partners who are going long China's future.  The Western view is that every Chinaman is seeking to get all of their wealth out of renminbi.  Admittedly, wealthy Chinese are prudently diversifying their investments.  Ironically, the perception of capital flight was erroneously promoted, in part, by the Chinese government encouraging Chinese companies to acquire real assets abroad with low cost government financing.  The Chinese government would sell U.S. treasuries and replace these assets with financings of SOE's (state owned or controlled enterprises) purchases of real assets abroad.  The Chinese government is changing course on this strategy.

As we've outlined above, Research Affiliates' expected real return forecasts are far more bullish for emerging market equities and debt than GMO's forecasts.  Research Affiliates's forecasts are downright bearish on domestic equities.  Running a portfolio optimization at a 9.5% volatility assuming a Purgatory scenario with Research Affiliates' on-line portfolio tools produces an expected real annualized portfolio return over 10 years of 3.7% compared to the 0.4% return with 5.3% volatility for GMO's 7 year portfolio optimization.  The chart below summarizes this optimized portfolio's characteristics. The asset allocation is markedly different with 40% in equities (24% EAFE and 16% EM), 29% in government bonds (mostly short-term U.S. Treasuries), 14% in corporate bonds and bank loans, and 17% in alternatives (U.S. TIPs, foreign currencies, commodities, and REITs).

 

 

 

Much like Dante's journey through Hell and Purgatory, there is no easy path for investors today.  GMO's analysis has demonstrated the considerable variability of investment outcomes depending on whether today's high domestic valuations are purged (Purgatory) or not (Hell).  We've also shown with Research Affiliates analytical tools that there is considerable variability of expected return outcome across investment experts, particularly for emerging market equities and debt and developed international equities.

Already historically rich domestic equity markets are rising and signaling that investors believe President Trump will deliver them to the promised land of higher investment returns while he Makes America Great Again.  We wish him well but believe the best salvation for investors in this high variability/risk environment is to think long term, contrarian, and pursue relative values.  We believe investors should maintain robust portfolios comprised of globally diversified baskets of assets with a sufficiently meaningful position in emerging market and developed international equities while mitigating the volatility of these asset classes by being conservatively positioned with larger money market balances and overweight high quality fixed income allocations.

Splice of Life

The following article was contributed by Helen Dospod. Helen assists Servant Financial with portfolio analysis and construction and investment research.

For several years the Biotechnology subsector of the Healthcare industry experienced an amazing bull market, gaining over 400% in the five years preceding its peak in July, 2015. The bullish interest in Biotechnology stocks was based on the industry’s rapid growth. The completion of the Human Genome Project in 2000, combined with other rapid technological advances, have helped to revolutionize medical research in the last decade. Low interest rates further helped to fuel research and development, as well as acquisitions of smaller Biotechnology firms with promising drug pipelines.

This wave of innovation prompted significant industry research and development and in 2012 the FDA announced a new “Breakthrough Therapy” designation to help bring promising drug advances to the public as quickly as possible. It was developed in order to expedite the development and review of drugs which are: 1) intended to treat serious or life-threatening conditions, and 2) show substantial improvement over other existing therapies.

Biotechnology is a subset of the healthcare industry and includes medical research, pharmaceuticals and therapies which have their basis in biological sources or processes. The term commonly refers to research or therapies which may use vaccines, blood components, tissues, gene therapies, allergenics, or other living cells. They are often produced through processes involving recombinant DNA technology (DNA molecules formed by gene splicing to bring together genetic material from multiple sources to create unique sequences). These kinds of therapies comprise a large number of the Breakthrough Therapy applications which have grown at a rapid pace in just a few years (figure 1 from FDA.gov).

 

 

One example of a drug that has been given Breakthrough Status by the FDA this year is Venclexta. It is used to treat people with chronic lymphocytic leukemia (CCL) by inhibiting a protein in the cancer cells (abnormal lymphocytes) that helps keep those cancer cells alive and makes them resistant to chemotherapy. Venclexta binds to this protein, which helps kill the cancerous lymphocytes in blood and bone marrow. In clinical trials, nearly 80% of patients with a specific genetic marker and relapsed CLL showed a strong positive response to the drug with deep remissions. It is also being tested as a potential treatment for other diseases like non-Hodgkin’s lymphoma and metastatic breast cancer.

The number of such Breakthrough Therapies that have been approved by the FDA’s Center for Drug Evaluation and Research (CDER) has increased from 3 in 2013 to 21 in 2015. Around 28% of the Breakthrough designations granted through 2015 were for oncology (cancer) therapies. This has inspired a lot of enthusiasm around Biotech companies and their ability to create innovative new molecular and biologic entities (or so-called “novel drugs”), that can be both distinctive in the market and life-changing for patients.

