First Quarter 2015
Key Takeaways

• Global equity market returns were positive during the quarter, with the strongest returns from overseas markets.

• US fixed income returns were also positive for the quarter but global bond returns using the Citigroup World Government Bond Index as a proxy were negative.

• Big picture themes continue to be global central bank policy actions, US dollar dominance and ongoing decline in oil prices. Dollar strength and oil price declines are impacting US company profits.

• Investors seeking yield continue to be in “yield purgatory” – yields are generally too low to generate satisfactory income.

• European and emerging market equities look attractive relative to US equities

First Quarter  2015 Investment Commentary
International stocks led in the first quarter with Europe, Japan, and China posting especially strong gains. U.S. stocks were also positive, with smaller caps outpacing larger caps, and growth beating value. Some of the quarter’s big-picture themes included global central bank policy, the strength (or lack thereof) in economic growth, U.S. dollar dominance, and the ongoing decline in oil prices.

Starting first with the United States, overall the U.S. economy appears to be in pretty good shape and on a positive uptrend. However, various forces have clouded the economic picture at least over the near term. Some of these forces are temporary (e.g., harsh weather in the Northeast), but others, such as the rising U.S. dollar and the decline in oil prices, could have spillover effects on the broader economy.

The stronger dollar is dampening export growth and has already prompted a spate of downward earnings and revenue estimates. While the decline in oil prices is a positive for U.S. consumers, it will weigh heavily on energy companies, their earnings, and their willingness to spend on new projects and hire additional workers.

All of these issues complicate the outlook for U.S. economic growth and are among the factors that the U.S. Federal Reserve has to weigh as it contemplates raising interest rates. The Fed’s March statement took the much watched step of removing the word “patient” from the official text, yet Janet Yellen continues to suggest the Fed will exercise exactly that quality as it moves toward its first rate increase and considers the pace of subsequent hikes. Markets appeared to take the Fed’s update to mean rates would remain low, potentially into the fall.

Meanwhile, other major central banks are expanding their support, with Japan in stimulus mode and the European Central Bank (ECB) the latest entrant to the mix. The ECB announced a quantitative easing program in January and launched its bond buying in early March. European stocks rallied during the quarter on the hope that this stimulus would have a similar effect in Europe as it has had in the United States. For U.S. based investors, strong local equity returns in international stocks were largely offset by currency movements due to an appreciating U.S. dollar.

In emerging markets, China’s growth continued to slow even as the government undertook monetary stimulus measures including changing reserve requirements and cutting rates. Nonetheless, emerging markets in aggregate were positive.

On the fixed income front, with a pronounced lack of competition from other developed market bonds, U.S. Treasury’s continue to look relatively appealing even with a 10-year yield below 2%. This factor, along with investors’ sense that the Fed might be slower to scale back its accommodation, helped government bonds to their fifth consecutive quarterly gain.

Investors’ search for yield has helped support returns for both investment grade and high yield corporate bonds as well. Floating rate loans, which tend to do well when rates rise, had a very strong quarter as investors girded for future rate hikes.

The strength of the dollar is a significant force affecting the economic landscape. The dollar has appreciated 23% over the past 12 months. Moreover, based on the concept of purchasing power parity (PPP), the dollar now looks to have significantly overshot its longer term fundamental value relative to the basket of other major currencies in the dollar index. The converse is true as well—other currencies have undershot their fair value versus the dollar.
There are several cross currents from the rise in the dollar in terms of its impact on both the real economy and financial markets. On the positive side, a strengthening dollar reduces the cost of imported goods and is also associated with falling oil and commodity prices that are priced in dollars on the global market. This will tend to depress domestic inflation—a positive result unless an economy is at risk of a deflationary spiral, which the United States is not. All in all, these things benefit U.S. consumers, increasing their purchasing power and leaving them more money available for spending (or saving).

A stronger dollar also tends to attract more foreign investment. To the extent this foreign capital flows into U.S. Treasury bonds or corporate debt, it helps keep interest rates lower, and it may also support higher U.S. stock prices. All of these factors are reasons why investors cite the stronger dollar as another reason for optimism about U.S. stocks. However, a dollar that is too strong is not necessarily good for U.S. stocks, as investors start to weigh the negative impacts more heavily. So far this year, the daily correlation between the dollar and U.S. stocks has been negative.

On the negative side, a stronger dollar has a negative impact on U.S. exports, U.S. manufacturers and U.S. multinational company profits. A strong dollar makes imported goods more attractive which typically leads to a worsening of our trade deficit. This has a negative effect on overall economic growth, because GDP is defined as the sum of consumer spending, investment spending, government spending, and net exports. Also, from a dollar based investor’s perspective, a rising U.S. dollar hurts foreign asset class returns as they are translated back into dollars from weaker currencies.

