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Themes for the Second Half of 2020

Image by Fathromi Ramdlon from Pixabay 

By KEVIN BARRY & SAM KIRBY/CAPTRUST

After its longest-ever period of growth, U.S. economic activity and markets collapsed during the first quarter in response to the initial pandemic shock and stay-at-home mandates. However, as shown in Figure One, major asset classes posted significant gains fueled by historic levels of policy support and reopening optimism during the second quarter. 

Source: Bloomberg. Click chart to enlarge.

The forces that drove markets so far in 2020 are powerful, including both the negative impacts of the virus and the positive impact of monumental stimulus and relief programs. By far, the greatest issue facing capital markets for the second half of the year is success in solving the medical crisis. Until effective treatments and vaccines are available, the economy and especially impacted industries such as travel, leisure, and hospitality will be unable to return to anything approaching normal.

But the hope is that more targeted policies can bridge the gap and contain the risks of overloaded health systems until medical solutions become available, with less severe disruption to the economy, education system, and daily life.

Policy Cushions Blow

The fiscal and monetary stimulus unleashed within the U.S. since March is not only the largest in history, it also arrived quickly, despite a fractious political environment. The combination of central bank liquidity programs and fiscal relief packages is estimated to exceed $9.5 trillion—a staggering number that represents more than 40 percent of U.S. gross domestic product (GDP).

An important driver of the future path of the recovery will be avoiding policy mistakes of the past, such as stopping stimulus too quickly during or after a crisis. Examples include the Great Depression, when monetary policy errors prolonged the crisis; the European response to the global Financial Crisis; and Japan’s Lost Decade of the 1990s.

As a result, all eyes are now on the next round of fiscal stimulus, which is expected before September.  

Labor Market Stress

The initial, heart-stopping spike of job losses in March drove the unemployment rate to 14.7 percent—the highest level since the Great Depression. As states have begun to reopen, we have seen significant improvement as workers sidelined by lockdown restrictions have been recalled. But despite these gains, the unemployment rate remains at a highly elevated and worrisome level of 10.2 percent.

Labor market recovery is a critical precursor for limiting the damage of this recession. For the remainder of 2020, we will watch closely for signs that effective virus containment efforts can coexist with job recovery, as well as any signs of increases in permanent layoffs as businesses adjust to the post-pandemic business environment. 

Balance Sheet Health

The virus isn’t the only health concern on the minds of investors and policymakers; the financial health of corporations is also in focus. We entered 2020 with storm clouds on the horizon in the form of elevated levels of corporate debt. Today, debt-saddled firms face an unprecedented revenue shock We have already seen many storied brands troubled sectors fall victim to the crisis, including Hertz, J. Crew, Gold’s Gym, Neiman Marcus, and Brooks Brothers. Already, the pace of bankruptcy filings has reached levels not seen since 2009, prompting some to fear that we could be on the brink of an avalanche of business failures.[1]

The unique nature of the current crisis does, however, allow room for optimism. During prior recessions, levels of economic activity were quick to fall, but slow to recover. This time, because the drop-off in activity was largely artificial—driven by lockdowns and social distancing requirements—we could see a sharper recovery once virus risks subside. Only time will tell. In the meantime, amid this uncertainty, it should come as no surprise that many firms have withdrawn future predictions of near-term business conditions, with more than 170 companies suspending earnings guidance over the past three months.[2] 

Election Season

Finally, markets will watch the election season unfold with great interest. This attention that will only intensify after party conventions. Although current polling suggests a lead for the Democratic challenger, we are still more than two months out from election day—an eternity in politics. Historically, presidential incumbents who faced a recession within two years of reelection have rarely won. However, this recession is anything but typical, and it remains to be seen whether this time will be different. We are mindful of the risks that a politically charged environment could slow or derail continued policy support for economic recovery and the potential escalation of trade disputes.

