With Market Indices at or Close to All-Time Highs, Investors Puzzle Over the Course Ahead. Meanwhile, The Slow-Growth Economy Is Perceived as the New “Goldilocks Scenario.”
A colleague recently told me that his 12-year-old son asked, out of the blue, “Hey Dad, do you watch Cramer?”—referring to Jim Cramer of CNBC’s Mad Money show. This anecdote reminded me of the legendary tale about Joe Kennedy exiting the stock market after a shoeshine boy offered up unsolicited stock tips. It was just days before the October 1929 crash. Taxi drivers, servers in restaurants, youngsters hawking newspapers and elevator operators also shared their favorite stock ideas. To the wise, these touts offered a cautionary sign.
Elevator operators—among many other professions—may have largely disappeared from the economic landscape. But many perceive that cautionary signs abound today. You don’t have to look far to find investors who’ve largely withdrawn from the markets, rattled by political surprises in the U.S. and abroad, all but certain that the current economic expansion—now the third-longest since the end of World War II—will soon come to an abrupt end.
While I think some concerns—including high equity valuations and rising debt levels in the U.S.—are valid, letting them dominate the investment process isn’t productive. In past messages, I’ve pointed to Warren Buffett and Howard Marks as strong advocates for continuing to invest, albeit carefully.
Unlike Cramer with his gimmicky sound effects and shouts of “Booyah!” and unlike the shoeshine boy with his up-to-the-minute stock tips, I offer no predictions about the short-term direction or magnitude of the markets’ movements. But I continue to believe that Wasatch’s long-term approach—based on finding companies that have competitive advantages, that are taking market share and that are growing revenues and earnings at attractive rates—will enable us to ride out difficult periods and serve our shareholders well over time.
ECONOMY
While it’s certainly possible that an unforeseen event could precipitate sharp declines in the economy and the markets, it’s hardly a given that the economy and the markets would then suffer sustained damage. As evidence, I suggest you look no further than the past 12 months or so. Despite dire predictions that voters’ approval of Brexit would create chaos, British stocks overall are significantly higher than before the Brexit referendum. Similarly, though investors panicked following the election of Donald Trump, stocks quickly rebounded despite many obstacles.
The usual measures of economic health present a mixed picture in the U.S. At 4.3%, the unemployment rate reported for May was the lowest in 16 years. While the unemployment rate for June edged up to 4.4%, a greater number of jobs than expected were added to the economy. The rate rose as even more workers were added to the labor force, an encouraging sign. The labor market has been tightening, but so far putting little upward pressure on wages. Inflation, at an annual rate of 1.9% through May, was still below the Federal Reserve’s (Fed’s) target of 2.0%. And U.S. gross domestic product (GDP) grew at an anemic annual rate of 1.4% in the first quarter, with forecasts for the second quarter little better.
While the Fed raised the federal-funds rate in June by a quarter point, central banks in Europe and Japan have kept benchmark interest rates near zero. And although the Fed has raised short-term rates, longer-term U.S. government bond yields have fallen close to their lowest levels of the year. The yield curve has flattened, creating smaller differentials between short-term and long-term yields.
In the past, I’ve warned that investors in long-term bonds face large principal losses if interest rates rise significantly. And that warning is still relevant today. But with 10-year government bonds in much of Europe and Japan yielding significantly less than 1%—and with 10-year U.S. Treasury bonds already yielding a much higher 2.4%—I can also envision a scenario in which U.S. rates confound the pundits by failing to rise as much as generally expected.
Oil prices, meanwhile, have declined more than 20% this year. Although that’s been a boon for summer travel and consumers, it’s taken a toll on energy and related stocks.
A consensus is emerging that the slow growth characterizing the current economic expansion, rather than presenting a problem, is actually a new “Goldilocks scenario.” In other words, the economy is neither too hot nor too cold—sustaining moderate growth, low inflation and rising asset prices. It’s becoming apparent that slow growth provides ample time for the economy to adjust to changes that might otherwise develop into excesses in a faster-growth environment. Previously seen as a source of frustration, the slow-growth economy is gaining acceptance as the unemployment rate continues to decline and help-wanted signs become more prevalent.
One key indicator of the accept-ance of slow growth is that the Fed is no longer trying to stimulate the economy with lower interest rates and bond purchases—a.k.a., “quantitative easing.” Instead, the Fed is now raising rates and shrinking its balance sheet, which are actions likely to keep a lid on economic activity.
Even though the continuing economic expansion has been slow, some investors worry about its long duration.
Recessions, however, aren’t caused by the passage of time. Instead, they result from excesses that build up during expansions. And our current slow-growth economy doesn’t seem to be building an abundance of excesses.
Nevertheless, I remain cautious based on valuations. In addition, I’m keeping my eyes peeled for problems that could derail the economy and the markets. One potential problem is debt, which has grown steadily since the end of the global financial crisis to the point that today there’s more private debt and public debt as percentages of GDP than ever before. And we all know that the global financial crisis resulted from poorly underwritten, poorly structured debt.
