Return Outlook: From Record-Setting to Subdued

Return Outlook: From Record-Setting to Subdued

12.31.2015 - Ronald Sanchez

Economic and market forces created powerful tailwinds for asset prices coming out of the Great Recession. Seven years after the financial crisis, values for many items have soared—from stocks, bonds and real estate, to art, jewelry and sports franchises. The evidence is persuasive. Do an internet search for "record-setting prices," and you'll see headlines for a $170 million Modigliani painting, a $35 million Miami penthouse and John Lennon's lost "Love Me Do" guitar, which recently sold for $2.4 million. And, some of the largest-ever corporate mergers have taken place, including Charter Communications' purchase of Time Warner Cable and Dell's acquisition of data storage provider, EMC.

Investors in US equities and fixed income have been well rewarded in this environment. However, we believe many of the factors that have been so supportive of US financial assets over the past several years have peaked, and that we are entering a multi-year period of subdued returns. Our expectations began to play out in 2015. After climbing 20% annually from 2012 to 2014 and touching a record high in May, the S&P 500 Index performance has been lackluster. Likewise, several solid years for the US bond market gave way to uninspiring results.

So what has changed? And more importantly, what does it mean for investors?

That Was Then...
Robust Profits and Abundant Liquidity

The worst US recession since World War II has also had the weakest recovery. Since the Great Recession ended in June 2009, US GDP has grown 14.2% on a cumulative basis, compared to an average of 28.3% growth at this stage in the previous ten recoveries.1 That said, the US economy has performed well compared to other parts of the world. After bouncing back relatively quickly from the financial crisis, China and other major emerging markets are slowing, while Europe and Japan have fallen in and out of recession.

The moderate pace of global growth has contributed to a nearly perfect backdrop for US corporate profits. Modest demand for goods and services has reduced the need for companies to make large capital expenditures, kept inflation in check and led to global monetary easing that has pushed interest rates to record lows. Amid slow capital spending, modest wage inflation and low borrowing costs, the profit margin for S&P 500 companies climbed to an all-time high of 10.5% in the second quarter of 2015.2 Surging profits and access to cheap credit have put hoards of cash at companies' disposal. Many are using cash to drive shareholder value by increasing dividends, buying back stock and making acquisitions. In an economy where it is hard for companies to grow by traditional means, such as increasing output, these activities have fueled earnings growth that has far outstripped revenue growth on a per share basis (CHART 1).

Chart 1

Corporate profits eclipsed their pre-crisis peak in 2010. By comparison, gross employment was only to regain its pre-crisis levels in 2014. If owners of capital were enjoying record profit levels, cheap credit to finance buybacks and growing dividends, suppliers of labor were finding wage gains constrained by a persistently high degree of slack in the post-credit crisis labor markets.

...And This Is Now
A Positive—But Less Supportive—Backdrop

While companies have been able to benefit from just about every aspect of economic and financial conditions over the past few years, we do not believe these conditions are sustainable. Interest rates are about as low as they can get, a period of historic US monetary easing is behind us and banks are tightening lending standards. Unemployment has fallen dramatically, and signs of stronger wage growth are beginning to emerge after an unprecedented stretch of monthly job gains. In addition, the US dollar has soared over the last 18 months, making domestic exports less competitive and leading to negative currency translations for US companies with foreign customers.

These dynamics will likely continue to pressure profit margins, as well as the ability for companies to issue debt to fund buybacks and other shareholder-friendly transactions. Already we have seen an erosion of corporate profits. Data indicates that the third quarter of 2014 served as the current cycle’s peak for profits. Unsurprisingly, the fierce and persistent downward pressure on energy prices in the year since then coincided with a 5% reduction in corporate profits, which are at their lowest share of GDP since the Great Recession.

After five consecutive years of accelerating job gains, including the best year for new jobs since 1999 in 2014, job gains, while still sharply positive, have slowed in 2015. Coupled with an unemployment rate set to fall through 5%, we have undoubtedly already removed the majority of the slack from labor markets. Anecdotally, consumer-facing companies like McDonalds, Chipotle, and Walmart with margins most at risk from tighter labor markets have confirmed throughout the year that their bottom lines are facing pressure from increased labor cost.

As capital owners benefited from the growth of profits, subdued wage growth, and falling use of cash for capital expenditures in favor of buybacks and dividends, a return to wage growth would imply further pressure on corporate profits. Additionally, we believe that financial conditions, which have favored financial investment relative to capital investment, may have peaked (CHARTS 2 & 3).

Chart 2

Chart 3

Our Outlook for 2016

In our view, the shift to less-favorable conditions, combined with full valuations, equates to a multi-year period of subdued performance for US equities and fixed income. Keep in mind that we are not saying that the tailwinds of the past few years are becoming headwinds. We simply think the tailwinds are moderating, creating a more challenging environment, but an environment in which returns will likely be lower but still positive. We believe economic fundamentals should remain supportive of asset prices in the year ahead. We see very few signs of imbalances in the economy, such as a buildup in business inventories or price pressures. Wage inflation could pick up; however, rising incomes could stimulate consumer spending, which accounts for more than two-thirds of US economic output. US monetary policy remains highly accommodative, foreign central banks continue to aggressively ease, and the muted nature of the current recovery suggests it could be elongated by historical standards.

This communication is intended solely to provide general information. The information and opinions stated are as of December 1, 2015, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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