Investing Amid Uncertainty

The breathtaking drop and breakneck recovery we have witnessed over the past four months represents perhaps the hardest-but-greatest lesson of all time on the dangers of market timing. Those who moved to the sidelines in March missed a rally for the record books. However, investors, institutions, and retirement plan participants who stayed the course or took the opportunity to rebalance portfolios may have benefitted from some of the extreme price dislocations witnessed during the first quarter.

While we hope the next six months is a smoother ride than the last, we expect volatility to persist as markets react to the fast-changing medical, economic, and political conditions described above. This degree of uncertainty underscores the importance of risk tolerance, asset allocation, and portfolio diversification. These foundational principles can give retirement savers a greater ability to seek out the new opportunities that will undoubtedly emerge from the first global pandemic of the modern era.

Sources:

[1] Hill, Jeremy; Crombie, James “Big Bankruptcies Sweep the U.S. in Fastest Pace Since May 2009,” bloomberg.com, 2020

[2] Strategas, 2020

CAPTRUST is an Associate Member of TEXPERS.The views expressed in this article are those of the author and not necessarily CAPTRUST nor TEXPERS.

About the Authors:

Kevin Barry is CAPTRUST’s chief investment officer and leads the Investment Group, the team responsible for investment manager due diligence, asset allocation, and discretionary investment management for the firm’s wealth management and institutional advisory clients.

Sam Kirby is a leader with CAPTRUST’s Investment Strategist team. He works with the firm’s financial advisors to assist clients with investment strategy, portfolio construction, and monitoring. He has 15 years of financial services experience and is a CFA charterholder.

U.S. Public Pension Underfunding — Don't Make the Same Mistake Thrice

Image by Mohamed Hassan from Pixabay

By CHARLES E. F. MILLARD/Amundi Pioneer

We are in unprecedented times. Coronavirus. Life and death health threats. Market upheaval. Economic shutdown. And now: talk of states potentially filing for bankruptcy. But whatever happens with bankruptcy proposals, public pensions will still have to be paid, and state and municipal governments should continue making their pension contributions.

When the dust begins to settle after current market turmoil, public pensions’ funded status will come into view. In some cases, it will likely be quite disturbing. A hypothetical pension portfolio of 60% stocks and 40% bonds would be down -8.4% since January 31, 2020. If that pension had been 70% funded then, it was approximately 64% funded through April 23.

Surely there will be criticisms by political leaders and policymakers: Why wasn’t the investment staff more conservative? Didn’t they know a crash was coming? Weren’t we supposed to rebalance? How did we get so heavily weighted to equities? Why do we have so much in the stock market anyway? This is for retirees — shouldn’t it be safe?

 

But the real problem in U.S. public pension underfunding is not related to investments — as long term investors, pensions have actually done pretty well. The real problem in public pension underfunding is the failure of governments (the plan sponsors) to make the necessary contributions to the pension plan in the first place. Going forward, pension funding status will depend as much on state and local governments’ meeting funding obligations as it will on investment performance.

Unfortunately, in the current economic environment, state and local governments will be tempted to cut back on pension contributions. With funded status as low as it is now, that could put enormous strain on already vulnerable systems.

Underfunding is not caused by investment performance

 

When the dot-com bubble and the 2008-09 financial crisis hit, pensions’ funded status fell dramatically — from 102% in 2001 to 89% in 2003, and from 84% in 2008 to 75% in 2010. Interestingly, the states that kept up their contributions during those difficult times are among the best-funded plans today.

Click chart to enlarge.

In the years following these crises, investment performance was relatively strong. After the dot-com bubble burst, the average public pension investment return for fiscal years 2003-2005 was 11.5%. And public plans averaged 11.3% in the three years that followed the Global Financial Crisis, based on data from the Pew Charitable Trusts. In fact, pensions truly are long-term investors. Their median annualized performance over the last thirty years is about 8.3%, according to the National Association of State Retirement Administrators.

Click chart to enlarge.

Unfortunately, in the years following these crises, at the worst time, state and local governments pulled back significantly on pension funding. That is the danger they must avoid today.

