QUARTERLY OUTLOOK

This quarter we asked Gratus Capital Director of Investments Todd Jones to weigh in on the current financial environment to learn more about critical market trends.

Here’s what Todd is talking about this summer:

With equity markets at new all-time highs, where is Gratus now looking for different equity allocations?

Certainly, we’re being a little more cautious with our equity investments, while remaining at our targets. The reason we’ve been giving more caution to this side of the portfolio is due to elevated valuations. Specifically, equity markets are experiencing valuation levels that haven’t been seen in a number of years.

Furthermore, the number of bargains available to equity investors is among the lowest we’ve witnessed at any point in this recovery cycle. It’s important to recognize this, since as value investors, we consider price an important factor in all of our positions when determining what investments to add to or remove from a portfolio.

For the past 12 months, we’ve been focusing on developed international markets, such as Continental Europe, because we continue to see select opportunities available in these markets. However, this is not the case for other developed areas of the world, including Australia and Japan. In our view, these areas are more risky than Europe because of their proximity to China.

Emerging market stocks and bonds have been performing well. Is this an area Gratus is considering for portfolios?

We’re still considering these allocations both on the equity and fixed income sides. However, Gratus has yet to make any investments in emerging markets. This is primarily because of the substantial liquidity risks that are evident in most of these markets. As an example, on May 17, 2017, the Brazilian stock market was down approximately 18 percent. This one-day price plunge highlights the hidden risks in emerging market equities. Unfortunately, many investors aren’t paying attention to this rapid movement.

On the emerging market bond side, this asset class looks unattractive. Yields on emerging market bonds relative to U.S. Treasury bonds are nearing all-time lows since the 2008 global financial crisis. We believe this represents a negatively skewed risk-return tradeoff.

Technology stocks have been drawing a lot of news attention and seem to be up almost every day. Is this something we should be concerned with?

There certainly have been a number of publications correlating where technology stocks are today versus a similar high valuation situation in 2000, when there was a tech bubble. However, this time around in 2017, technology segments within the equity markets appear far less risky than in 1999 and 2000.

There are two reasons why:

#1 – The tech-knowledge economy is becoming larger, certainly larger than in 1999.

#2 – Technology companies are generating substantial earnings. Therefore, given that these companies are generating far-superior earnings as compared to 1999, the valuations are much more believable and reasonable.

Are there any portfolio changes Gratus is making now?

There are a number of things that we’re doing and have been doing throughout 2017. I’d like to highlight three:

#1 – Similar to the first quarter in 2016, we rebalanced all of our accounts this year, but for different reasons. Last year, equity markets had sold off dramatically. Therefore, we rebalanced in order to add to our equity positions. This year, we rebalanced all of our accounts in order to reduce equity positions, because prices have moved up substantially as compared to last year.

#2 – We are increasing cash positions where available. Overall, we haven’t held much cash in our accounts through this recovery. Still, we believe cash will create potential opportunities within portfolios in the near future.

#3 – We are continuing to transition some of our equity and alternative positions from passive indexes to active strategies. Given the deluge of money being invested in passive strategies, we believe active strategies will have better potential to outperform than they have at any point in the last 10 years. We discussed this active management approach in our June Market Insights, Investing In An Era Where Price Is Irrelevant.

Authored By:

Gratus Capital is an SEC registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of July 2017, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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Each quarter we ask Gratus Capital’s investment experts Todd Jones or Marc Heilweil to weigh in on the current financial environment—addressing key issues you’ll want to have on your radar. This spring we reached out to Todd Jones, Director of Investments, to learn more about critical market trends.

Here’s what Todd is talking about this spring:

Are you concerned about current market levels being so high? If not, what are the reasons you are comfortable with staying invested in stocks?

We are eight years into the current bull market in equities, and all indications point to a continued upward bias. Yes, there are indicators that are flashing caution signs that occurred around previous equity market highs (e.g., elevated Schiller P/E, record margin debt, record profit margins, high levels of insider selling, etc).

Yet these are all known issues which are currently being discounted by the market. On the positive side of the equation, there is no denying that while the U.S. economy may be slowing down a little, other parts of the globe are counterbalancing this slowdown, particularly Europe.

This brings us to why we are comfortable with our global equity holdings at this point in the market cycle.  The primary reason we remain fully invested is due to the fact that we’ve been transitioning a portion of our equity holdings away from U.S. based companies to (primarily) European-based companies given their significant valuation and yield difference.

