Much changed in the third quarter. The narrow trading range that characterized the first seven and a half months of 2015 was breached in mid-August with a significant market decline and increased volatility. The S&P 500 peaked on May 20th at 2,135 and troughed on August 25th at 1,868, 12.5% below the peak and officially in “correction” territory. We closed the third quarter at 1,920, which represents a 10.1% decline from the peak and a -5.3% total return year-to-date. A market that is down more than 10% from a peak is said to be in a “correction.” A decline of 20% or more is a “bear market.” The last bear market in the U.S. ended in March 2009, after a 47% decline from November 2007.
The recent sell-off followed a tightening of monetary conditions. Corporate bond spreads widened and inflation expectations plunged. Both constitute monetary tightening even in the absence of explicit policy moves. These conditions, together with the anticipation of actual Fed tightening, are a recipe for equity market volatility.
Unfortunately, we don’t think the equity markets will stabilize soon for two primary reasons.
1. The Fed’s desire to move away from its zero interest rate policy may cause financial conditions to tighten even more and constrain economic growth both in the U.S. and abroad. Unlike prior rate hike cycles, the Fed is not looking to raise rates to cool an overheating economy, but simply to bring rates back to a more “normal” level after being super-accommodative for nine years.
Usually the Fed begins raising interest rates when the economy is accelerating, profit margins are expanding, corporate pricing power is broadening, commodity prices are rising and the dollar is depreciating. None of these trends are currently present. It is unprecedented for a tightening cycle to begin when sales and profit growth are this weak. Just the threat of rising interest rates is currently weighing on equity markets. We expect monetary conditions to tighten further if the Fed does raise rates.
2. The economic backdrop outside the U.S. is bleak.
Many emerging market countries are experiencing slowdowns in manufacturing and exports amidst a decline in global trade. These regions account for more than half of global GDP. Their weakness will continue to negatively impact large multi-national companies. The MSCI Emerging Markets equity index is now down over 17% year-to-date and over 25% from its high in April 2015, and we believe it can fall further.
There are also two counter-balancing positive factors we consider important.
1. The US economy is still growing moderately and employment trends continue to improve. U.S. unemployment has fallen from 10.0% in 2009 to 5.1%. Consumer balance sheets are benefitting from lower debt levels and higher housing prices. From a macroeconomic perspective, the issues weighing on emerging markets help our largely consumer led economy, because declining commodity prices benefit the U.S. consumer. The U.S. is probably not on the verge of recession and absent a U.S. recession, it would be highly unusual for this correction to turn into a bear market.
2. With the exception of materials and energy companies, U.S. corporations, particularly those with high domestic exposure, are generally performing well. Corporate profits as a share of GDP remain near record levels and corporate and consumer free cash flow generation is strong. Earnings estimates have not moved materially lower since the sell-off, which means multiples have declined. Equity markets now appear reasonably valued on an absolute basis and relatively attractive compared to other asset classes like fixed income and real estate.
The bottom line is that the U.S. economy is not particularly strong, but, in our view, is not on the threshold of contraction either. We think we are still in a long, though generally underwhelming economic recovery perpetuated by broadly accommodative monetary policy, yet restrained by deleveraging and aging demographics. Given these cross-currents and increased volatility, we are positioning portfolios defensively with the following biases:
- Moving equity exposure to the mid-point or lower-end of allocation ranges;
- Favoring companies with high percentages of U.S. exposure;
- Maintaining no or very limited direct exposure to emerging markets;
- Opportunistically adding to long-term thematic holdings made more attractive from non-fundamental selling or high volatility.
Although we are tactically cautious on equities in the short-term, if we see signs that strength in employment is broadening to other areas of the U.S. economy and that global excess capacity is being absorbed, we will alter this view.
Opportunistically Adding to Thematic Positions
Fitness/Ath-leisure: Developed market re-urbanization has led to a significant increase in spending on fitness and a new category of apparel called “ath-leisure.” U.S. gym memberships have increased from approximately 30 million in 2000 to well over 50 million today. There has been an even greater increase in exercise boutiques with specialties like cycling, yoga, boot camps and personal trainers. Most of these boutique options are much more expensive than a generic gym membership, contributing to a significant spike in fitness spending.