All of these impacts are reversed for the investors, consumers, and economies whose currencies are depreciating versus the dollar. The international stock managers that we use and other research we read echo a few key points with regard to the recent currency volatility. First, international managers acknowledge that the negative currency translation effect creates an immediate negative impact on their dollar based returns. But the managers typically do not try to hedge against this translation risk. Several of them state (as do we) that they don’t believe they have an edge in predicting currency movements, so they are doubtful they would add value to client returns over time from doing so.

Second, while they rarely hedge currencies, our international managers do consider potential currency impacts as part of their fundamental, company specific analysis and valuation. For example, they say that over the medium term a weaker currency should begin to positively impact the profit margins and earnings of foreign companies that do business globally.

Asset Class Views and Portfolio Positioning
U.S. Stocks— We have written in the past about the current level of profit margins, relative to history. Profit margins are a key driver of earnings and earnings growth. The adjacent chart shows profit margins for the S&P 500 are at all time highs. The chart is also very clear in showing that profit margins are cyclical. That is, neither the trend nor the level of margins is sustained for very long.

Moreover, history has shown that high profit margins are negatively correlated with subsequent five year earnings growth (i.e., foretell lower future earnings growth). Will this time be different? Much has been written about this important topic and why current margin levels may not revert towards their longer term averages, including the impact of technology and improved productivity. However, we do believe in reversion to the mean over the long term and for us the question is how much will profit margins decline from the current level.

In addition to the natural forces of competition, a big reason profit margins are likely to decline is from increased labor and wage costs, which have yet to really kick in. Another factor is the sharply rising dollar, which, as we highlighted earlier, is hurting the profits of U.S. multinational companies.

We seem to be seeing this impact already, as earnings per share estimates for the first quarter have dropped sharply to a 5% year over year decline, compared to the positive 4% growth that was expected for the first quarter at the beginning of the year. The plunge in oil prices, which hurts earnings for energy companies specifically, is also a significant driver of these negative results.

Reduced profitability and the current level of US stock prices have resulted in elevated valuations. We measure valuations in a number of ways and across many different metrics, and they all tell pretty much the same story: U.S. stocks are fairly valued to overvalued.  While valuations are not a good short term market indicator—overvalued markets can get even more overvalued for a while—history shows that high valuations are a deterrent to future long-term returns, which is our focus.

US equity markets have not had a meaningful correction in years and we do expect a meaningful market correction at some point. All else equal, we would view such a decline as an opportunity to shift some additional capital back into U.S. stocks (which at that point should be offering attractive return potential commensurate with their risk) and out of our more defensive fixed income holdings.

In the meantime, many of our active equity managers are still able to find some great stock picking opportunities within what we (and many of them) see as an overvalued and relatively unattractive overall market opportunity set. One area where many of our managers are carefully picking amongst the rubble is energy—the S&P energy sector is down 22% compared to a 9% gain for the overall market over the past three quarters.

European Stocks— Moving to developed international stocks, and Europe in particular, the top down asset class view is almost a mirror image of the United States. Unlike in the United States, where we see potentially unsustainably high profit margins, and high valuation multiples, in Europe we see earnings that are below trend and relatively attractive valuations.

Over the next five years, we think European stock market earnings growth will be higher than the market is currently expecting, and more in line with its long term trend, as the economy recovers and companies benefit from operating leverage, cost cutting, and the weaker euro currency. We also believe European stock market valuation multiples will at least be in line with their longer term norm, consistent with an economic and earnings recovery.

As such, expected five year returns for developed international stocks could be around 10%–11% (annualized). This is an attractive spread relative to U.S. stocks. As such, we are at or near a full weighting to international/European stocks in our balanced portfolios.

Emerging-Market Stocks— Emerging market stocks are similar to Europe, in that their valuations look attractive and earnings appear to be depressed relative to longer term expectations. Of course, emerging markets face some unique risks, which we have discussed frequently in past commentaries. These include most prominently:

1)    the potential for a sharper than expected economic slowdown in China, as the authorities try to gently deflate their infrastructure/credit bubble and engineer a transition to a consumer led economy.

2)    the potential negative contagion effects from the impact of continued strong dollar appreciation on the high levels of dollar denominated debt on emerging markets companies’ (and some governments’) balance sheets.

While we don’t claim to have unique insight into how these complex and multifaceted (and, really, unknowable) situations will unfold, we look at emerging markets—as we do all the asset classes we evaluate—across a range of scenarios that try to take into account a number of eventualities that could result from combinations of these and other macro factors. Moreover, in determining our emerging markets allocation, we seek a high margin of safety before overweighting the asset class.

In other words, we’d want to have such a strong positive case that we could have a lot of things go wrong or differently and we’d still expect good investment results. Today, as we weigh what we believe are the most likely scenarios, we believe expected five year annualized returns for emerging markets stocks are in the mid-single to low double digits. The low end of that range incorporates pretty bearish assumptions, yet if they played out we would still earn at least decent returns.

