Our Thoughts

The Bear That Wasn’t (Marjorie Fox Reflects on the First Quarter)

In the first six weeks of 2016 pundits were talking about another 2008-2009 drop in the share prices of global equities, causing many investors to respond by deciding to sell and sit out this widely-predicted start of a protracted bear market. What a mistake! After falling to a low on February 11th, the widely-quoted S&P 500 index of U.S. large company stocks posted a gain of 1.35% in the first quarter. Real estate investments fared even better. International real estate as measured by the S&P Global ex-U.S. REIT index was up 8.82%, and U.S. real estate as measured by the NAREIT index, was up 5.84% for the first quarter.

The fixed income asset classes weren’t far behind U.S. real estate with interest rates continuing their downward drift. At the end of the quarter, 3-month Treasuries yielded 0.21% and 12-month Treasuries just 0.60%. If you go out to ten years, you can get a 1.78% annual coupon yield. Given that prices move inversely to yields, falling yields meant gains in bond portfolios. U.S. fixed income as measured by the Barclay’s Capital Aggregate Bond index was up 3.03% and International fixed income as measured by the JP Morgan Global Bond Index ex-U.S. (Hedged) index was up 4.27%.

Part of the wind at the back of U.S. bonds and stocks this past six weeks has come, yet again, from the U.S. Federal Reserve Board, which had originally signaled that it planned to raise interest rates four times this year. After its most recent meeting, the Fed is projecting just two interest rate hikes in 2016, and Fed Chairman Janet Yellen has clearly indicated that the Fed will remain cautious about disrupting the markets or the economy as it unwinds its various Quantitative Easing (QE) initiatives. Another tailwind was provided by the falling dollar. In the first three months of the year, the dollar’s value against a basket of six major currencies fell 4.2%. A weaker dollar makes U.S. exports more price-competitive against goods and services sold in other currencies, potentially leading to higher top-line revenues for companies that do business overseas. Investors also seemed to take comfort that the Chinese stock market has stabilized – for now at least. Chinese officials recently reported the first rise in an important manufacturing statistic – the purchasing managers index – in eight months.

But arguably the biggest stabilizer of U.S. and global stock markets was the rise in oil – or, more precisely, the end of a long unnerving drop in the price of crude that caused anxiety to ripple through the investor community. Analysts are not sure how the price of a barrel of crude oil is connected with the value of stocks; indeed, for most companies, lower energy costs are a net plus to the bottom line, but investors seemed to take comfort in the fact that the price of the world’s most important commodity had stabilized. It’s worth noting that the day the S&P 500 hit its low for the year – February 11 – was also the day when oil futures hit their low of $26.21 a barrel.

Emerging market stocks of less developed countries, as represented by the MSCI EM index, gained 2.73% for the quarter. However, that was the extent of the good news for international equities. The broad-based MSCI EAFE index of companies in developed foreign economies lost 3.74% in dollar terms in the first quarter of the year and are now down more than 10% over the past 12 months.
International Equities?

International equities as measured by the MSCI EAFE index have been the worst performing asset class of the decade ending on December 31, 2015. For this ten-year period the MSCI EAFE returned a cumulative 29.71% while the S&P 500 returned 91.37%. Given the returns of the first quarter of 2016, this under-performance continues. And, international investing may involve greater risks than U.S. investing due to currency fluctuations, unforeseen political and economic events, and legal and regulatory structures in foreign countries. So, why invest in international equities? There are at least four reasons for FJY’s inclusion of international equities in client portfolios:

First: Academic research has concluded that investors have better long-term outcomes when they diversity widely among industries, company sizes, and countries. Guess how many times the U.S. (as measured by the S&P 500) has been the best performing developed market since 1995. Just three! Australia fared better with four (2001, 2002, 2004, and 2009), Japan matched with three (1999, 2008, and 2015), and Spain matched with three (1996, 1998, and 2006). Emerging market stocks don’t have a direct counterpart in the U.S. Furthermore, history is replete with examples of once-strong stock markets that ran into long-term headwinds. Japan’s stock market over the past few decades is a case in point. Around the time the Berlin Wall was coming down and Madonna was climbing the music charts, Japan was a powerhouse economy with a soaring stock market to match it. The Nikkei Index peaked at 38,915.87 on December 29, 1989. It currently trades at less than half of that pinnacle. Japan is a warning of what can go horribly wrong both economically and with a stock market.

Although U.S. equities (as measured by the S&P 500) outperformed international equities in the decade ending December 31, 2015, there are also long periods when international equities have outperformed U.S. equities. A recent example is the period from 2000 through 2009. In those 10 years, the S&P 500 index had a compound annual loss of 3.4%. The MSCI EAFE index produced a compound annual gain of 1.2%. Those who invested exclusively in large-cap U.S. stocks had reason to be profoundly disappointed; those who had added international stocks had reason to be glad they had done so.

Second: Unhedged international stock funds add currency diversification. Sometimes that helps U.S. investors, and sometimes it hurts them. But in the long run, currency diversification reduces expected volatility and thus risk.

Third: Investors often ask whether they get enough international exposure from U.S. multinational companies that do so much business outside the U.S. In short, the answer is “no.” U.S. multi-nationals, predominately large growth companies, do not give you much exposure to value and small-cap abroad, or to emerging markets.

Fourth: Almost half of the world’s market capitalization (48% as of December 31, 2015) lies outside the U.S. The top twelve holdings in the MSCI EAFE index are Nestle, Novartis, Toyota, HSBC, British American Tobacco, Novo Nordisk, Anheuser-Busch Inbev, Total SA, GlaxoSmithKline, Commonwealth Bank of Australia, Bayer, and Royal Dutch Shell. Great companies that investors don’t get exposure to unless they invest in international equities.

In Summary: Clients of FJY have experienced returns in their equity holdings that in some years are quite different from those of the U.S. markets, particularly the S&P 500. Remember – diversification works, even when you don’t want it to work. Sometimes this will seem like a curse, but more often it will feel like a blessing!