Climbing the Wall of Worry: A Review of Investor Concerns and Risks

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1 THIRD QUARTER 2017 Climbing the Wall of Worry: A Review of Investor Concerns and Risks Risk means more things can happen than will happen. Elroy Dimson, London Business School co-author, Triumph of the Optimists As any bull market progresses, investors are challenged to overcome the rolling concerns and risks that inevitably emerge along the way. As we glide through the ninth year of a domestic equity bull market, we hear a range of concerns broadly pertaining to: the length of the bull market and stretched valuations; low inflation and the risk of deflation; tightening monetary policy; and geopolitical JASON D. PRIDE, CFA Director of Investment Strategy risk. In this Market Insights, we will assess the risks of each and discuss our strategy for investing in this environment. While we continually monitor these risks, we believe the expansion and bull market should continue. WORRY RISK LEVEL ASSESSMENT / REASONING #1 Over-Extended Markets Modest: U.S. equity valuations likely to remain high, international equity valuations reasonable #2 Deflation / Low Inflation Low: Tight labor markets and rising wages likely to lift inflation on the margin #3 Tightening Monetary Policy Modest: Risk of a policy mistake exists, but central bankers appear to be proceeding cautiously #4 Geopolitical Instability Modest: Geopolitical instability seems higher, but be careful not to over protect portfolios

2 #1 Over-Extended Markets Concern regarding over-extended equity markets is usually described in one of two ways: either as a lengthy bull market or as an overvalued equity market. It is a fact the expansion is in its ninth year, but it is important not to infer the logical outcome is a downturn. Domestically, two expansions since 1919 have lasted longer. Internationally, many have lasted longer, including the expansion in Australia currently in its 27 th year. While informative, the length of an expansion and bull market cannot alone be relied upon to predict the next downturn. EXHIBIT 1: Equity Valuations Can Remain High for Long Periods Source: Glenmede, MSCI Data as of 8/28/2017 The index used for the analysis is MSCI USA. Note: Long-term fair value based on normalized earnings, cash flows, and book value using MSCI s USA index. Past performance is not indicative of future returns. This is an unmanaged, total return index measuring performance of U.S. large and midcap stocks with dividends included. Yes, U.S. equities are overvalued (Exhibit 1). The green line above shows the current value of the U.S. equity market and the blue line fair value; the grey-shaded bands show different degrees of valuation disparity from fair value. Currently, the market sits in the top 25 th percentile of valuations, yet still below the important 10 th percentile when overvaluation becomes more predictive of future negative returns. Valuations have reached such levels twice in the past 20 years and lasted over five years. Market Insights Page 2

3 Climbing the Wall of Worry: A Review of Investor Concerns and Risks EXHIBIT 2: Low Likelihood of Recession Source: Glenmede Data as of 8/2/2017 * Glenmede s Recession model is a tool developed by Glenmede to help estimate the probability of a recession. The model is a well-balanced mix of long-term excess indicators covering manufacturing, employment, and debt balances and near-term leading indicators covering monetary policy, credit markets, business sentiment, and other economic trends. Though created in good faith, there can be no guarantee that these indicators will be accurate. Shaded regions are recessions as defined by the National Bureau of Economic Research (NBER). Sustaining high valuations requires ongoing economic and profit expansion. Fortunately, the outlook for the economic expansion appears strong. Our proprietary model 1 (Exhibit 2), points to a low likelihood of recession in the next 12 months. This low expectation of recession can be attributed to the slow-growth expansion and resulting lack of excesses. #2 Deflation / Low Inflation As widely reported, inflation has risen but remains quite low. We recommend looking at the rising cost of labor rather than Consumer Price Index readings for indications of future inflation. Wage growth, as measured by the Atlanta Fed (Exhibit 3), has accelerated since the end of 2014, and interestingly, has occurred amid tightening labor markets. Based on a 2014 National Bureau of Economic Research paper 2, wages rise faster when 1 Glenmede s proprietary model balances near-term economic trend indicators against measures of economic excesses that may reverse course. 2 Blanchflower, D. and Levin, Andrew T., Labor Market Slack and Monetary Policy. NBER Working Paper Based on economic data from 1990 to Q Page 3

4 labor markets are tight because businesses must pay more to attract and retain needed workers. According to the study, the current unemployment rate would suggest wage growth should accelerate to percent per year, consistent with where we are today. EXHIBIT 3: Rising Wages Should Create Broader Inflationary Pressures Source: Federal Reserve System Data as of 8/28/2017 The Federal Reserve Bank of Atlanta s Hourly Wage Tracker is a 3-month moving average of median wage growth. #3 Tightening Monetary Policy The U.S. Federal Reserve is tightening monetary policy, and other central banks are discussing steps in this direction. Even at current inflation rates, interest rates are low, leading the U.S. Federal Reserve to gradually tighten policy despite inflation having not yet accelerated to an alarming rate. The Fed raised short-term interest rates in summer 2016 and in the months following, outlined a plan to sell bonds purchased during and after the financial crisis. The plan starts by selling $10B/month in bonds, gradually increasing this amount to $50B/month in order to significantly reduce the Federal Reserve s balance sheet by 2023 (Exhibit 4). Market Insights Page 4