According to data from JP Morgan, the price-to-earnings ratio for the next 12 months on the S&P 500 sits at 17.49x while the MSCI EAFE is a more reasonable 14.86x.  On a yield basis, the S&P 500 current dividend yield is 2.01% while the MSCI EAFE yield is 3.03%.

In all, we recognize that financial markets are cyclical.  We just believe that there are a number of positive factors at work right now that lead us to believe that there is still a decent way to go until we reach the end of the current market cycle.

What are the biggest risks you see with the global stock markets right now?

It’s important to recognize that predicting what will be the catalyst for the next downturn with any degree of accuracy is next to impossible. Market turns are usually a confluence of events conspiring to sap investor confidence to a point that leads to a mass “sell” in the markets.

That being the case, the biggest risks to global stocks within this mosaic approach appear to be two-fold: (1) a rapid change in inflation expectations (which causes bond yields to rise quickly) and, (2) a rapid rise in the U.S. dollar.

The impact of either of these events would be a reduction in global liquidity. A reduction in global liquidity is a difficult environment for risk-seeking assets like stocks, as leveraged holders of equities can be forced to liquidate their holdings to meet capital calls in other parts of their portfolios. Post-2008, global central banks have broadly filled the liquidity gap with assets purchases (e.g., quantitative easing) but the efficacy of such policies is starting to be called into question now that the U.S. Federal Reserve has embarked on an interest rate-hiking paradigm.

Are you concerned with inflation or interest rates rising soon?

This is the million-dollar question as all financial assets derive their value from a risk-free rate. Our base case is that long-term U.S. interest rates remain contained and will trade within a range for the foreseeable future.

Shorter term U.S. interest rates will likely rise at a measured rate in lock step with the increases of the Federal Funds rate over time. The reason we believe longer term rates will remain contained is because economic growth in the U.S. is slowing and U.S. demographics continue to gray (leading to incremental demand for bonds).

As we’ve pointed out in the past, this “flattening” of the yield curve starts to turn problematic typically when short-term rates move higher than long-term rates. We are still a long way from this occurrence.  What would be highly problematic, however, is if intermediate/long-term rates were to rise in a rapid manner over a short period of time.

Look for the next edition of our quarterly newsletter this summer, when it’s Marc Heilweil’s turn to share his expert insight on the key financial issues of the day — and points you’ll want to consider.

Authored By:

Gratus Capital is an SEC registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of February 2017, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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Welcome to Gratus Capital’s Quarterly Market Outlook.

Each quarter, our investment experts – Marc Heilweil, Senior Portfolio Manager, and Todd Jones, Director of Investments – weigh in on the current financial environment. They lend context to common areas of interest or concern, and hopefully spark new conversations between you and your Gratus advisor.

Here’s what Marc and Todd are talking about this quarter:

What are the reasons the market has reacted so strongly to President Trump being elected?

TJ: There are three primary reasons why the market has reacted so strongly to the recent change in our country’s leadership.

#1 – There are potential tax changes that have the ability to improve earnings by double digits. Therefore, the market is discounting in anticipation of favorable tax changes.

#2 – Anticipation of regulatory change is also adding to market discounting. For example, by reducing regulations on banks and other industries, such as energy or mining, these share prices have taken off dramatically. Some projects will likely be more accessible in the near future, such as drilling offshore near California.

#3 – The earnings recession is ending. For approximately the last 18 months S&P earnings were flat; however, we’re starting to see movement toward more positive returns.

Why are alternative investments important now in order to reduce risk in portfolios and provide a reliable return?

TJ: There are two key reasons why alternative investments are important right now. First, they offer diversification benefits that come from earning a return in a different way with no correlation to the equity or fixed income markets. Secondly, because both equity and fixed income markets are currently fairly expensive.

Bonds have been selling off post U.S. election on a global basis. Are bonds still a good investment to have in a portfolio? How is Gratus addressing the recent back up in yields?

TJ: Yes, bonds are still a good investment. They provide two critical components within a portfolio, specifically income generation and volatility dampening. Keep in mind that bonds and stocks don’t move in the same direction. Therefore, when equity markets are rapidly selling off, bonds help provide diversification.

Certainly there has been a notable move up in yields, which tends to push prices down. The way Gratus has addressed this, dating back as far as 2009, is by avoiding government bonds. They’re the most exposed to a changing interest rate environment. More recently, we’ve been gradually migrating away from fixed income investments and moving toward alternative investments in order to take advantage of lowering yields.

