Second Quarter, 2016 Economic and Market Commentary


· The long-term implications of Britain leaving the European Union (i.e. Brexit) are impossible to forecast at this point in time as this is uncharted territory.

· The investment policy for your policy acknowledges that equity market volatility due to events such as Brexit is inevitable and is structured accordingly.     

· One thing that is a near certainty is that investors will have to either take more risk or lower return expectations in this persistently low interest rate environment.

· The last decade has been a challenging one for equities in general and specifically for international stocks.  We believe over time mean reversion will take hold and investors will be rewarded for staying the course with this asset class.

· Similarly, active managers have struggled to keep pace with respective benchmark returns since the economic recovery began in 2009 as all stocks and sectors have for the most part benefitted equally.  Looking forward, we do believe investors will benefit from sector and stock selection in certain areas. 


We trust that the media has saturated you with commentary on Brexit over the past few weeks.  We also have been inundated with such commentary and the only conclusion we can make at this time is that everything that is being published at this point is pure speculation.  This is because the result of the Brexit vote puts both Britain and the European Union (EU) in uncharted territory and the impact of the vote is not likely to be known for years.  Whether the Brexit will significantly weaken or even lead to the dissolution of the EU, or ultimately will help the remaining EU members to come together in a more practical manner, the outcome is just impossible to gauge at this point. 

Although the result of the Brexit vote was somewhat unexpected, the resulting equity market volatility that followed should not have been a surprise given the equity markets disdain for uncertainty.  The investment policy suggested for your portfolio concedes that equity market volatility is inevitable and is intended to help deal with events such as Brexit.  Such an event makes it an opportune time to review the fundamental tenets of our suggested investment policy: 

1. The overall allocation amongst cash, fixed income and equity exposures is best determined through the use of comprehensive cash flow projections that show anticipated portfolio withdrawals over the next several years. 

 2. Sufficient amounts of cash and fixed income exposure should be held in your portfolio to ensure that there is adequate liquidity to meet the identified withdrawal requirements for the next several years.  This cash and fixed income exposure provides you insulation aginst needing to draw capital subject to pricing volatility (i.e. equities) in the near term.   

3. The exposure to the areas subject to these types of risk (i.e. equities) needs to be broadly diversified and well managed.  

In order to achieve growth-oriented returns, risk must be assumed within a portion of your portfolio. Growth-oriented returns should be measured as a function of risk-free rates of return, not in absolute terms.  For example, the 30 year Treasury rate was well over 6% for almost all of 1995 and inflation was running at close to 3%.  Fast forward to today where the 30 year Treasury rate is just over 2% and inflation is running at closer to 1% and it is clear that an investor in 1995 would expect a higher return from a diversified portfolio of bonds and equities than an investor would today.  To put this in context, in 1995, a portfolio made up entirely of bonds had an expected annual return of 7.5%.  By 2005, in order to have a 7.5% annual expected return, a portfolio could only have a 52% exposure to bonds with the other 48% allocated amongst various types of equity investments.  To make a 7.5% return in 2015, the allocation to bonds would have to shrink to just 12% of the portfolio with 88% allocated to riskier equity investments.  In today’s persistently low interest rate environment, investors are forced to either lower their return expectations or take on significantly more risk to bolster returns.  This sounds worse than it actually is, however, as in a real sense (after taxes and inflation) the growth oriented premium is still meaningful.    

The past decade in particular has been a challenging one for equity markets, characterized by tepid growth, the worst bear market since the Great Depression and a prolonged rally in bond prices that saw long-term Treasury securities outperform the S&P 500 over the last 10 years.  While it’s natural for investors to have recency bias, there is still robust statistical evidence that investors should expect to be rewarded by taking on the additional risk and volatility that is associated with equity investments over most long-term market cycles.  Consider the following statistics that were reported by Morningstar earlier this year: 

As it relates to Brexit, our model growth component’s exposure in the international area is widely diversified in terms of geography and type of market.  Further, just about all international exposure in the growth component is actively managed.  These managers have been keenly aware of the issues surrounding the Brexit vote for some time and continue to focus on investment opportunities for specific businesses and industries.  

The U.S. stock market has consistently outperformed overseas markets over the past nine years, leading many investors to question the value of an international allocation in their portfolios altogether. Historically, however, U.S. outperformance has typically been cyclical and the current cycle has already extended beyond historical norms.  This is not to say that a shift in favor of international equities is imminent, but we fully expect the international markets to eventually recover and investors who stay the course with these investments to be rewarded when that recovery takes hold. We believe that a lot of the recent domestic outperformance is due to the fact that the U.S. enacted aggressive stimulus measures sooner than other countries after the global financial crisis of 2008-2009, which resulted in an earlier economic recovery.  U.S. companies have seen stronger corporate earnings and better profit margins as compared to overseas companies over the last several years, but earnings growth is slowing in the U.S. and further margin improvement is going to be difficult.  A strong case is starting to take hold that there is more upside potential abroad if policymakers can reignite economic growth. 

Similarly, prior to the last couple of quarters, growth stocks had been outperforming value stocks for the last several years.  Investors put a premium on growth stocks in the current environment, characterized by low growth, low tight yields, excessive debt and heightened uncertainty.  Historically, value stocks have outperformed growth stocks.  With value stocks currently trading at larger discounts relative to growth stocks based on historical averages, we believe mean reversion is inevitable and investors will continue to be rewarded over time by owning both growth and value stocks in their portfolios. 

U.S. stocks are at all-time highs and bond yields at historic lows. In reaching these milestones, most actively-managed investments have struggled to add value to their respective indices, resulting in large capital inflows to passive investments. The concept of “a rising tide lifts all boats” has applied to equity investing since the stock market recovery took form in 2009. The recovery benefited almost all stocks and sectors equally as stocks rebounded from unsustainably low levels, muting the importance of stock selection. Although investors can meet their objective of earning a growth-oriented rate of return using a purely passive approach, we still believe that active management in certain areas has a propensity to add value over longer market cycles. Thus, we do continue to favor active management in areas where it is statistically attractive and believe that that the actively managed portion of our model growth component will have a propensity to recover and add value over the next several years.  

You well know by now that we shy away from making any predictions concerning the equity markets, the economy, and, in this year, political contests.  We do not believe it to be prudent investment policy to try to make such market timing calls, especially when one considers that historically a small number of days a year on average produce a large majority of the market’s return.  Conversely, we do have a substantial track record of developing sound investment policy tailored to the unique financial and tax planning objectives of each of our clients.  We believe this investment policy assumes appropriate amounts of risk and you will be rewarded for doing so over the longer term. 

Urban Financial Advisory Corporation - July 2016