 

Underfunding is actually caused by ... well, underfunding. Under the guidelines of the Government Accounting Standards Board (GASB), the governments that sponsor pension plans are supposed to make necessary contributions to the plan each year. These contributions have traditionally been known as the Annual Required Contribution (the ARC). Unfortunately, the problem with the Annual Required Contribution is that the word “Required” is just a word. In reality, governments are not required to follow GASB guidelines and, unfortunately, many have failed to do so.

 

In the years after the markets tumbled, many states and cities fell short on pension contributions, and pensions’ funded status has not recovered. States missed their ARCs by significant percentages and dollar amounts. The weighted average contribution was about 89% of the ARC in 2003, 87% in 2004, 84% in 2005, and 83% in 2006. The total value of those missing ARC payments was $27.7 billion. That is money that could have been growing in those plans all this time.

 

The situation declined even more after the Global Financial Crisis. The weighted average contribution was about 81% of the ARC in 2010, 80% in 2011, 78% in 2012, and 82% in 2013. The total value of those ARC shortfalls was $68.5 billion.

Not only must political leaders make the full ARC, they must also calculate the ARC responsibly. They must choose shorter time horizons to amortize liabilities. For a plan with a $10 billion unfunded liability, the difference in total dollars contributed between a 15-year amortization and a 30-year timeframe would be over $7 billion. They should never roll their amortization periods into new ones, and they must never allow negative amortization — the equivalent of capitalizing interest on a mortgage.

These three methodologies invariably make near-term contributions lower and long-term liabilities higher. Making a “full” ARC with these methods is not really making the full ARC. The chief investment officer of one public fund told me that my using those kinds of methods, “my state legislature is ripping me off by $2 billion a year!” And that was before the current market turmoil.

One of the arguments in favor of the current huge Federal rescue legislation is that the companies are not at fault and that this is a crisis. Similarly, the workers are not at fault and the public pension system in some states is in crisis. So even though it will surely be difficult to do so, states and cities must make the proper contributions and not let their funding practices put their pensions in further peril.

Amundi Pioneer Asset Management is an Associate Member of TEXPERS.The views expressed in this article are those of the author and not necessarily Amundi Pioneer Asset Management nor TEXPERS.

About the Author:

Charles E. F. Millard is a Senior Advisor at Amundi Pioneer. He advises the institutional

team and clients on topics related to pension strategy, pension fund regulation, and the
growing interest in Responsible Investing. He is a frequent speaker, writer, and advisor on pension-related issues. Millard has appeared numerous times on CNBC and been published in The Wall Street Journal, Bloomberg, Financial Times and elsewhere on a variety of pension topics. 

In addition to working with the institutional team and clients, he works with the marketing team to strategize on speaking opportunities and editorial content. Millard was appointed by President George W. Bush to be the Director of the United States Pension Benefit Guaranty Corp. He was the first Director to be confirmed by the U.S. Senate and carried the rank of Under Secretary.

Subsequently, he was Managing Director and Head of Pension Relations with Citigroup. He also taught pensions and public policy at the Yale School of Management, served as a Senior Advisor for McKinsey, and held various senior roles in the private sector. Earlier in his career, Charles served as the President and Chief Executive Officer of the New York City Economic Development Corporation, and as a member of the New York City Council representing the Upper East Side of Manhattan.

Millard is a member of the Editorial Board of the Journal of Retirement and the Advisory Board of the Georgetown University Center for Retirement Research. He holds a B.A. from the College of the Holy Cross and a J.D. from Columbia Law School.

BY NICK CLAY & ANDREW MACKIRDY, Newton Investment Management

The long-term returns from U.S. equity markets eloquently illustrate the role of dividends in wealth creation. While capital gains accounted for the growth of $1 invested in U.S. equities at the beginning of 1900 to $215 at the end of 2011, the additional effect of income and its reinvestment turned that original investment of $1 into $21,978.[1]

Dividends Can Boost Long-Term Earnings Growth

It is often suggested that, by following a dividend-focused strategy, investors are likely to suffer since paying a dividend may be viewed as evidence of the paucity of a company’s investment opportunities. However, various international studies have shown that there is actually a positive correlation between a company’s payout ratio and subsequent long-term earnings growth.[2] They suggest that the payment of a dividend actually encourages greater capital discipline which, in turn, leads to better long-term returns.

