Under the Hood

WhartonHill Investment Advisors’ Under the Hood series is a more technical commentary than our Viewpoints series, designed for both clients and peers in the investment industry.


The third quarter ended with strong performance across equity markets, with international and emerging market equities leading the way. U.S. small cap stocks also performed well, as hopes for a tax package grew towards the end of September.  For the quarter ending September, the MSCI EM index rose 8.0%.  YTD, the EM index is up 28.14%.  The Russell 2000 small cap benchmark gained 5.7% during the third quarter and is up 10.94%, YTD.

Source: JP Morgan

Source: JP Morgan

Though large cap U.S. equities have lagged international equities in 2017, they have still performed very well.  The S&P 500 returned 5.5% during the third quarter and is now up 14.24%, YTD.  Fixed income, thought by many to be out of favor as the year started given the sharp year-end ramp in yields, has also performed well.  The Barclays US Agg is up 3.14%, YTD, while the Barclays Municipal index is up 5.28%, YTD.  Taxable high yield bonds have performed very well as spreads have continued to narrow, with the BAML US High Yield Master index returning 7.05%.[1]

Last month, we assessed some of the probable catalysts for a correction in markets.  Among the potential causes for volatility were a move towards a tighter interest rate policy by the Fed, which could disrupt currency and equity markets.  This month, we will take a look at why stocks could continue to find strong momentum into year end.  First, though stocks have performed remarkably well this year, investor sentiment has not exactly steam rolled into ‘euphoria’ territory.  A recent Merrill Lynch fund manager survey showed that 46% percent of portfolio managers view equity markets as overvalued, a record high.  According to Lipper, equity funds and ETFs saw a net outflow of $6 billion during the last week of the quarter, and have seen $60 billion in outflows from March to the end of September.  Cash levels within funds also remain high, at 4.8% as of mid-September, according to Merrill Lynch.

Merrill Lynch fund manager surveys show equity portfolio managers believe markets are overvalued, leading them to hold high cash balances. This could be a contrarian signal if economic data and earnings continue to improve.

Merrill Lynch fund manager surveys show equity portfolio managers believe markets are overvalued, leading them to hold high cash balances. This could be a contrarian signal if economic data and earnings continue to improve.

Were market sentiment euphoric, you would tend to see cash levels drop to 3.5% (where it was in 2007).  Instead, the rally almost seems hated by both investment professionals and retail investors alike.  The American Association of Individual Investors (AAII) survey at the end of September showed just 33.3% of investors were bullish vs. a historic average of 38.5%. Equity fund flows have picked up since 2013, but still lag fixed income by $600 billion since 2007.  To be certain, there is not a 2009-2010 level of dry powder on the sidelines, waiting to be deployed into stock markets.  However, it is our view that stocks could still continue to climb the wall of worry into year end, particularly given the fact that fund managers who have sat on the sidelines may need to play catch up as the year wraps up just to get closer to their benchmarks.

Turning towards the global economy, growth has continued to move towards the upside. In prior calendar years, it was only the U.S. economy pulling global growth to the upside. Now, economic engines in Europe and emerging markets have started building steam and are contributing towards economic momentum.

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European economic data has continued to accelerate and German PMI has hit multi year highs.  Regarding investment activity, Eurozone equity flows have just started to gain steam and have much ground to make up.


Gone are the debates over austerity, tax hikes, and economically punitive actions taken by European governments.  Also gone is the threat of another Greek debt crisis.  Whereas Greek debt was yielding nearly 10% at the start of the year, now a Greek 2 Year bond is yielding 2.67%.


To be clear, there are far better investment opportunities, in our opinion, than funding the Greek government at 2%, but we highlight the graph to show that bond markets and lending conditions are supportive of economic growth.  Eurozone unemployment rates are at decade lows while Japanese unemployment rates are at their lowest level in the last 20 years.

Source:   LaSalle Investment Management

Source: LaSalle Investment Management

On emerging market economies, which have provided significant fuel to the global rally over the last year, we still appear to be in the beginning stages of expansion.  Per Credit Suisse, many economic indicators such as currency strength, profit margins, earnings revisions, and capex build out, are in the early to middle stages of the cycle.


Capital economics notes that Q3 emerging market GDP growth picked up to its fastest pace since the beginning of 2014.  They believe emerging market growth will settle in around 4.3% next year, compared to 2.1% estimated growth for the U.S. in 2018.  Emerging market central banks are also loosening policy, which is keeping financial conditions supportive of continued equity market growth.

Source: Capital Economics

Source: Capital Economics

This is not to say that every global economic data point will continue to march higher from here. PMI data and earnings have been very strong and could cool off as we head into 2018, but for the moment, global growth is accelerating, central bank policy remains fairly easy, labor markets are strong, and inflation is tame.  Though there could be a pullback in spending or corporate investment if central bank policy turns less accommodative, the backdrop for global economic growth is in very good shape.

