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Investment e.Perspective

Current Issue | April 27, 2017

2016/2017 Review/Preview – Our Annual Visit with Mr. Doe

By: Robert Schaefer, CFA, CFP®, Director, Investment Research and Oxford Investment Fellow


Executive Summary

  • Despite a year of upsets and surprises, domestic equity markets delivered strong performance in 2016, though other asset classes were mixed.
  • We have dubbed 2017 The Great Transition, with Trump likely to launch multiple pro-growth initiatives even as the Fed unwinds its extraordinary monetary stimulus.
  • Economic growth should see a modest boost in 2017 and a bigger one in 2018.
  • International equities, bonds and hedge funds all remain valuable components of a diversified portfolio, despite recent disappointments.
  • Skepticism with a dose of optimism is probably the best approach to 2017.

Long-time readers of our Investment e.Perspective know that every January one of our most sophisticated clients, Mr. J. Doe, pays me a visit to discuss annual performance and to get Oxford’s take on the year ahead. A retired executive and astute follower of markets, I can always count on Mr. Doe to ask timely questions and to be a fully-engaged (i.e., opinionated) participant. Enjoy our conversation.

Mr. Doe: Bob, as you know, I’ve been skeptical of this bull market – too skeptical. When we last got together a year ago, stocks were in a near freefall and I was feeling pretty good about my conservative bias. But that all reversed in a wink of an eye. I can’t believe the S&P 500 returned 12% in the year of Brexit and Trump. Personally, I think Trump is a colossal mistake – and I’m a Republican! Have investors lost their minds or am I the one that just doesn’t get it?

Schaefer: 2016 was indeed a year of upsets and surprises. It just goes to show how difficult it is for anyone to time the markets. As the election approached, a number of clients asked us if we would change our investment advice if we thought Trump would win. We told them probably not, as there were just too many variables. Even if we somehow knew Trump was going to pull off the upset, we would have also had to know that the market would actually rally on the news – a view that almost no one shared at the time. Same goes for Brexit. No one thought the UK would actually vote to leave the European Union, and if it did, the consensus thinking was it would be very bad for stocks. But guess what? The S&P 500 sold off for all of two days and then bounced right back to new highs. If there is someone out there that predicted all that, I’m sure we would have read about them by now. Reportedly, George Soros lost a billion dollars betting the market would fall following Trump’s victory. Whoops.

As you pointed out, the US equity market did finish the year quite strong after a very poor start. It was the eighth-straight year the large cap S&P 500 Index was positive, which ties a record. Small cap stocks had an even bigger year, a result of less global trade and foreign currency exposure. We also experienced some welcome reversals during 2016, with value stocks soundly beating growth stocks for the first time in several years and natural resource equities – the big losers of 2015 - rebounding strongly thanks to firmer commodities prices.

But as is often the case, not everything worked well. International stocks lagged behind again, making it four-straight years they have trailed the domestic market. Likewise, the hedge fund industry continued its streak of challenging results. And bonds, which had started out so strong, reversed course as interest rates rose late in the year, ending up with only modest gains.

Mr. Doe: I want to circle back to you later about international stocks, hedge funds and bonds, but first I am not done with Trump. Every investment rag I pick up these days seems to be drinking the same Trump Kool-Aid. I can’t tell you how many times in the last two months I have seen the latest hot buzzwords “regime change” used to rationalize an improved outlook. It’s amazing how quickly the consensus has flip-flopped and euphoria has taken over. I wish I could share their enthusiasm. I suppose you’re going to tell me the economy is about to take off like all those other guys?

Schaefer: I wouldn’t say that, but we do think there is reason to be hopeful. We have dubbed 2017 The Great Transition, not only because of changes Trump is likely to make, but also due to the continued unwinding of the Fed’s extraordinary monetary stimulus. As long-term investors, we don’t spend a lot of time trying to make precise short-term economic forecasts. We do think, however, Trump’s pro-growth initiatives are likely to have at least a modest positive impact on growth during 2017 and perhaps set the stage for even more growth during 2018. With the Republican Party in control, it seems clear that some sort of agreement will be reached to reduce corporate taxes and increase much needed infrastructure spending. And while it’s perhaps less of a sure thing, we are likely to get some individual tax cuts and a meaningful rollback of business-choking regulations. If most or all of those things come to pass, it’s easy to envision a revival of the corporate sector’s animal spirits and capital spending, pushing US GDP growth somewhere north of the 2% malaise we have been stuck in.