So, is there potential for another global financial crisis? Probably not. Regulations have limited the exposure of banks to questionable loans. This means we’re unlikely to see another crisis in banking. In fact, recent reports show banks are in such good shape that they’re increasing dividend payout ratios and buying back shares.
If new debt problems do arise, there’s a good chance they’ll be outside the banking system—in areas like loan securitizations and junk bonds, for example, where the dollar volumes of activity have been quite large. But the trigger for another debt crisis would probably be significantly higher interest rates, which I don’t expect.
An additional source of potential problems is widespread dissatisfaction with the status quo among the world’s populations. This dissatisfaction came to the fore with the vote in favor of Brexit, the election of Donald Trump and the recent failure of British Prime Minister Theresa May to achieve her hoped-for majority in Parliament. In each of these cases, voters were essentially saying “no” to whatever was currently in place—sometimes without fully understanding what a change really would mean.
One explanation for voter unease is that “full” employment doesn’t mean workers are reasonably satisfied with their jobs and their ability to make ends meet. We’ve long heard about skilled employees resorting to working as “burger flippers” when they’re laid off from their former high-paying jobs. Modern retailers increasingly hire on an as-needed basis, so people don’t necessarily know in advance whether or not they’ll be working in a few days.
A recent article in The New York Times describes the difficulties traditional retailers must face in adapting to e-commerce, often with little choice but to let workers go. Unfortunately, as the article points out, the growth of e-commerce hasn’t led to significant hiring of the displaced workers. Consider the rise of e-commerce in the context of the Trump administration’s stated priority of restoring manufacturing and industrial jobs in the U.S. One of President Trump’s key campaign promises was to bring back coal-related jobs. Well, the entire U.S. coal industry today employs only about 75,000 people. Traditional retailing in the U.S., on the other hand, employs millions. So the potential for disruption in retailing—whether related to Amazon or others—is huge.
How dissatisfaction with the status quo and a general sense of unease might lead to a global recession isn’t clear. But if that dissatisfaction and unease precipitate poorly conceived economic-policy changes, a recession is a risk we must consider. Having said that, so far at least, frustration has been expressed more in rhetoric than in actual policy. In this regard, consider recent reports that policymakers are looking for ways to water down Brexit as it becomes clear that a hard-line approach would be much more complicated than most voters realized.
International conflicts are also concerning to me because they have the potential to spread rapidly. But they’re very difficult to factor into an investment process because specific flare-ups and their ramifications can be quite unpredictable. At a macro level, I’m worried about tensions surrounding immigration, the refugee crisis, continuing unrest in the Middle East and increased aggression from North Korea.
Finally, it is worth noting the potential pro-cyclical behavior of exchange-traded funds (ETFs). An investor buying a stock directly will pay attention to its price—if the stock is too expensive, the investor will sit on his or her hands rather than buying. However, if that same investor buys an ETF to “participate in the market,” the prices of the stocks, which the ETF buys, aren’t visible to the ETF buyer. Because the ETF itself lacks the price sensitivity of a direct investor, ETFs will buy at increasingly higher prices (or sell at increasingly lower prices). Hence, ETFs are pro cyclical and will tend to amplify underlying stock-price volatility in a manner reminiscent of portfolio insurance, which amplified the 1987 correction.
MARKETS
You need only one word to describe the performance of most global securities during the second quarter: “Up.” In fact, of 145 stock, bond, municipal, U.S., foreign, target and commodity indices found on Morningstar.com, all but 14 were positive for the quarter. Of the 14 that were down, only seven fell more than 1%. Energy stocks and commodities were the notable decliners during the quarter, consistent with the feeling that—excluding health-care costs—inflation is mostly missing in action.
In the U.S., the large-cap S&P 500® Index rose 3.09%, the Russell 2000® Index of small caps moved up 2.46% and the technology-heavy Nasdaq Composite Index advanced 4.16%. Bond markets also gained for the most part, as the intermediate-term Bloomberg Barclays US Aggregate Bond Index returned 1.45% and the long-term Bloomberg Barclays US 20+ Year Treasury Bond Index leapt 4.18%. International stock markets were generally quite strong too. The MSCI World Ex-U.S.A. Index rose 5.63% and the MSCI Emerging Markets Index advanced 6.27%.
For the year-to-date period, according to The Wall Street Journal, all but four of 30 major indices representing the world’s biggest stock markets by market capitalization have risen in 2017—a performance unmatched in the same periods since 2009. In the past 20 years, only four rallies in the same periods were as widespread as or better than the 2017 year-to-date surge.
It’s possible that demand for passive investments added fuel to the recent rally. For example, according to the Federal Reserve Board, ETFs bought $98 billion in U.S. stocks during the first quarter of 2017, on pace to surpass total purchases for 2015 and 2016 combined. In addition, according to an analysis of Fed data by Goldman Sachs Group, these funds—which are dominated by passive strategies—owned nearly 6% of the U.S. stock market in the first quarter, their highest ownership on record. An obvious concern is that ETF activity could send prices the other way if cash flows were to reverse and stocks were to become less liquid. For our part at Wasatch Advisors, we’ve never offered passive investments.
