Happy new year! Welcome to Montaka in 2017.
As we say goodbye to 2016 and begin a new calendar year, it is worth reviewing what markets delivered over the last 366 days and how this compared to our expectations exactly one year ago. First the score sheet: the MSCI TR Index (the “global market”) delivered +7.5% in US dollar terms in 2016. All in all, not a bad result given the global market was already down by (11.5%) by February 11 of that year. From this low, the global market rallied hard on coordinated global stimulus and put on an additional +21.5%. Furthermore, the US Dollar Index – a measure of the value of the US dollar against other major currencies – increased by +4.0% in 2016.
The global market certainly improved upon its performance in 2015 during which it declined by (0.9%) in US dollar terms. And its performance in 2016 was above the average return of the prior 27 years of +6.5% per annum.
As 2016 began, we mounted the argument that equity returns over the coming decades will likely not be as high as they have been in recent decades. The reasons were twofold:
- Interest rates have been about as low as they can go. From here, they can either go sideways or up. The tailwind to equity valuations from a 30+ year decline in interest rates has likely ended.
- US corporate profit margins, which have historically mean-reverted as businesses compete with each other, are at all-time highs. One should not be surprised to see these flatten or decline from current levels, going forward.
We think this argument remains valid and that average equity returns over the coming decades will likely not be what they have been over recent decades.
But what about for 2017? Or 2018? We have no idea – and neither does anyone else. On the one hand, President Trump and his Republican-controlled Congress could cut US corporate taxes and fiscally stimulate the world’s largest economy to boost corporate earnings. On the other hand, the Fed is anticipating to raise interest rates at least another three times in 2017 which could compress valuation multiples.
Then there’s China. While 2016 marked a year of renewed stimulus, it’s unlikely this will be renewed in 2017 as financial risks continue to build in the Chinese banking system. And in the EU, it would take only one of Germany, France or Italy to leave the monetary union for a likely sovereign default and a wave of bank and insurance company nationalizations. (And we note that 2017 will include a general election in Germany, France and possibly Italy as well which could see the rise of new populist, Eurosceptic leaders).
In this sense, the variance in possible outcomes for the next 12-24 months is probably wider than it was one year ago. Said another way, the central estimate of a low returning equity environment is still the highest probability outcome, in our view; but the probabilities of either very good or very bad outcomes have also increased, as shown below. We articulated our thinking behind this chart here after the result of the US election in November.
We believe Montaka’s strategy is entirely appropriate for such an uncertain environment. Montaka maintains a reasonable net market exposure (currently 59%) to take advantage of rising markets. But Montaka’s short portfolio is like an insurance policy to protect the downside in a scenario in which markets turn down. Furthermore, we only buy high-quality businesses at prices below our assessment of intrinsic value. This philosophy adds further protection to the downside.
Finally, we continue to bias the portfolio’s underlying currency exposure towards US dollars. We believe the risk in the US dollar remains heavily skewed to the upside against other major currencies in nearly all possible economic scenarios.