Mid-January, 2016 Update
The resumption of selling in global equity markets (including the US) in 2016 has tripped up investors over the short-term. This market action extends a lackluster calendar year 2015, which offered few pockets of returns to support diversified portfolios.
Slowing global economic growth (below the long-term average of 3.5%) has been a source of anxiety for equities and “riskier” strategies like high-yield bonds. Geopolitical concerns in North Korea, Iran, and Saudi Arabia are worrisome, as are Chinese officials’ attempts to “control” markets and their slowing economy as it rebalances. Finally, the US Federal Reserve (Fed) has begun to raise interest rates, a policy that diverges from Europe and Japan, where accommodative monetary policy remains supportive.
Over the first seven trading days of 2016, a sharp selloff moved the S&P 500 Index (S&P 500) into negative territory by over 7%. US bonds have moderated that shortfall in balanced funds and added positive returns in bond funds.
We believe current market action reflects a return to a more normal environment. The previous lack of volatility, especially in US markets, was an anomaly caused by a hyper-supportive monetary policy established by the Fed. During that period, the equity markets, especially in the US, had more than tripled from the 2009 lows.
Economic growth in the US has held up relatively well. Earnings growth — admittedly helped by share buybacks and select technology outperformance — has held up (except for commodity companies), and profit margins are high. The labor market also continues to improve, with the unemployment rate now down to 5%. The flip side, of course, is that wages have started to expand, and while this development is positive for workers, it may slow corporate earnings growth.
As a result, while we believe the market could become more volatile, we do not expect a bear market and believe that global equities, in particular, have favorable risk-reward characteristics after the selloff. This outlook is dependent on avoiding a US recession.
[quote_right] The Beyond Fossil Fuels Fund just completed its first full year in 2015 with the manager outperforming the S&P 500 since inception by 72 basis points.[/quote_right]
While core US bonds remain attractive from a diversification perspective, their total return potential, based on current valuations, appears limited compared to recent history. We do not expect a rapid rise in interest rates, and believe price risks to core bonds are not high, but positive return potential should remain low.
What have we done?
Equity Funds: We maintain a healthy weight to developed markets (including the US), and we added a new manager in mid-2014, Baillie Gifford, to take advantage of opportunities in Europe and Japan in high-quality growth companies.
The Beyond Fossil Fuels Fund just completed its first full year in 2015 with the manager outperforming the S&P 500 since inception by 72 basis points, before fees. This equity option focuses on index-like returns with additional screens for coal and oil exploration and production companies.
Balanced Funds: In UCF’s balanced funds, we can alter the mix between stocks and bonds based on forward-looking market projections, and will take advantage of disproportionate selloffs when prudent. At the end of October, we cut back on equity allocations to a neutral stance. We have recently begun to add back to equity positions.
Fixed Income Funds: In November we reduced some of our diversifying strategies in favor of core US bonds. We maintain a 10% allocation to bank loans though, which we believe can offer 5-6% returns per year over the next few years. We own no high-yield or “junk” bonds. We replaced Standish Mellon Asset Management and upgraded our emerging markets manager with the hiring of Lazard Asset Management, giving them increased flexibility to invest in hard (US) currencies. Finally, we added an allocation to Community Capital Management, a firm that specializes in managing impact investing and fossil fuel free portfolios. Their intermediate fixed income strategy, launched in 1999, focuses on making qualified investments under The Community Reinvestment Act. Over the last 16 years, it has delivered steady risk-adjusted returns while providing added diversification and positive impact on the community.
In broad market selloffs, it is easy to get consumed by the immediacy of negative headlines and sentiment. A thoughtful approach to evaluating opportunities, rather than succumbing to short-term concerns, remains the optimal approach.