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News, research and market insights from our team of experts.
It has now been seven years since stock prices bottomed-out in March 2009, in the wake of the financial crisis and great recession. Looking back, the path we've followed has been unexpected in many ways. In December of 2008, we wrote that the path to a "new equilibrium" for the economy and financial markets would come in three distinct phases:
Knowing well that we couldn't predict the future, we nevertheless made a guess on timing. We thought the crisis containment phase would last through the first few months of 2009, the deflationary bust would last through 2009 and into 2010 and the policy focus would shift to the inflationary muddle sometime in 2010 and beyond. The first two parts worked out about right but we're still waiting on the inflationary muddle. So, what happened instead?
While the Fed's repeated rounds of quantitative easing helped recapitalize the banking system, little of the newly created "reserves" found their way into actual loans to businesses and consumers. The stimulative effects of monetary easing on real economic activity have been weak, at best, leading to sluggish growth, a slow pace of household deleveraging and stubbornly high unemployment for much of the period.
Instead, liquidity flooded into the financial markets, pushing asset prices higher and driving a wedge between "Wall Street" and "Main Street." What inflation we have seen has been mostly in prices for financial assets – stocks and bonds – powering one of the longest and strongest bull markets in history. Moreover, the ongoing support from the Fed has reduced market volatility to unusually low levels for most of that time. At the risk of oversimplifying, that's all been great for the S&P 500 Index and long-dated US Treasury securities, but has been bad for active managers of stocks, bonds and hedge funds. Exceptions abound but the trend is undeniable.
As ineffectual as economic policy has been in the US, the situation overseas has been even worse. The European sovereign debt crisis was a major pre-occupation, from 2009 through the middle of last year. Japan stutters in fits-and-starts, despite the massive "Abenomics" program of government spending and quantitative easing. Both the European Central Bank and the Bank of Japan have entered a twilight zone of negative interest rates – charging banks to keep reserves on deposit, in an effort to get them to increase lending to the private sector.
Then there are the emerging markets. Again at the risk of oversimplifying, the emerging markets have traditionally been a leveraged play on commodities and global growth. Despite their development and the nascent rise of a so-called "middle class," these markets have never been decoupled from the rest of the world and likely never will be. When global growth is weak and commodity prices are down, these markets feel the pain first and worst. Never more so than in recent years. There have been pockets of success, to be sure, but the overall experience of investors in Brazil, Russia, India and China has been one of disappointment and capital loss.
Not surprisingly, with hindsight at least, investors having a choice of where to allocate capital in the world have reasonably preferred the safety and liquidity of US markets, even if they have to pay up for the privilege. And pay-up they have. The dollar, which has been rising steadily since the financial crisis, recently peaked at a level not seen since 2003. That capped a nearly 20% rise in 2015, making US assets significantly more expensive for foreign investors. The valuation gap between US equities and those in developed and emerging international markets remains historically wide. The overall flow of liquidity into US equities has been disproportionately absorbed by indexing strategies. That, in turn, has made it one of the most difficult environments in memory for active managers, and has led to the widest separation between value and momentum factors since the technology bubble of the late 1990s.
What about alternative strategies? Low interest rates, subdued volatility and a flood of institutional assets seeking "uncorrelated return streams" in recent years have made it difficult for most hedge fund strategies to perform as expected. In fact, despite a few exceptions, the experience for most investors in long/short equity or credit, event driven or trend following strategies has been disappointing.
Some real asset strategies, typically a hedge against inflation, did well during much of the post-crisis period. Many of these assets had high current yields attached to them, especially real estate and energy-related master limited partnerships. But sluggish growth, ongoing concern about deflation and the recent price collapse in the commodity complex has dramatically undercut the very rationale for owning these assets.
On top of these economic and market headwinds, the "risk on / risk off" nature of institutional trading during this period – driven more by headlines and sentiment than by investment fundamentals – whipsawed many investors as capital toggled between stocks and bonds. Anyone trying to actually manage risk – through traditional portfolio management concepts like diversification, valuation and margin of safety – has had a difficult time keeping up with US equity indexes and long-dated treasuries. Ourselves, included.
That brings us to 2016. The financial markets seem to have passed through an inflection point in late 2015 and early this year. The dollar has come off its high in recent weeks, value has outperformed momentum, oil and other commodity prices have recovered somewhat. The turmoil experienced in many sectors of the market last year seems to have settled down and capital seems to be moving toward intrinsic value. While there are still plenty of distractions and disruptions (economic, capital market and political in nature) the markets may be focusing once again on fundamentals. We hope so.
Elsewhere in the Investment e.Perspective this month we have another video in our series highlighting elements of Oxford's investment philosophy, in which Brendan O'Sullivan-Hale examines the perils of trying to predict the future, especially in the capital markets. In Taming Animal Spirits, Jim Mahoney further develops the link between the Federal Reserve's monetary policy and the capital markets, concluding with an overview of our current portfolio positioning.
The above commentary represent the opinions of the authors as of 3.30.16 and are subject to change at any time due to market or economic conditions or other factors.Print