Investment Update, Fourth Quarter 2016

2016 was a good year for equity markets. The S&P 500 generated a total return just shy of 12% and the MSCI All-Country World Index, excluding the U.S., returned 4.5%. While the U.S. Presidential election and Brexit dominated headlines, the broad economic recovery was the most important financial development of the year.

The current equity bull market began in March 2009. It has been called the most unloved bull market in history. Still fresh memories of the financial crisis have led to an almost pathological assumption that good times can’t and won’t last. In fact, since the start of the recovery, there have been net redemptions from domestic equity mutual funds and ETFs every year except 2013. Unlike 2013, when a rise in bond yields was relatively short lived, the current rise in yield appears more sustainable. This could spur a rotation back to equities from bonds, providing a catalyst for yet another leg up in the current bull run.

The most recent surveys of institutional investors show that the majority of participants believe U.S. equity markets are overpriced. This is understandable given that the market capitalization of the S&P 500 has increased by almost $1 trillion just since the election. While we would not be surprised by a fourth consecutive weak January, led by investors who deferred selling stocks with embedded gains, important near-term indicators, including healthy market breadth, narrow credit spreads and accelerating earnings growth, point to continued strength.

The bull market is very likely closer to its end than its beginning, but it may not be over yet. Alan Greenspan first used the phrase “irrational exuberance” in 1996. That market had three more years to go and more than doubled before it ended in 2000.

Signals Versus Noise

Recently, many traditional economic relationships have broken down. Sharp parallel rises in both currency and yields are rare. Usually when the U.S. dollar appreciatesrapidly, long-term interest rates do not since dollar strength slows economic growth. Emerging markets usually do well when commodity prices rise since many emerging market economies are commodity dependent. However, since the election, the MSCI Emerging Market Index has declined 5% while the Goldman Sachs Commodity Index has risen almost 15%. In an environment of strengthening global growth, cyclical currencies usually strengthen against the U.S. dollar. The opposite is occurring.

Given these paradoxes, the metric we are watching most closely is inflation. A relatively low and stable level of inflation is a sign of a healthy economy. Equity market multiples tend to be at their highest when inflation is between 0% and 2%. The Federal Reserve Board believes that an inflation rate of 2% is ideally conducive to its mandate of price stability and maximum employment. Over time, a higher inflation rate would hamper the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would increase the probability of deflation.

Broadly speaking, the past 30 years have been characterized by increasing globalization which is inherently deflationary. In a globalized world, more competition and access to cheaper labor reduces the costs of goods. Further, if a country experiences an idiosyncratic shock that raises domestic demand, the demand can be met with more imports rather than higher prices. Many of the factors that facilitated globalization over the past 30 years were one-off developments. China cannot join the WTO more than once. Tariffs in most developed countries cannot fall much further because they are already close to zero. There is nothing on the horizon that will match the breakthrough productivity gains in global shipping that stemmed from containerization. And the global supply chain is already highly efficient.

We believe the deflationary pressures that were the hallmark of the post-Bretton Woods era are behind us and we are entering a reflationary period where the risks of deflation have receded, but widespread inflation is not yet imminent. This is generally good for risk assets in the short-term, particularly cyclical equities.

Portfolio Positioning

With global economic growth improving, higher inflation still suppressed and real yields negative in Europe and Japan, stocks remain attractive relative to bonds. The majority of our equity holdings are beneficiaries of trends that we believe are powerful enough to influence corporate performance.  Most of our investment themes are secular rather than cyclical, driven by technological or demographic forces that persist independent of economic cycles and thus have the potential to outperform across different market environments. On occasion, at economic turning points like we believe we are witnessing now, cyclical forces can have an outsized influence on equity market performance. Currently, two of our six themes are motivated primarily by cyclical changes impacting financials and energy.

The macroeconomic transition from a deflationary to a reflationary environment will put upward pressure on interest rates. Concurrently, the financial regulations implemented post-crisis have been absorbed and will likely ease under a new administration. Both of these changes will benefit banks. The financial sector is the only major S&P sector still trading below its 2007 high. We believe a pick-up in lending activity due to accelerating global growth, rising interest rates, wider net interest spreads and financial deregulation will be tailwinds to large U.S. banks in 2017.