Of course, companies may choose to carry out share buy-backs rather than pay dividends.

Proponents of buy-backs argue that, not only are they more tax efficient, they are also equivalent in terms of their effect on the capital structure of a company. While these observations may be theoretically true, it is human nature and incentives that drive human behavior. If done at a price above intrinsic value, share buy-backs are in fact a dilution of shareholder value. Furthermore, a share buy-back is only equivalent to a dividend if it is maintained in a downturn. We observe, however, that companies tend to carry out share buy-backs when times are good and quietly drop them subsequently when conditions deteriorate.[3]

A Focus on Dividends Helps to Lower Volatility

Even during periods in which capital returns fall, dividend income tends to be relatively stable. Once a dividend is established, companies tend to try to keep paying it to avoid the negative signal that the market receives when the payment of a dividend is halted.[4] Crucially, if a dividend continues to be paid after a share has fallen in price, investors receive a greater number of shares upon reinvestment of that income than if the share price had not fallen. Therefore, investors may, by concentrating on the income they receive, withstand the volatility in the economy and in the capital value of their portfolios with greater equanimity.

The Need to Be Active

While the profound role of dividends in long-term real returns is statistically demonstrable, yield alone is not necessarily an indicator of corporate strength. The difference between forecast yields and realized yields, shown in the chart below, demonstrates that in order for an equity income strategy to be successful an active approach to investment is necessary.

Comparing Forecast Yield of FTSE World Income Stocks Versus Actual Yield Achieved, End-1995 to December 31, 2018

Click graph to enlarge.

Source: FTSE World. SG Quantitative Research, Factset, December 31, 2018.

Clearly, companies that are over-distributing to shareholders and underinvesting in their business will be likely to harm their fundamental prospects and jeopardize the sustainability of a dividend. A fundamentally healthy business, receiving enough reinvestment to maintain itself and grow, is a prerequisite for a sustainable and growing dividend stream.

In this context, it is our view that an active approach can improve on the statistical tailwind of dividends in three key respects:

• by ensuring that dividends are backed by sustainable cash-flow streams
• in an uncertain world, establishing that the range of future cash flows and intrinsic valuation is favorably asymmetric
• ensuring that the current share price offers a reasonable degree of margin of safety.

By focusing on these disciplines, we believe an investment approach centered on dividend income – the dominant source of long-term real returns – can boost long-term earnings growth and reduce volatility.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Newton Investment Management nor TEXPERS, and are subject to revision over time.
Article Sources:
[1] Credit Suisse, Global Investment Returns Yearbook (2011) and Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002), with updates from the authors; February 2012.
[2] Arnott and Asness, Surprise! Higher Dividends = Higher Earnings Growth, Financial Analysts Journal, (2003); Gwilym, Seaton, Suddason and Thomas, International Evidence on the Payout Ratio, Earnings, Dividends and Returns, Financial Analysts Journal (2006).
[3] Jagannathan, Stephens and Weisbach, Financial Flexibility – the choice between dividends and stock repurchases, Journal of Financial Economics (2000).
[4] Laarni T. Bulan, To Cut or Not to Cut a Dividend, International Business School, Brandeis University (November 2010).


About the Authors:
 

BY SCOTT KRAUTHAMER, AllianceBernstein

In recent weeks, the U.S. yield curve has been making investors nervous again. The curve has inverted before each of the last seven recessions, and it did so again on March 22. But what does an inversion really mean for equity returns?

The yield curve simply tracks how long-term interest rates stack up to short-term rates, and it’s said to invert when short-term rates are higher than long-term ones. After three-month Treasury bill rates topped those of 10-year Treasury yields for the first time since 2006, we took a closer look at what happened to equity returns after the 11 other inversions that have occurred since the 1960s.