Will the US dollar stay strong throughout 2017 and how will this impact your investment decisions?

TJ: In the past two years, the US dollar has strengthened and has been a key macro variable in question. The reason why the dollar’s strength could be an issue is because of its impact on international earnings by U.S. companies. Specifically, the US dollar’s strength impacts foreign earnings. The degree to which earnings are impacted is the variable we’re watching closely, including how companies are adapting to the stronger dollar environment.

Keep in mind that when the dollar is strong it negatively impacts emerging markets’ currencies. This is the primary reason why we presently don’t believe in having emerging market exposure within our portfolios. 

Does the rise in global populism concern you as an equity or fixed income investor?

MH: For some time now I’ve been concerned about the rise in global populism. It’s quite understandable that the rapid rate of change has caused people to question whether their governments are actually looking out for them. There’s no doubt in my mind that governments haven’t shown adequate sensitivity to this concern and it’s caused people to question whether their government could have done more to control the rate of change. In particular, I’m very guarded about the outlook for the Eurozone. The populist candidate, Geert Wilders, appears likely to get a majority in the Netherlands and he advocates withdrawing from the Eurozone.

As with many of these upsets or changes, the breakup of the Eurozone may not be as damaging in the long term as current fears would have it. Relief from the Brussels bureaucracy may provide a stimulus to European economies, similar to how President Trump has unleashed some confidence in the American business community.

Health care seems to be a bad place to be since the ACA will likely get repealed. Why would we own it?

MH: Unfortunately the demand and the need for health care will not change. Whether it’s a minor illness or a more serious heart problem, we’ll need our health care system. Whether or not the ACA gets repealed in full or merely gets modified remains to be seen. In a stock market of very high valuations, the uncertainty over health care reform has created some attractive opportunities in that space. Very high-quality health care companies are discounting negative changes that may not occur.

For Example:

Pricing and competitive bidding for pharmaceuticals would have to be instituted by Congress. However, in the past they’ve shown no willingness to accomplish this. One of the benefits I’d like to see happen and is consistent with President Trump’s viewpoint is measures to ensure that other wealthy countries pay better prices for the inventive products of American pharmaceutical companies. Essentially, America has been subsidizing the research and development of medical devices and drugs while other wealthy countries, through their price controls, have not contributed. In fact, countries such as Japan and Germany drop the price of drugs on an annual basis.

President Trump and Congressional Republicans have talked a lot about lowering corporate tax rates. Has the rise in stock markets resulted from this, are companies really improving, or are we going back to “irrational exuberance”?

MH: Unquestionably the policies of the new administration are being viewed positively by the financial markets. Certainly there is a large discrepancy between the corporate taxes shown as paid for financial statement purposes versus the actual amount that is paid to the IRS. Therefore, while cleaning up the corporate tax situation is long overdue, and the lower stated rate currently thought to be 22% is a positive for small business, one must be humble in the face of the uncertainties in the current environment. Remember that when share valuations are very high the market becomes susceptible to unforeseen shocks.

What’s an investor to think about the stock market today?

MH: I think it’s important to concentrate on what can be known, and what’s knowable is analyzing businesses from the ground up. Remember that buying shares is buying a piece of an existing business. Ask yourself whether the business is well positioned within its marketplace and whether the culture and leadership are acting in the interest of all shareholders. What’s more, never forget to pay attention to the price that is paid for a share of the ownership of the business.

How can people follow up with you on these issues and any related questions?

TJ: I gladly welcome any follow-up questions or questions for next month’s commentary. Send them to tjones@gratuscapital.com.

Authored By:

 Gratus Capital is an SEC registered investment advisor.  Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of February 2017, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.
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Welcome to the Gratus Capital Quarterly Market Outlook.

market-outlookStarting in Q4 of 2016, we adopted a new format for our Quarterly Market Outlook. We hope you find that this refresh makes our insights more well-balanced, engaging, and accessible.  

You asked… our experts answered. Each quarter, our investment experts—Marc Heilweil, Senior Portfolio Manager, and Todd Jones, Director of Investments—weigh in on the current financial environment. They lend context to common areas of interest or concern, and hopefully spark new conversations between you and your Gratus advisor. Here’s what Marc and Todd are talking about this month:

Relative to other market environments you have experienced over your 30+ year career, how would you characterize where we are currently in the US?