The upside in the more neutral or positive scenarios is significant. Given the unique risks of emerging market equities and current valuation levels, we are maintaining meaningful exposure to the asset class but still below a full or neutral weighting, especially given the better appeal of developed international equities. If valuations improved, we could increase the allocation across our balanced portfolios.

Investment Grade Bonds—With the U.S. core bond index yielding only 2%, any reasonable interest rate or macro scenario implies very low returns over the next five years. There is no refuge to be found looking to core bond markets outside the United States either. In Europe, the comparable index has a yield of only 0.5% and almost a third of European government bonds actually have a negative yield to maturity, meaning investors who hold these bonds to maturity are locking in a certain loss.

The collapse in global fixed income yields, as well as the prospect of yields staying lower for longer, creates challenges for many investors, especially those who need income from their portfolios. We recently came across a chart from Bessemer Trust that illustrated how much times have changed. According to their chart, if you invested $1 million in a global bond portfolio in 1995, the yield would have been 5% or about $50,000 per year. Ten years later, 2005, that same portfolio yield had declined to 3% or income of about $30,000 per year. As of March 31, 2015, that same portfolio yields under 1%, just $8,800 in income.

The result is yield purgatory (and a reason that we talk with all of our clients about a total return portfolio, whose return includes interest, dividend and appreciation) with current bond yields too low to generate satisfactory income.

We think there are relatively more attractive—and more durable—options within pockets of the bond market, and we’ve tilted the portfolios to take advantage of these. Specifically, we have shifted more than half of the fixed income exposure in our balanced accounts into active funds that have significant flexibility to manage their interest rate risk as well as other risk exposures, and that we believe are run by skilled, proven managers (we refer to these managers as our flexible fixed income managers).

The portfolios of these managers have much lower duration which means they face less of a negative price impact from rising interest rates. Our investments in floating rate loan funds (in more conservative portfolios) will actually benefit from rising rates, and their higher yields provide a head start in terms of their multiyear total return potential.

We also have meaningful allocations across all balanced portfolios in alternatives. Although the risk profile of the alternatives position is greater than investment grade bonds, based on our analysis outlined above, we do not believe we are giving up much in downside protection. The alternatives portfolio invests in all segments of the capital markets and over the long term, we expect to earn returns comparable to a 40/60 stock/bond portfolio, with lower volatility.

What Does It All Mean?

For the valuations reasons set forth above, we will be making a tactical move into European stocks in the coming weeks, decreasing our exposure to US stocks. In addition to the various research and analysis previously cited, other valuation metrics such as the Shiller Price/Earnings ratio (which is based on long term normalized earnings) suggest European stocks are providing a fat pitch opportunity at this time. Currency movements have been considered as well, namely that the euro may now be attractive versus the US dollar and our fat pitch move could benefit from currency movement in addition to the return we anticipate capturing as stock valuations improve. According to Ned Davis Research, the euro is now over 20% undervalued versus the US dollar.

However, we are also mindful of the extraordinary policies currently being enacted by the ECB, which has been a key driver of the decline in the euro over the past year. It would be reasonable to think that much of the effect from the ECB’s QE has already been priced into the euro but the general consensus in the market is that the euro will continue to decline versus the US dollar and possibly go well past parity. While normally this would call for a contrarian approach (i.e. fully hedge), we also know currencies tend to exhibit momentum and can be significantly out of sync with valuation measures for a long time.

Therefore, we think it is prudent to split our 5-6% tactical European stock move into a hedged and unhedged position. Dividing the allocation effectively removes currency as a performance factor for this tactical trade. If the euro declines further, then it is possible we may switch entirely to an unhedged position. This will give us full currency exposure at a point when the euro should look even more undervalued and therefore more likely to provide a tailwind to our anticipated total return from the fat pitch.

We will implement the European stock position using two ETF’s, which will also remove any active management variables from the trade.

River Capital Advisors News
RCA is pleased to announce that Bradley T. Miller has rejoined our team as our Client Service Specialist. Bradley was an intern at RCA and after spending approximately a year in the financial services industry, we are glad to have Bradley rejoin us on a full time basis. Bradley will be involved with almost all of our clients, helping them with various service needs. Bradley also works closely with our Wealth Managers on various financial and related matters. Bradley received his BBA degree in finance from the University of North Florida.

RCA has also updated its ADV and included in our client quarterly package is the Summary of Material Changes. If a client (or potential client) would like a complete copy of the ADV, please contact Bradley Miller.

We have received a number of referrals over the early part of this year. It means a lot to us when a client makes a referral. We know that we are not the planning firm for everyone but being the exception and not the norm in the financial services industry (because we are independent, fee-only financial fiduciaries affiliated with the CPA firm of Smoak, Davis & Nixon LLP) makes us appropriate for individuals who want an advisor who is an advocate for them.

We hope everyone has an enjoyable spring!