In the very short term, the effect of an inversion is negative. In recent years, that may be because the yield curve has gained incredible power in the minds of financial market participants as a foolproof signal of impending recession. In other words, the signal itself, rather than any fundamental conditions it signifies, might make investors nervous. In earlier years, when yield-curve inversions didn’t even warrant a mention in the New York Times, concern over how rising short-term interest rates would affect loan conditions seemed to be more top of mind.

However, average stock returns were negative only in the first month after an inversion. Further out, average returns were positive. And the more time that elapsed since the inversion, the more positive the average returns were.

Looking more closely at long-term trends, however, the picture is more nuanced. Three months after an inversion, stock investors booked positive returns nearly three-quarters of the time. But by the time a year had passed, the results were usually much more extreme: either very positive or very negative.

Click chart to enlarge.

What’s the Central Bank Got to Do with It?

The Federal Reserve may have contributed to those extreme results. During the three best yearlong periods of post-inversion returns, with gains ranging from 27.1% to 33.6%, the Fed was generally in loosening mode.

On the flip side, the Fed was generally in tightening mode during all but one of the five yearlong post-inversion periods in which investors experienced negative returns. And the one year of negative returns in which the Fed was not strictly tightening, having both raised and lowered interest rates between October 1980 and October 1981, turned out to be the “best of the worst.” The returns of –7.3% that year compare favorably to double-digit losses in other post-inversion periods.

At the moment, the Fed has put further rate hikes on ice, and some investors even believe cuts are in the offing. Historical data reinforce the idea that cutting would likely be better for markets, but the data also show that it’s possible for equity markets to keep going up even under tightening monetary conditions.

Zooming Out: The Bigger Economic Picture

Much depends on the broader economic context in which inversions occurred. For example, when the yield curve inverted in September 1988, the US economy was in its eighth year of expansion. The Asian financial crisis hit many global economies hard, but it failed to slow job creation, arrest the falling unemployment rate or nudge inflation higher in the US. The economy continued to expand into 1999, and US stock investors enjoyed the best returns of all 11 post-inversion periods.

The worst post-inversion returns, however, came soon after that period, with the April 5, 2000, inversion. The Fed had hiked interest rates five times since June 1999, unemployment began rising in May 2000 and technology stocks melted down. The disputed presidential election in November 2000 only added to the tumult. The US ended a 10-year run of economic growth with a recession that began in March 2001.

Investors can and will debate whether history will remember 2019 more like 1998 or 2000. And in the late stages of an economic cycle, it’s tempting to let events like a yield-curve inversion influence investment strategy. But we think investors should not be guided by these impulses.

The yield curve is a signal with no precision: though inversions have preceded recessions, they don’t pinpoint when they’re coming. We’ve also never seen an inversion in the post-QE age, and we’re skeptical that it’s a valid signal for equities this time around. Rates are still historically low, global central banks have paused any move toward tightening and some countries are even unleashing fiscal stimulus. This inversion was also quite brief, and the curve has since steepened, making this a faint signal at best.

Perhaps most importantly, however, inversions say very little about the fundamental ability of individual corporations to grow and prosper under a range of economic conditions. That’s why returns at any point after an inversion aren’t reliably positive or negative. Companies with high-quality growth, low leverage and high-rated credit are likely to fare well whenever the cycle finally turns. It’s best to stick with what works for now.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams nor TEXPERS, and are subject to revision over time.

About the Author
Scott Krauthamer is managing director of AB’s equity business development and covers the U.S., international and global services for both its institutional and retail growth products. Prior to joining the firm, he held a variety of investment and product-management roles at Legg Mason, U.S. Trust, Bank of America and J.P. Morgan Private Bank. He holds a bachelor's degree in finance and management information systems from the State University of New York, Albany. He is a CFA charterholder and a CAIA designee.

