BY ERIC STURDZA
During the month of September debates surrounding the Federal Reserve’s potential actions, the ongoing US presidential election, and the upcoming earnings season were the primary focus of investors. The financial market found itself at odds with what appeared to be the Fed’s initial intention to implement a rate hike in September. Indeed, despite the number of public statements made by senior Fed officials, Chair Yellen’s more hawkish tone during her Jackson Hole speech in late August, and eight Federal Reserve district banks (out of 12) pushing for higher interest rates, the market’s implied probabilities of a rate increase never rose above 45%.
A few factors explain this divergence: (1) the data received between Yellen’s Jackson Hole speech and the FOMC’s meeting was mixed, amid an already moderate growth outlook, (2) the central bank has historically converged toward consensus expectations (a 45% probability priced by markets is very low by historical standards), 3) the asymmetry of policy errors: the Fed could probably respond more effectively to a surprisingly strong inflation uptick by raising rates than to a weakening outlook and falling inflation.
In the end, the Fed’s final decision not to raise rates in September met the market’s assessment of where the economy stands and how the underlying data has recently been trending. Chair Yellen indicated “our decision does not reflect a lack of confidence in the economy” thereby pointing at the strengthening job market and their belief that the trend will continue. Even though inflation (PCE Price Index) is not at desired levels, policymakers believe it will eventually reach the 2% target. As such, it is the Investment Adviser’s view that the Fed remains in a tightening mode and currently foresees a move before year end. This view is shared by the market with odds for December currently hovering around 60%. It is worth noting that such odds have clear sectorial impacts which favour the Fund.
US elections are typically known to increase uncertainty as investors attempt to evaluate the many different scenarios and risks involved. Recent changes in implied election probabilities would suggest that US equities would rise or be less affected if Secretary Clinton wins as the status quo would be preserved (especially if Republicans maintain control of at least one chamber of Congress). On the other hand, if Trump ends up winning, equities would probably suffer as heightened uncertainty in areas such as trade policy would potentially weigh on risk assets.
While forecasted to improve on a sequential basis, the upcoming earnings season is somewhat clouded with some uncertainties. Indeed, 3Q 2016 consensus expectations for the S&P 500 earnings are showing -2.6% year over year (but are positive if we exclude the Energy sector). Approximately 7 out of 11 sectors are expected to post positive earnings growth with the consumer discretionary and health care sectors (two of the Fund largest sectorial exposures) expected to lead the upside (in addition to real estate and utilities). On the other hand, energy is anticipated to be the largest detractor (with earnings expected to decline over 60% on a year over year basis). The Fund does not invest in this sector.The Fund’s performance has been disappointing over the last twelve months (since it was attributed 5 stars by Morningstar). However, the Investment Adviser’s conviction in the potential outperformance in both absolute and relative terms has only increased. The following observations are some of the main reasons that explain this dichotomy: (1) active management has experienced a substantial cash outflow whilst passive instruments such as index trackers and/or ETFs have seen increased cash inflows. Consequently, this is one reason why a significant amount of companies that are held by active managers have underperformed the market whilst many companies that don’t have similar growth or quality attributes have outperformed. (2) The above mentioned movement also feeds into the sector rotation that has taken place. Sectors with much slower growth and quality attributes, in which the Fund has no exposure due to its strict selection process, have largely outperformed the benchmark on a year-to-date basis i.e. Energy (+18.5%), Telecommunication Services (+15.5%), and Utilities (12.4%). (3) Since 2012, the S&P 500’s multiple expansion (from approximately 13x earnings to 21x) has largely outpaced the Fund’s (which has essentially remained the same at approx. 18-19x earnings) whilst its compounded annual growth rate has been much slower. (4) Therefore, on top of having a superior growth rate than that of its benchmark, on both a historical and forward looking perspective, the Fund is also trading at a better valuation. (5) Even though the Investment Adviser is convinced that these trends will not last, as investors will eventually return to high growth and high quality profiles that are trading at similar or lower valuations, he is cognizant that a slightly higher emphasis on a top-down approach will help mitigate short term fluctuations. As a result the following two changes have been applied: (1) the Fund’s weightings have been and will continue to be shifted toward companies held that have larger market capitalizations and lower betas. (2) The Fund has and will also use specific sector trackers (up to 10% of AUM) in order to mitigate any large sectoral movement where the Fund’s stock selection process restricts it from investing. This extra touch, even though light, has already helped the Fund’s performance stabilize over the past 3 months and has led it to outperform its benchmark by +1.24% since September.
All in all, when taking these factors amongst others into account, the Investment Adviser is confident with the Fund and the potential value it can return to its shareholders over time – as secular and above market average growth rates eventually translate into price performance. The Fund’s objective of combining momentum and value by selecting businesses with a stellar track record of persistent growth throughout business cycles and focusing on companies for which these characteristics are underappreciated by the market is more relevant now than ever.
The views and statements contained herein are those of the Eric Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 13/10/16 and are based on internal research and modelling.