Another sector that we believe will disproportionately benefit from faster global growth is energy. It is often said, the cure for high oil prices is high oil prices and the cure for low oil prices is low oil prices. At $30 per barrel, most oil companies could not profitably drill for oil, so they stopped and supply fell. Because demand growth was also tepid in the first half of the year, the drop in supply did not result in an increase in price.  As economic growth accelerated in the second half of the year, demand rose and the price of oil began to climb.  Simultaneously, OPEC reemerged with some unity and production discipline. Ride-sharing services like UBER have and will continue to increase automobile usage and gas consumption, likely at the expense of public transportation. This creates additional oil demand in the short run. These factors should combine to produce tailwinds for some energy companies in 2017.

Genomics remains one of our highest conviction secular themes. The broader healthcare sector underperformed the market in 2016 after five straight years of strong performance. We still believe advances in molecular medicine will dramatically improve the ability to identify and combat disease, and will benefit innovative companies facilitating this life sciences revolution. The pipeline of oncology drugs has never been greater. A November 11th article in the Washington Post, titled “How a researcher used big data to beat her own ovarian cancer,” provides a real life case study of how a combination of DNA sequencing, new therapies and big data analytics (another Chevy Chase Trust theme) can dramatically change the impact of cancer.

From a geographic perspective, we are increasing our holdings in developed market non-U.S. equities, in particular, Japan. In the third quarter of 2016, Japan corporate profits reached a record high yet foreign fund flows into Japanese equities were still negative for the full year.  Japan is a prime example of how an aging population will eventually push up interest rates. The household savings rate in Japan was over 14% in the early 1990s. Since then the percentage of the population that has moved from working age to retirement age has more than doubled, from 12% to 26%. The savings rate today is only 2%. Meanwhile, the ratio of job openings-to-applicants is at a 25-year high. This will eventually lead to higher wages and end persistent deflation. Japan will benefit from this shift because inflation will pressure real rates (as opposed to nominal rates), lead to a weaker yen, a stronger stock market, and even higher inflation expectations.  We are looking at investment opportunities in Japan, particularly ones tied to our global themes.

From a longer term perspective, there are reasons to be concerned. In the U.S., rising interest rates coupled with a stronger U.S. dollar will be a drag on U.S. economic growth.  Additionally, when inflation is on a firm upward trajectory, central banks everywhere may find it difficult to slow the trend. These two factors will then weigh on equity market multiples. And a strong U.S. dollar puts pressure on emerging markets. As of mid-2016, dollar denominated debt held outside the U.S. had risen to almost $10 trillion dollars. About one-third of the debt is held in emerging markets. As the dollar rises against other currencies, the cost of servicing debt increases. Nonetheless, barring an exogenous shock, these risks are real but probably not pressing enough to change near-term equity market momentum. It may be a bumpy ride, but we believe there is still upside entering 2017.

Fixed Income

2016 was a wild year in the bond market. 10-year bond yields started the year at 2.27% and fell to a low of 1.32% shortly after Brexit. Prior to the U.S. election, yields climbed back to 1.88%, and after the election shot up another 76 basis points to a 2016 high of 2.64%, before settling back to end the year at 2.44%. Although the absolute numbers may seem small, in percentage terms these are large moves.

Pundits debate whether the 30-year bull market in bonds is finally over. We do think the cycle-low for bond yields is behind us and yields will continue to climb from current levels, just not linearly. But, we don’t expect another doubling in yields until spare capacity outside the U.S. is absorbed. Only when other central banks start raising rates will the Federal Reserve be able to sustain its rate hikes. Until then, any Fed tightening beyond what is already expected will put upward pressure on the U.S. dollar, thereby reducing the need for further hikes.

Given this outlook, we are maintaining our current portfolio positioning. The average duration of our bond holdings is approximately 3.5 years. As bonds reach maturity or we identify swap opportunities, we will seek to reinvest the proceeds in higher yielding instruments. Continued volatility in the bond market will present opportunities to buy high quality securities at discount prices.  We will capitalize on these opportunities to add value.