A lack of volatility during the second quarter was also notable, especially given the continual barrage of headlines that we might normally expect to spark panic among investors. A steady stream of revelations about the Russia probe, the firing of the FBI director and terror attacks in London prompted little reaction from the markets. Rather than appearing skittish, investors seemed to be eyeing small dips as opportunities to put more money to work.
WASATCH
“True gold is not afraid of the refiner’s fire.”—Chinese Proverb
Last year, we at Wasatch Advisors certainly felt tested by fire in managing several of our funds. The Russell 2000 Value Index outperformed the Russell 2000 Growth Index by about 20 percentage points. British voters unexpectedly decided to leave the European Union. Volatility suddenly took hold in many of our favored Japanese stocks. Moreover, most of our Indian and Mexican investments suffered during the fourth quarter based, respectively, on India’s surprise demonetization initiative aimed at reducing corruption and Mexico being viewed as the target of Donald Trump’s America-first/anti-foreign rhetoric. During that period, to use another metaphor, we experienced the feelings of being in a small boat buffeted by raging seas while doing our best to hang on and stay the course.
So far this year, however, we seem to have calmer waters and the winds at our backs. The Russell 2000 Growth Index was more than nine percentage points ahead of its value counterpart for the six months ended June 30, 2017. Markets in the U.K. and Europe have adjusted to the Brexit vote and have continued to advance. Gains in Japan have not only resumed, but have broadened to encompass more segments of the economy. As for our Indian and Mexican stocks, they’ve generally come back strong—more than making up for their fourth-quarter 2016 losses.
While we may not be as astute as we look this year, neither were we as uninformed as we appeared toward the end of last year. That said, I think we’re good at what we do. We’re also consistent with our approach of investing in companies that we believe have significant long-term growth potential, and that have the management teams, capital structure and market opportunities to thrive over time. I don’t believe we can successfully predict the multitude of macro storms that may lie ahead. But I do believe we can select companies that possess the solid fundamentals necessary to weather those storms and succeed over time.
Yes, we did make some slight course corrections at times to avoid the choppiest waters. For example, in some of our non-U.S. funds, we sold several of our Mexican investments shortly after the U.S. presidential election. But we largely invested the proceeds of those sales in places like India, which have since done exceptionally well. And we never lost sight of our objectives. Though it isn’t always easy, I think we’ve been well-served by sticking to our core philosophy through good times and bad.
With sincere thanks for your continued investment and for your trust,
Sam Stewart
RISKS AND DISCLOSURES
Mutual-fund investing involves risks, and the loss of principal is possible. Investing in small-cap funds will be more volatile, and the loss of principal could be greater, than investing in large-cap or more diversified funds. Investments in value stocks can perform differently from the market as a whole and from other types of stocks and can continue to be undervalued by the market for long periods of time. Investing in foreign securities, especially in frontier and emerging markets, entails special risks, such as unstable currencies, highly volatile securities markets, and political and social instability, which are described in more detail in the prospectus.
An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit www.WasatchFunds.com or call 800.551.1700. Please read the prospectus carefully before investing.
CFA® is a trademark owned by CFA Institute.
Wasatch Advisors is the investment advisor to Wasatch Funds.
Wasatch Funds are distributed by ALPS Distributors, Inc. (ADI). ADI is not affiliated with Wasatch Advisors or Wasatch Funds.
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
DEFINITIONS
Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016 referendum whereby British citizens voted to exit the European Union. The referendum roiled global markets, including currencies, causing the British pound to fall to its lowest level in decades.
An Exchange-Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on a securities exchange. ETFs experience price changes throughout the day as they are bought and sold.
The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.
The financial crisis of 2007-09, also known as the global financial crisis (GFC) and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.
Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.
Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Valuation is the process of determining the current worth of an asset or company.
The yield curve is a line on a graph that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, two-year, five-year and 30-year U.S. Treasury securities. This yield curve is used as a benchmark for other interest rates, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks.
The Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.
The Russell 2000 Value Index measures the performance of Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values.
Source: Frank Russell Company is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. This is a presentation of Wasatch Advisors, Inc. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. Frank Russell Company is not responsible for the formatting or configuration of this material or for any inaccuracy in Wasatch Advisors, Inc.’s presentation thereof.
The NASDAQ Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The NASDAQ was created by the National Association of Securities Dealers (NASD) to enable investors to trade securities on a computerized, speedy and transparent system, and commenced operations on February 8, 1971.
The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.
The MSCI Emerging Markets Index captures large- and mid-cap representation across 23 emerging market countries. With 832 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI World Ex-U.S.A. Index captures large- and mid-cap representation across 22 of 23 developed market countries—excluding the United States. With 1,004 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS) (agency fixed-rate and hybrid adjustable-rate mortgage [ARM] pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (agency and non-agency).
The Bloomberg Barclays US 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.
You cannot invest directly in these or any indices.
© Wasatch Funds
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