BY NICK YEO, Aberdeen Standard Investments

It’s an odd time to talk up Chinese stocks. China is locked in a bitter trade war with the U.S. and it was the world’s worst-performing major market last year.

It's an inefficient market 

Retail mom-and-pop investors account for 80% of trading turnover on the country’s stock exchanges, which, until recently, were closed to overseas investment. They tend to be swayed by breaking news rather than cool-headed analysis of company prospects. The result is a volatile, sentiment-driven market.

But this creates opportunities for investors to pick up good companies trading below fair value. Sentiment can change quickly. Two drivers that could inspire a turnaround are a U.S.-China trade deal and China’s inclusion in global indices.

A prolonged trade conflict would hurt corporate profitability. Tariffs dent the earnings of companies that benefit from global supply chains, many of which are listed on U.S. exchanges. This may have been a factor behind last December’s S&P 500 Index slump.

It’s in the interest of both sides to resolve this dispute. The catalyst could be another market rout. President Trump is already risking backlash from rural Republicans impacted by Chinese duties.

While we expect talks to continue, we’re confident a deal will be struck — especially with a U.S. presidential election on the horizon. Any deal would likely be received positively by markets, giving companies greater clarity on their revenue prospects and spending plans.

At the same time, global index provider MSCI is doubling the number of Chinese stocks — or A-shares — in its emerging-markets index. Within five years, it’s estimated they could account for 20%. This would draw in capital from foreign institutions that track the index passively.

This is long-term money, stickier than today’s sentiment-driven flows. It will expose Chinese company managements to global standards of accountability and best practice.

Improving governance tends to enhance corporate performance and helps to realize value for shareholders. We believe it’s better for investors to get ahead of this curve.

Back to the future

So why invest in China? The answer is growth. Despite frequent bulletins on China’s slowing GDP growth, it is still above 6% a year — faster than advanced economies.

At the start of this year, consensus 2019 earnings forecasts for A-share stood at 15%. Investors will struggle to find many markets offering double-digit growth.

Perspective is important. China and India used to account for half of global GDP growth, before the industrial revolution gripped the U.S. and Western Europe in the 18th century and reduced both to a statistical irrelevance.

It was only in 1978 that Communist Party reformists set in motion a process of industrialization and urbanization on an unprecedented scale. China is now the world’s second-largest economy in nominal terms.

Within 30 years, China and India are again forecasted to account for 50% of global GDP growth. It points to the mother of all mean reversions.

Today 60% of China’s population lives in urban areas — and this figure is rising. People gravitate toward cities to find better jobs, health care and education services. It means they get wealthier, too. In 1960, China’s GDP per capita was $100. Today it’s $7,500, and in Shanghai it’s $20,000.

Some 39% of the population is classified as middle class now — from 2% in 1999. That’s half a billion consumers. Life expectancy has also more than doubled since 1960, to 76 years.

Rising wealth and living standards mean China is moving to higher-value goods and services. Investors can buy into listed companies poised to benefit from this structural growth. We have found quality stocks in areas including travel, food and beverages, luxury goods and Chinese medicine.

China’s exchanges also have low correlation to global markets. Chinese policymakers are steering the economy away from manufacturing and exports to reliance on domestic consumption and services. The latter make up more than half of China’s GDP growth today.

Domestically focused firms are less tied to global-economic and interest-rate cycles. They are also more insulated from the worst effects of the trade war. In this way, A-shares can bring valuable diversification benefits to a portfolio.

So investors prepared to look beyond today’s trade war and focus on the long-term opportunity will be well placed to ride on China’s future consumption growth.

Important information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries. Diversification does not ensure a profit or protect against a loss in a declining market.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Aberdeen Standard Investments or TEXPERS.

About the Author
Nicholas Yeo is the director and head of the China/Hong Kong Equities team at Aberdeen Standard Investments. Yeo holds a bachelor's degree in Accounting and Finance from The University of Manchester and a master's degree in Financial Mathematics from Warwick Business School. He is a CFA charterholder.