If a consumer were to attend one Soul Cycle class per week, it would cost approximately $1,700 per year. One CrossFit class per week costs $2,500 per year. Of course, most participants attend far more frequently, which means spending is that much greater. If consumers are willing to spend that much on exercise, naturally they will spend money to look good doing it. Annual spending on athletic gear has increased from $140 billion in 2010 to $175 billion today, and we expect the level to approach $225 billion by 2020.
In addition, athletic gear is no longer only worn to exercise. Yoga pants have replaced jeans as everyday apparel for many young women and celebrity endorsed sneakers have become the “must have item” for many boys and young men. Sneakers and athletic gear have even penetrated the gilded world of high fashion. Last year Chanel paired upscale running shoes instead of stilettos with each outfit in its Haute Couture Paris fashion show. Luxury apparel companies have added sneakers and ath-leisure type clothing to their collections. This has not only expanded the category, it has raised the pricing umbrella.A $125 pair of Nike Air Zoom Elites seems reasonable when compared to a $600 pair of Prada leather sneakers and a downright bargain compared to Rick Owens leather high tops priced at almost $4,000.
The stock prices of several well-run companies with significant exposure to this trend declined precipitously with the wide-spread sell-off in August. This provided
us the opportunity to start positions in premier companies that we believe are well positioned to benefit from the continued uptrend in the category.
Healthcare: Through August 10 healthcare had been the best performing sector in the S&P with the sector rising10.7% year-to-date versus 2.2% for the Index. From August 10 through the end of the third quarter, the healthcare sector dropped to the second worst performing sector declining 12.6% versus the Index which declined 8.8% over the same period.
There are a few reasons for the sell-off in healthcare. Not only did healthcare outperform during the first seven months of 2015, the sector also outperformed in 2013 and 2014. During the two-year period from January 1, 2013 through December 31, 2014, healthcare was the best performing sector of the S&P, rising over 71% versus the index return of 44%. After a long period of significant outperformance, a short-term pull back is not unusual.
Additionally, recent political jawboning about a host of healthcare related issues, including the elimination of direct-to-consumer advertising, new requirements on drug companies to reinvest in research and development, caps on out-of-pocket costs for patients, increases in FDA funding for the Office of Generic Drugs to clear out the generic application backlog, a reduction of the biologic exclusivity from 12 years to seven years, and new rules pertaining to drug importation, have all weighed negatively on sentiment.
While we think many healthcare related topics being debated are extremely important, given other near term issues facing Congress, including funding the government and the debt ceiling, we think it unlikely that changes in healthcare policies will be implemented any time soon. Although the 5,500% increase in Daraprim, from $13.50 to $750 per pill after it was acquired by Turing Pharmaceuticals, lit a front page political fire that spread to the markets, in fact, prescription drugs only represent about 10% of national health spending.
Despite the politics, healthcare’s strong fundamental trends have not changed. The sector is currently the fastest top line grower in the S&P due to numerous tailwinds, including an aging population, increased coverage under the Affordable Care Act, high domestic/low international exposure and advancements in molecular medicine. Sometimes headlines create temporary headwinds that we see as buying opportunities in companies with secular thematic tailwinds.
Fixed income markets have been relatively stable compared to the recent volatility in equities. Two-year bond yields spiked up just before the much anticipated Fed meeting in September, but quickly returned to within ten basis points of average levels for the year. Ten-year yields traded between 2.00% and 2.45% throughout the quarter. Once again, the third quarter underscored the importance of a balanced investment portfolio and the role of fixed income as an asset class largely uncorrelated to and less volatile than equities.
Bonds, and more particularly bond funds, however, are not without risks. The bond market has changed over the last five years. In the past, big banks and broker- dealers acted as “market makers,” facilitating trades between buyers and sellers and when needed acting as buyer or seller. Now these institutions have reduced their bond-trading activities because of new regulations and higher capital requirements. As a result, some market segments may experience illiquidity. Both the International Monetary Fund and the Securities and Exchange Commission have recently warned that illiquidity could disrupt bond markets. The combination of illiquid corporate credit markets, high new issuance and the proliferation of bond exchange traded funds (ETFs) could be problematic. Supply in the primary market is growing at a time when liquidity in the secondary market is shrinking. The result is a crowded theater with a tiny exit and conditions ripe for a fire.
ETFs and bond funds holding illiquid and lower quality bonds are particularly vulnerable. Chevy Chase Trust core fixed income portfolios emphasize credit quality, individual bonds over funds, and the ability to hold bonds until maturity, all of which reduce portfolio risk.