MH: We are in unknown territory right now. I’ve been a student of market history for many years, and this is perhaps the first time wherein history offers very little to inform us about what to expect. Therefore, we all need to be humble in the current environment. Central banks are suppressing interest rates by buying up fixed-income instruments (government bonds, etc.) throughout the major economies of the world. As a result, asset prices are higher than they normally would be. I think the overarching message is to take any major forecast with a grain of salt, and remain cautiously optimistic with individual investment selections.

It seems as if the markets approve of the recent OPEC plan to curtail production.  What are your thoughts?

TJ: This is a topic that’s been in the news quite a bit. It’s certainly on the minds of our clients and investors. To us, the whole energy question is not necessarily impactful to how we manage accounts (because we work on a much longer-term basis than this question might suggest). But as far as putting credence into the OPEC decision, I would just remind people we’re talking about a loose association of countries that don’t like each other very much. Expecting them to do what they say they’ll do is a large ask. Right now these are just words, not actions; and historically you can’t trust what all OPEC members say. Short term, people should be skeptical of the bottom line.

What types of opportunities are you finding in international markets versus domestic?  Do you have a preference at this point in time?

MH: If I had to make a generalization, most markets—adjusting for their riskiness—are somewhat more attractive than U.S. markets. Part of the reason for that is because (except for China, which never saw a big dip) the U.S. recovery has been much faster in the wake of the Great Recession. The dollar has also been quite strong, so that has attracted more investments from abroad rather than the reverse: U.S. investors going to international markets. People would rather have dollar-denominated investments.

At the moment, Switzerland is a particularly attractive market. There are some extraordinarily well-run, multinational corporations in that country, and there’s been an effort made by Swiss National Bank to keep the currency from becoming too strong. Somewhat more speculatively, India seems to have enormous potential. If policies continue to address India’s financial reforms, I think the Indian market will be quite profitable over the next decade. 

What is the outlook for interest rates over the next 12 to 18 months? 

TJ: Again, this is a bit of a challenge to answer, but the discussion is critical to understanding forward-return projections for a number of different asset classes—specifically equity or fixed income. Barring periodic spikes higher in global rates, it’s been our belief—at least over the past five years—that the long-term trajectory of interest rates remains firmly downward. That may be a non-consensus view, but there are definitely a number of factors keeping rates low for the time being:

  • Declining worker productivity—Workers are becoming less productive, so less income is being generated.
  • Demographics—The world is getting older. Seniors require higher levels of fixed-income investments. Going forward there will be buying pressure from older cohorts, globally.
  • Tech improvements leading to job disintermediation—Increasingly, robots can do the routine jobs that people used to do, putting deflationary pressure on wages.
  • Debt—In and of itself, debt is deflationary. It’s pulling demand forward, and at some point you have to pay back your debts.

What could send rates higher, on a more predictable trajectory? Following the next recession, once all the excess debt gets worked out, we may see a more sustained trend upward.

What do you see as the biggest risk to global financial markets currently?

MH: The biggest risk comes from central bank policies. The markets have been somewhat complacent ever since the 2008 financial crisis, in assuming central banks can bail financial markets out. That has been true, but it won’t always be true. At some point, the markets will become more powerful than banks, which have been weakened in their ability to react. The rekindling of inflation is another factor. From a macro point of view, I’ll be keeping my eye on that.

Why are investors turning to private real estate investments?  What is the opportunity in private investments versus public right now?

TJ: Private investments are a big focus for us at Gratus these days. Many markets—equity and fixed-income, for example—are elevated in valuation relative to historic norms. Bond yields are a lot lower than where we started the recovery; the S&P is about 100 percent higher than where it started in 2009. And forward returns, based on valuation metrics, aren’t nearly as good as they were even a couple of years ago.

All told, returns are getting harder to make in public markets. That leads us to the private investments, which certainly has its risks and unique considerations, but also far higher starting return potential because of the large illiquidity premium—i.e. the amount you’re compensated for taking on illiquidity risk.

We’ve hired a talented and experienced real estate analyst to identify opportunities and create fund strategies in this arena. These “less traveled” roads are a natural place to look, as we work to help clients earn an acceptable rate of return, in an effort to achieve their financial goals.

Where can people follow up with you on these issues and any related questions?

TJ: I gladly welcome any follow-up questions or questions for next month’s commentary. Send them to tjones@gratuscapital.com.

mark-heilweil

 

Marc Heilweil, Senior Portfolio Manager
mheilweil@gratuscapital.com

 

todd-jones

 

Todd Jones,  Director of Investments
tjones@gratuscapital.com

 

Gratus Capital is an SEC registered investment advisor.  Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of October 28, 2016, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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