The tradeoff will be higher interest rates and possibly further US dollar strengthening, both of which could create headwinds. But unless inflation surprises on the upside, it is likely the Fed will move very cautiously on monetary tightening, so these potential economic drags should only partially offset Trump’s initiatives.

Mr. Doe: That all sounds well and good, but how is all this spending and tax cuts going to be paid for? Are we trying to become the next Japan? I remain highly skeptical.

Schaefer: You make a fair point. Too much debt was the catalyst for the 2008 Financial Crisis and very little progress has been made to reduce that debt load in the years since. Consumers and financial institutions are less leveraged today than in 2008, but government borrowings continue to swell. The good news is that eight years of interest rate suppression has basically allowed the US Treasury to refinance its debt at extremely affordable yields. As a result, our debt service costs have gone down even as our debt outstanding has gone up. If and when interest rates normalize, our debt obligations could become a massive problem, but that is not a key issue for today.

Frankly, what concerns us more about Trump is his erratic bull-in-a-china-shop approach to international relations. An all-out trade war with China could be very damaging to the global economy, and what’s the deal with him and Vladimir Putin? Maybe Trump’s a genius negotiator and we’re all just too stupid to understand his logic. We’ll see.

You have every right to feel skeptical, but we think you should at least consider what could go right. Skepticism with a dose of optimism is probably the best way to approach 2017.

Mr. Doe: Okay, enough about Trump. I’ll concede there are reasons to believe the US could do somewhat better in the near term, but I see no reason to expect improvement overseas. Why does Oxford continue to defend an allocation to international equities when the outlook for places like Europe, Japan and China remains so dismal?

Schaefer: Dismal is probably too strong of word. China’s economic growth is slowing but it is still stronger than almost anywhere else on the planet. Europe has actually preformed quite resiliently in the days since Brexit. And Japan…well, Japan is still Japan, but corporate balance sheets actually look okay there and the central bank’s new policy of pegging 10-year yields to zero ensures ultra-easy monetary conditions for the foreseeable future.

Since 2009 US large stocks have gained 131%, while developed international equities and emerging markets have increased just 32% and 1%, respectively. These lagging results have become frustrating even for patient investors. However, poor results are not a reason to abandon an investment. If anything, that investment has become cheaper and may represent a bargain. We think that’s the case today with international stocks. Cyclically-adjusted price/earnings multiples for many overseas markets are about one-half the US’s elevated levels. Granted it is hard to see the catalyst for stronger growth in places like Europe, but it wouldn’t take much improvement to launch corporate earnings higher. Unlike the US, European profit margins are very compressed; any positive economic traction could send earnings and stock prices soaring.

By definition, a diversified portfolio will always consist of outperforming and underperforming assets. People often make the mistake of thinking they can pick which asset class will do best from year to year. Honestly, we don’t know when it will be international’s turn to outperform again, but we feel confident that day is coming.

Mr. Doe: Let’s shift gears. As much as I worry about the global equity markets, I think I am even more concerned about fixed income. I was surprised by the losses my bond portfolio experienced during the fourth quarter. Now with the Fed resuming its interest rate increases, I’m not sure we should consider bonds the “safe” portion of my portfolio anymore. Am I overreacting?

Schaefer: I understand your concerns about bonds, but yes, I think you are probably overreacting to what you saw in the fourth quarter. For sure the fourth quarter was bad – very bad as fixed income markets go. The Barclay’s US Aggregate Bond Index was down 3.0%. Still, we need to keep that loss in perspective. It was the worst quarter for investment grade intermediate bonds in over 30 years, yet results for the full year were positive.

Like you, we tend to think last July’s record low interest rates probably marked the end of the 35-year secular bull market for bonds. Interest rates seem poised to rise in the years ahead, but we doubt the pace of economic growth and inflation will be sufficient to trigger another 4Q. If you’re a long-term fixed income investor, you actually want rates to move up, as it will allow you to earn a higher yield going forward. In the bond market, short-term pain means greater long-term gains down the road.

And of course we could both be wrong about interest rates going up. Economists have wrongly predicted higher rates for years. Should your skepticism about the economy prove correct, bonds will likely benefit while stocks will likely decline. Therefore, we think high quality bonds remain an important component of a portfolio’s safety allocation.