On the U.S. economy, what we will be closely following over the next few years is the level of leverage in the system. Leverage can feed through in two ways to the economy and markets, positively or negative.  Economic expansions typically die when either one or both prongs of leverage – consumer and corporate – are cut.  Since the end of the last recession, corporations have increased their leverage by a sizable amount, primarily to fund share buybacks while pouring a modest amount of money into capital expenditures.  The bottom left chart shows that corporate debt, as a percent of GDP, is at a level similar prior economic pullbacks.


However, cash, as a percent of corporate assets has grown to around 30%, a multi-decade high.  Companies have increased their leverage, but have also seen their cash levels increase. The boost in cash has primarily come from increased debt and cash flow at firms like Apple ($200 billion in cash), Microsoft, and Google, among others.  In many cases, Apple being the most noteworthy, the increase in debt has been utilized to buyback shares rather than launch a massive capital expenditure program.  This is part of the reason the stock market has performed so well since 2009 while the ‘real economy’ has seen minimal growth.  To close the loop on corporate leverage, this is one area which could become a headwind for the economy.  We do not think this is an imminent threat, as the Fed continues to keep monetary policy loose, but if they begin to tighten interest rate policy at a faster than expected rate, corporations could be faced with cutting back debt levels due to tight funding markets.

While corporate leverage is a bit worrisome, consumer leverage has not grown at nearly the same rate.  In fact, in many respects, consumers have done the opposite of lever up their balance sheets after the financial crisis.  The following charts show a snapshot of the consumer balance sheet and highlight that total assets far exceed liabilities.  Household net worth, the bottom right chart, has increased significantly since the financial crisis in 2008.


The most interesting chart to us is the one in the upper right, which shows household debt service ratios.  In effect, this is illustrating how much people are spending on things like car loans, mortgages, and other debt payments each month.  During expansions, consumers typically tend to feel more confident and take on greater amounts of debt, and begin an increasing amount to service that debt.  However, after the financial crisis in 2008, people went in the opposite direction by paying down their existing debts and not taking on additional amounts of leverage, even in spite of the Fed holding interest rates at zero.  What this chart signals to us is that consumer deleveraging has held back growth over the last few years, but also allows for upside growth if consumers to take on increasing debt and ultimately, increased spending over the upcoming years.

To close, on fixed income, the asset class remains a challenging one to garner much excitement about given the fact that global government bond yields are close to record low levels and corporate bond spreads have tightened substantially.  As of the end of September, investment grade bonds trade at a spread of just 105 bps vs. a historical average of 159 bps.  High yield bonds trade at a spread of 355 bps compared to a historical average of 573 bps.  Though we see little reason why high yield bonds would sell-off materially in the near future, valuation discounts are few and far between and the higher credit quality names within the junk bond space have an increased degree of interest rate risk.  As a result, we have steered fixed income allocations towards shorter duration high quality bonds as well as floating rate securities, which have minimal interest rate sensitivity and yield around 4.5%.



U.S. equities finished the third quarter on a strong note, with international and emerging market equities increasing their 2017 gains. U.S. small cap stocks, which have underperformed the broad market this year, bounced back in the third quarter as tax reform rumblings increased.  Looking forward, small cap, international, and emerging market equities may be poised for continued outperformance vs. large cap U.S. stocks.  As we have noted in prior commentaries, large cap U.S. stocks have held their place atop the asset class leaderboard for some time but may be setting up for future underperformance given stretched valuations and profit margins.

Regarding global economic growth, we are pleased with the momentum exhibited in foreign economies, which have largely been stagnant over the last few years and are just now showing signs of life. The backdrop for continued global growth is favorable: central bank policy is fairly loose, inflation is subdued, labor markets are in healthy shape, lending is robust, and the consumer is beginning to feel increased confidence.  Though the U.S. economic expansion is in its later stages, foreign economies, particularly emerging markets, appear to be in their early to middle innings.

Fixed income remains a challenging asset class, as yields in Treasuries and developed market government bonds remain near decade low levels and the Federal Reserve continues to raise interest rates.  Credit spreads have tightened substantially over the last year, which provides a healthy backdrop to corporate borrowing but makes for less attractive return prospects in traditional corporate bonds.  As a result, we continue to favor short duration high quality bonds in addition to floating rate securities, in order to generate attractive income while mitigating interest rate risk.











Investment Advisory services offered by Independent Financial Partners (IFP), a Registered Investment Advisor. WhartonHill Investment Advisory and IFP are separate entities.

 The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

[1] All data via JP Morgan and Morningstar, as of 9/30/17, unless otherwise noted.