We are writing to share our perspective on the current volatility in the market. Emotions can be our greatest adversary. We, therefore, as your advisors, seek refuge in facts to frame and provide perspective. To help make some sense of this unprecedented beginning of year correction, we believe it is helpful to look at this episode in context and, more importantly, to provide clarity on what we are thinking as it relates to your investment portfolios.
The beginning of 2016 has seen a continuation of the volatility that began in earnest in the 4th quarter of 2014. The main contributors remain the same: declining oil and commodity prices, renewed concerns over the pace of expansion in China, and the impact of rising interest rates and a strong dollar on the U.S. economy.
To be clear, the current issues are real and they are likely to persist. If anything, the first few weeks of the year have served as a valuable reminder that investing in public markets is inherently volatile and that our main defense against that volatility is to diversify our risk exposures by owning a variety of asset classes and risk factors.
1. What is normal? Granted, the sharp decline in the first weeks of January isn’t “normal” given the historical record, but a 10 percent correction actually is. Since 1980, the S&P has experienced on average each year, a correction of -14.2 percent. We just have not had one since 2012. Interestingly, five percent corrections are even more common, with one occurring on average every 45 days (since 2011; every 36 days since 1987). It is very reasonable for us to “feel” this correction more acutely, particularly when we are conditioned to be optimistic for the beginning of a new year.
2. Desynchronized Global Growth. The sum impact of the drop in oil and commodity prices, complex transition of China’s economy, and uncertainty around rising interest rates and direction of global currencies, creates a foggy picture for country level and overall global growth expectations. Currently, the global economy is projected to grow 3.3 percent over last year’s estimated global GDP of $79 trillion. However, the country level components of this growth vary meaningfully, with some countries expanding at greater rates than others. When the 2nd largest economy (China) shows cracks in a 25 year expansion story, the markets will get nervous. Nevertheless, the recent market correction isn’t based on any new information, but we believe it is a reflection of the markets seeking clarity where full transparency to data is difficult to rely on. What is lost in the media’s attraction to headline news is the fact that China is still expanding at a rate 3x that of the U.S., and that with the decline in energy prices there is a positive economic outcome for users of that resource (businesses and consumers). Nevertheless, when sector level (oil) and country level markets move into transitional periods, volatility takes over, risk capital tries to find cover, and retail investors bail.
We may not be at the end of the cyclical declines relating to China and oil, but we are far from the beginning. Also, for the first time in a long time, we do have clarity from the Federal Reserve Bank on their intention to manage moderate rate increases. While the road may be bumpy for a while longer, we do not believe that global markets are on the cusp of a crisis or at risk of contagion leading to prolonged negative growth. In fact, we have been discussing the need to invest given these desynchronized growth dynamics by ensuring we diversify in assets around the globe.
3. We have high conviction in what you own. As you know, we believe in constructing diversified portfolios – namely owning bonds, equities, and real assets around the globe – with managers that have proven, long-term, intellectual, and repeatable processes to identify and take advantage of opportunities for you. We do not just diversify and passively observe, however. We spend a great deal of time evaluating the assets you own from a valuation perspective and watching to make sure that the managers that are buying them are doing what we expect. During volatile times like these, this exercise becomes particularly important – holding over-valued assets or employing managers that do not hold firm to their strategy during cyclical market volatility can exacerbate the problem.
In this current environment, we really like what you own and we really like the managers that you have hired.
Investment-grade fixed-income and municipal bonds are doing what they should in this environment – protecting your capital and anchoring your portfolio in stability. Domestic Equities, as measured by the S&P 500 Index, are trading at a shade over 15x forward earnings, which is below the 25 year average of slightly above 16x. The same observations can be made for developed Non-US equities, and the valuation case becomes even more compelling when looking at Emerging Markets. Even Real Estate, which has been the top performing asset class in five of the last six years, is also trading within historical ranges of fair value.
There are two asset classes that have been very disappointing to us: natural resources (commodities) and master limited partnerships, or MLPs. We did not anticipate the sharp and prolonged cycle of decline in commodity prices and have been working hard to understand the market forces at work that will provide for a sound tactical argument to re-balance in this space. As such, we do not believe that now is the time to add to commodities just because prices are depressed. These cycles can persist for longer than anticipated and we prefer to wait until we have a better sense of what is happening.
MLPs are a different story. The economic fundamentals of this asset just do not support current depressed valuations. Granted, there are risks on the horizon that can impact recovery. For example, production volumes (a key driver of MLP revenue – not oil prices) may decline further than current expectations (currently we are seeing a floor around 8.5 million barrels a day by summer before stabilization). Also, given the potential for increasing numbers of distressed producers, there is a level of counter party risk that we need to be wary of (producers that go bankrupt and cannot satisfy their distribution contracts with the pipelines). However, our managers have shown a history of doing an exceptional job of owning the “right” MLPs that mitigate these risks. We will discuss with you your positioning in this asset class, and believe gradually bringing you back to target this year and into 2017 will make sense.
For additional insight into our longer term view, please click here to see a piece provided by our research consultant, Asset Consulting Group, that takes a brief look at the year-end review. As a member of our Investment Committee, the work ACG does helps shape our near-term tactical and longer-term strategic views.
There is no discounting the fact that market corrections like the current one create angst and real concern. However, we believe our role as your family’s advisor is to process all of the data in an unemotional way, to guide you through these periods of volatility and identify changes, if any, that are reasoned and recommended. In doing so, we avoid changes that are reactionary and not in your or your family’s long-term interest.
We take very seriously our responsibility working with you and on your behalf and are grateful for it. Again, please reach out to your teams here at Matter if you have questions or concerns.
This report is the confidential work product of Matter Family Office. Unauthorized distribution of this material is strictly prohibited. The information in this report is deemed to be reliable but has not been independently verified. Some of the conclusions in this report are intended to be generalizations. The specific circumstances of an individual’s situation may require advice that is different from that reflected in this report. Furthermore, the advice reflected in this report is based on our opinion, and our opinion may change as new information becomes available. Nothing in this presentation should be construed as an offer to sell or a solicitation of an offer to buy any securities. You should read the prospectus or offering memo before making any investment. You are solely responsible for any decision to invest in a private offering. The investment recommendations contained in this document may not prove to be profitable, and the actual performance of any investment may not be as favorable as the expectations that are expressed in this document. There is no guarantee that the past performance of any investment will continue in the future.