Mr. Doe: Over the past year Oxford has continued to expand its offering of private alternative investments, which as you know is an area of keen interest for me. While I have been pleased with the recent results of our private equity and natural resource investments, the hedge funds have generated pretty mixed results since the Financial Crisis. Do we still have the right hedge funds? What is Oxford’s thoughts here going forward?

Schaefer: Thanks for acknowledging the work we are doing in the private alternatives space. As you know, Oxford has been an investor in alternative investments for roughly 25 years and we remain committed to constantly enhancing our offerings in this important portfolio segment.

It’s fair to say the hedge fund industry has, as a whole, generated lackluster results during the current eight-year bull market. Of course, part of that is simply the result of being in a long bull market. Many hedge funds are designed to preserve capital during down markets but will often lag in the up years. But that said, the industry is facing some headwinds that go beyond just a bull market. Many of the largest hedge funds have grown well beyond their capacity to deploy capital profitably. Further, the strategies they follow are no longer unique and competition is fierce. As a result, we started shifting our research focus about a year ago to smaller hedge fund managers displaying specialized expertise in a given strategy or sector. These smaller managers can be more volatile than the big overly-diversified guys but their greater return potential makes for an attractive tradeoff. We think hedge funds continue to serve a valuable role, but the job of sourcing truly outstanding managers has certainly gotten tougher over time.

Mr. Doe: While on the subject of alternative investments, I have to ask you about the outlook for oil prices. We experienced a very strong bounce back last year on our natural resources investments and MLP positions. What should we expect for 2017?

Schaefer: It’s really amazing how much the oil and gas industry continues to evolve. Since the Saudi’s decision two years ago to maintain output and let oil prices collapse, the US energy industry has continued to adapt by dramatically lowering production costs. It wouldn’t be an overstatement to say the US oil and gas sector has become a technology play, as advancements in drilling equipment and extraction techniques have revolutionized the entire energy landscape. Even $40 oil is no longer a barrier to profits in prime US shale basins.

It’s always dangerous to try and predict where oil prices go from here. By recently agreeing to new production cuts, it appears OPEC has finally blinked and given up its strategy to shut down US production. If the agreement holds, than current oil prices of around $50 are likely sustainable. However, the upside also appears to be capped. There is already early evidence of US producers scaling up their production to take advantage of today’s firmer prices, so don’t expect oil to go back to $100 anytime soon.

Mr. Doe: I promise I’m almost done grilling you. Before we wrap up though, I feel compelled to ask you about the massive shift of capital flowing from active managers to index funds. Frankly, it makes me a little nervous and I find myself wondering if the ETF (exchange traded fund) industry has transformed boring old indexing into the latest market bubble? Should we be worried?

Schaefer: You raise a really interesting question. The ETF industry has exploded over the last 10 years or so, attracting money from small and large investors alike. A big part of the appeal is low costs and an ability to easily make trades throughout the day. And as we talked about last year, active managers have gone through a cyclical period of relative underperformance, so indexing – whether with an ETF or a traditional mutual fund – has attracted some hot money.

Despite some obvious performance chasing that will likely reverse at some point, we don’t view the move to indexing and ETFs as a fad or a bubble. As you know, Oxford has long been an advocate of low-cost, tax-friendly indexing in information-efficient segments of the market like US large cap stocks. We think a thoughtful mix of active and passive strategies can create an attractive and complimentary portfolio combination. Carefully-selected active managers still make the most sense for most asset categories, but we intend to take advantage of the ever-widening opportunity set the ETF industry offers as well.

All that said, some of the best performing ETFs tend to attract gobs of hot money every year. Conversely, over a hundred ETFs that fell out of favor with investors or never got traction to begin with were shut down last year. Does the world really need an ETF that pays three times the inverse return of oil? Probably not.

Bottom line: the ETF industry has given investors more choices than ever before, but it’s strictly buyer beware.

Mr. Doe: Bob, thank you once again for taking the time to be with me. I really enjoy these annual visits – even when I don’t always agree!

Schaefer: As usual you have raised all the right questions. I just wish I had a crystal ball with all the right answers. The longer you’re in this business – and I’ve been at it for more than 25 years – the more you realize how little you actually know. If I have one redeeming quality, it’s the fact that I know my limits!

Thank you for your continued loyalty to Oxford. We sincerely appreciate your business and wish you and your family a successful 2017.

*Mr. J. Doe is not an actual Oxford client.

This document represents the opinions of the author as of 1.26.2017 and is subject to change at any time due to market or economic conditions, or other factors.