However, since Hillary Clinton famously tweeted last September her intention to create a plan to address “price gouging” (in reaction to the drastic overnight price increase of the specialty drug Daraprim), stock prices in the Healthcare sector plunged and have not yet recovered. While there has been a lot of market volatility since Clinton’s tweet, the S&P 500 has managed to gain 10% in that time while the iShares NASDAQ Biotechnology ETF (IBB) is down by 25% over the same period. In the looming shadow of the presidential election, the Healthcare sector has continued to lag the broader US market, plagued by the uncertainty of how possible political policies will affect future pricing power and profits in the industry. We think this regulatory uncertainty has produced a favorable long-term investment opportunity for the Biotech sector.

According to Morningstar’s Market Fair Value analysis, the Healthcare sector as a whole is currently one of the cheapest sectors (aside from Financials), and Biotechnology is the most underpriced sub-sector. When Morningstar calculates a fair value, they do it based on company earnings, cash flow and other fundamentals and their long-term outlook in order to determine the business's intrinsic value. According to Morningstar, the combined market prices of Biotech stocks are selling for only 81% of their intrinsic value (as of 10/26/16), which implies a potential 23% gain in the market price.

 

 

While many might consider Biotech as too volatile or even speculative, there are several large-cap Biotech companies with healthy balance sheets, broad drug portfolios, and consistent cash flows. One indication of the profitability and capital efficiency of a company is its Return on Invested Capital (ROIC). Investment research firm New Constructs composed a list of the currently traded S&P 500 stocks that gained 10% or more in 2008. There were not many stocks during the height (or lows) of the market downturn that posted double-digit annual returns:

 

 

All of the stocks listed in the chart above had double-digit ROIC figures in 2007, which most of them have maintained for the past decade. Amgen, Celgene, and Gilead highlighted in blue are Biotech companies. Their ROIC for the trailing 12 months (ttm) are currently still above 10%, showing that these companies have remained profitable even while their stock market prices have decline over the past year. If we can use ROIC as an indicator of a high-quality company, then these largest companies of the Biotech sector fit the bill.

Technical analysts would say that the momentum for Healthcare has shifted upward lately. The chart below for IBB points out how “biotech has been making higher highs all year.” Pullbacks, like the one surrounding the pricing of Mylan’s Epi-Pen, “have been short-lived.” Goldman Sachs indicated in August that the Healthcare sector overall is gaining momentum and looks as if it will become a leading sector in the near future.

 

 

According to Fidelity’s most recent Quarterly Market Update, the U.S. is shifting into a more mature, late phase of the business cycle (characterized by credit tightening and slow growth) with low odds of a near-term recession. Historically the Healthcare sector has done very well in late cycle phases, as well as during recessionary phases.

In 2008, while the S&P 500 lost over 38% of its value in 2008, the IBB (the iShares Biotechnology ETF which has the broadest exposure to U.S. Biotechnology stocks) was down only 12%. Biotechnology holdings might once again serve a more defensive role in a portfolio during the next downturn.

Although the Biotechnology sector looks attractive on many levels, there is still the uncertainty surrounding the 2016 election cycle. There are two main factors to consider. Firstly, there is uncertainty about who will win the Presidency and what, if any, healthcare policy changes the winner would try to enact. A Clinton victory would likely see a push for change in drug pricing. While she is currently favored to win by most recent polls, those same polls show that the legislative branch is also likely to remain divided, making extreme policy changes unlikely. In the off chance that the Democrats sweep both houses of Congress, many think that pharmaceutical companies with older and generic drugs are the most at risk from policy changes. It is believed that few politicians would be willing to curtail life-changing and life-saving drug developments from coming to market. It should also be noted that any changes that are eventually pushed through probably would not take effect for years.

Secondly, it is difficult to ascertain how much of an impact policy changes would actually have on Healthcare companies. Morningstar recently examined the Biotech sector and determined that its pricing power should “remain strong, especially for innovative new drugs” and for drugs which meet currently unmet needs in the market. Larger Biotech companies, with larger product portfolios and pipelines, are less likely than their smaller counterparts to be reliant on above-inflation drug pricing policies to secure profits.

Furthermore, we might be able to look to the enactment of the Affordable Care Act and its impact on the Healthcare sector. While there was a lot of fear about whether Healthcare companies would be able to remain profitable with these changes, the Health Care Sector SPDR ETF (XLV) rose by 120% since Obamacare went into effect in March of 2010. Given the uncertain and charged political environment, Servant Financial has added only a small toehold position in the VanEck Vectors Biotech ETF (BBH) in our aggressive and moderate portfolios. BBH focuses on the 25 Biotech companies with the largest market capitalization and highest liquidity. VanEck's selection process leaves out the smallest and most volatile Biotech companies.

We believe that a focus on larger cap stocks helps BBH maintain an overall higher quality portfolio of companies. The Biotech companies listed above (which did best in 2008) account for 3 of the top 4 holdings of VanEck Vectors Biotech ETF (BBH) and one-third of its portfolio. The ROIC, which we used as one indicator of high quality stocks, is 21% for the overall BBH portfolio. We plan to opportunistically add to these positions, as we eagerly await the outcome of the election.