5 Climbing the Wall of Worry: A Review of Investor Concerns and Risks EXHIBIT 4: The Federal Reserve s Quick Reduction Source: FactSet, International Monetary Fund (IMF), Glenmede Data as of 8/28/2017 Graph represents the Fed s balance sheet as a percentage of U.S. GDP. Chart assumes the Fed begins trimming their balance sheet according to the plan outlined at the June meeting, starting in December, Future GDP is represented as projected by the IMF. Historically, fast tightening cycles have had a dampening impact on both economies and markets. The important question right now is whether current tightening will happen too fast. From the chart above, we see the balance sheet reduction outlined in the Fed s plan is similar in magnitude to the balance sheet expansion pursued between 2008 and If we agree the Federal Reserve s use of its balance sheet during the financial crisis materially curtailed the magnitude of the recession, these announced bond sales could understandably cause investors to worry. A counter thought to this concern, however, is the notion that enough demand for bonds exists outside of the Federal Reserve, greatly reducing the impact on the markets and economy. In order to deal with this uncertainty, the Fed s plan includes a gradual transition from $10B per month of sales to $50B/month, allowing for revision as needed. #4 Geopolitical Instability Concerns of geopolitical risk span North Korea s nuclear missile development and the war of words between President Trump and North Korea s Kim Jong Un, to concerns about Britain s departure from the European Union, and perceptions of an increasingly polarized U.S. government. Many investors are perplexed that despite numerous exogenous Q Page 5

6 risks, there is unusually low volatility and risk priced into the financial markets. We, too, keep a close eye on these developing events, but recognize this concern has been part of the backdrop for nearly 10 years. Perceived political risks, in some form or another, have been part and parcel of this economic expansion, and none have halted the forward progress. EXHIBIT 5: Corrections Occur Quite Frequently, But Are Often Transitory S&P 500 Return (Price Index) Intra-Year Peak-to-Trough Decline Source: JP Morgan, Factset Data as of 8/28/2017 Returns are based on the price index only. Intra-year peak-to-trough decline refers to the largest intra-year drop. It is important to remember that markets frequently experience corrections, even during longer-term bull markets and expansions. In fact, markets tend to have a 5-15 percent correction annually (Exhibit 5, the red dots). Afterward, the upward trajectory typically resumes as the economy and profits continue to grow. Despite the intra-year corrections, stock markets see positive annual gains most years (Exhibit 5, the blue bars). Strategy: Opportunistic Investing in an Ongoing Expansion We recognize there are valid risks posed by the markets and economy, and hypothetical ideas of what could happen in one form or another with varying impact. Even when certain Market Insights Page 6

7 Climbing the Wall of Worry: A Review of Investor Concerns and Risks play out, most will prove temporary disruptions if the economic and profit expansion persists. We recommend investors continue to position portfolios for an ongoing expansion and be ready to participate in opportunities presented by near-term market dislocations. EXHIBIT 6: Recommendations for a Moderate Growth Investor 3 Underweight fixed income Employ opportunistic strategies Lower-Cost absolute return Allocate to real assets Fixed Income Fixed Income 13% 13% Cash 5% Absolute Return Real Assets 8% 4% 13% Private Equity US Large Cap Equity 33% 18% 6% US Small Cap Equity International Equity Healthy equity weighting Utilize defensive strategies Emphasize Japan and emerging Asian consumer This represents Glenmede s Growth with Income All Asset with Partnerships model. Not every product is suitable for every investor; decisions about what to invest in are individualized and will depend on facts and circumstances. Alternative funds are typically open only to investors meeting certain minimum qualifications, and there is no assurance that an application to invest will be accepted. Managers generally charge fees for these products in addition to other fees which may be charged by Glenmede. All investment has risk, including risk of the loss of principal. Please discuss all questions you may have regarding matters raised here with your Glenmede representative. There are nuances to our still-positive economic and market outlook. Our recommended positioning for a moderate growth investor 3 (Exhibit 6) shows a relatively full (neutral) allocation to equities, using defensive strategies in the U.S. equity portion where valuations are higher and investing in international markets where valuations and room for profit improvement are more attractive. We recommend a small allocation to real assets to provide some inflation capture and continue to recommend limiting interest rate exposure through a combination of underweighting fixed income and use of opportunistic strategies. Lastly, in order to control risk and offset the lower fixed income allocation, we recommend the use of absolute return strategies. Cumulatively, such positioning should enable investors to participate in both the ongoing expansion and benefit from emerging opportunities that may occur. 3 This represents our Growth with Moderate Income All Asset with Partnerships model. Not every product is suitable for every investor; decisions about what to invest in are individualized and will depend on facts and circumstances. Alternative funds are typically open only to investors meeting certain minimum qualifications, and there is no assurance that an application to invest will be accepted. Managers generally charge fees for these products in addition to other fees, which may be charged by Glenmede. All investment has risk, including risk of the loss of principal. Please discuss all questions you may have regarding matters raised here with your Glenmede representative. Q Page 7

8 Market Insights is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information gathered from other sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative. Cleveland Morristown New York Philadelphia Princeton Washington, DC Wilmington GlenmedeCommunication@glenmede.com Visit: