Last year, our annual outlook publication, Confronting the Unknown, focused on risk: how we define it, how we measure it, and what we saw as the major risks facing investors in 2018. The discussion, unfortunately, was timely given the market volatility we experienced last year. Two of the five risks we highlighted—the risks of rising interest rates and heightened global trade tensions—were top of mind for investors throughout the year. Later in the year, markets became anxious about other topics, such as a potential economic slowdown, a new level of dysfunction in Washington (including unusual executive challenges to the Fed's independence and an extended partial government shutdown), and escalating trade disputes between the U.S. and China. All of this weighed heavily on equity returns across the globe in 2018.
Entering 2019, we face rising economic, political and market risks. But the drop in valuations experienced at year’s end, alongside higher bond yields, offer a foundation for better long-term return expectations across most asset classes. Given that backdrop, many of our client conversations during the back half of 2018 centered on how we might balance these opportunities and risks. Valuation is one of the key drivers of long-term future equity market returns, and as such, we thought an appropriate topic for this year’s publication would be a deeper dive into valuation—the figures we examine to gauge valuation, the manner in which we adjust portfolios to valuation shifts, and the state of market valuations today in our view. There is no silver-bullet metric for valuation analysis, and as we will demonstrate later in this report, the variety of metrics that we monitor—from price/sales ratios to enterprise value/EBITDA multiple—sometimes point in different directions. We believe that by gathering a wide spectrum of information, we can begin to cut through the market’s noise and make informed decisions that help us lean into value and away from more expensive areas.
One example of this which we will explore in depth is examining the opportunity set between U.S. vs. non-U.S. equities along with the topic of geographic diversification. The prolonged period of strong U.S. performance has led many U.S.-based investors to consider severely reducing or even abandoning non-U.S. equity exposure. Consistent headlines about political turmoil (such as in the U.K., Italy and Turkey), economic challenges (such as in China, Argentina and Germany) and structural issues (such as in Japan and Italy) have fueled concerns about non-U.S. markets. But there are still long-term opportunities to invest in great companies in these countries. We wanted to offer a holistic look at how we think about the geographic mix of our equity investments.
This is also a fitting moment to review the intersection of risk and valuation. 2018 marked the 10-year anniversary of the depths of the 2008–09 financial crisis, an event that tested the strength of the global financial system, the will of the global body politic, and the mettle of everyday citizens throughout the world. We are now also nearly 20 years separated from the collapse of the internet bubble in the late 1990s. During both of these events, asset prices became disconnected from reasonable estimates of intrinsic value. Investors who weathered these storms all bear scars, but we can all draw important lessons from those events about the risks of excess leverage in portfolios or on balance sheets, the importance of sticking to your investment discipline, and the need to maintain a diversified asset allocation with robust liquidity to withstand periods of market mayhem.
We don’t see the same levels of excess in either market valuations or excessive debt levels that we saw in 1999 or 2008, but global economic growth appears to be slowing, and we do see rising risks of a recession in the U.S. Our base scenario for 2019 includes a deceleration of U.S. growth, but not a recession. Nevertheless, we are concerned about the pressures of rising interest rates and the potential blowback from global trade strife. On the other hand, the recent market sell-off has taken valuations in equity markets to somewhat more attractive levels. In our conversations with external managers, and with Brown Advisory’s own equity and fixed income research teams, we are hearing more excitement about bottom-up investment opportunities than we have in the past few years. In non-U.S. markets, the opportunities look even more attractive from a pure valuation perspective, and one area of particular focus in this publication will be how valuation and other factors inform our views and decisions about investments in Europe, emerging Asia and other areas of the world.
We are moderately cautious in our portfolio positioning at the start of 2019, with reduced equity exposure vs. our long-term targets and an emphasis on liquidity in our client portfolios. In times of elevated volatility, we seek to remain disciplined, control the natural human impulse to retreat from losses, and avoid any overreactions to near-term price movements. We have been preparing client portfolios for these conditions for more than two years and believe we are in a good position to approach today’s challenges from a position of strength and patience.
But this stance is a baseline that changes for every client, depending on that client’s situation. The title for this year’s report comes from a quote from the Greek philosopher Protagoras, often paraphrased as “Man is the measure of all things”—a statement about relativism (i.e., two people can experience the same set of conditions differently, and both experiences are equally valid representations of reality) that cuts to the heart of our work. The objective realities of today’s market may lead to very different advice and diverging paths for our clients, informed by their time frame, circumstances and temperament. Our aim is to help them reconcile the objective and subjective factors that each play a key role in their long-term plans.
As always, we hope this paper leads to valuable conversations with our clients and helps us make better decisions together as a result. We look forward to hearing your thoughts and comments.
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
1Private and alternative investments (including hedge funds and private equity, credit and real estate funds) available for qualified purchasers and/or accredited investors only.
The following indexes were used throughout this report to represent returns and characteristics of various asset classes and regions:
U.S. Equities: The S&P 500® Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include: market capitalization, financial viability, liquidity, public float, sector representation, and corporate structure. An index constituent must also be considered a U.S. company. Standard & Poor’s, S&P, and S&P 500 are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc. The Russell 3000® Index is a market-capitalization weighted equity index that provides exposure to entire U.S. stock market. It tracks the performance of the 3,000 largest U.S.-traded stocks, which collectively represent about 98% of all U.S. incorporated equity securities. The Index is completely reconstituted annually. The Russell 3000® Index and Russell® are trademarks/ service marks of the London Stock Exchange Group of companies.
Emerging-market equities: The MSCI Emerging Markets® Index captures large and mid-cap representation across 23 Emerging Markets countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI Emerging Markets Net Total Return (Local) Index tracks the performance of the MSCI Emerging Markets Index in local-currency terms. The MSCI Emerging Markets EMEA Index captures large and mid-cap representation across 10 emerging markets countries in Europe, the Middle East and Africa. With 145 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. European equities: The MSCI Europe Index is designed to represent the performance of large- and mid-cap equities across 15 developed markets. As of December 2017 it had more than 400 constituents and covered approximately 85% of the free float-adjusted market capitalization across European developed-market equity. Japan equities: The MSCI Japan® Index is designed to measure the performance of the large and mid-cap segments of the Japanese market. With 319 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan. EAFE equities: The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada. With more than 900 constituents as of December 2017, the MSCI EAFE Index covered approximately 85% of the free float-adjusted market capitalization in each country. The MSCI EAFE Net Total Return (Local) Index tracks the performance of the MSCI EAFE Index in local-currency terms. Asia ex-Japan equities: The MSCI Asia ex Japan Index captures large and mid-cap representation across 2 of 3 developed market countries (excluding Japan) and 9 emerging markets countries in Asia. With 953 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. Latin American equities: The MSCI Emerging Markets (EM) Latin America Index captures large and mid-cap representation across 5 emerging markets countries in Latin America. With 108 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. Non-U.S. equities: The MSCI World Ex-U.S. Index represents the performance of large and mid-cap securities across 22 of 23 developed-market countries, excluding the U.S. With more than 1,000 constituents as of December 2018, the Index coves approximately 85% of the free float-adjusted market capitalization in each country. The MSCI World Ex-U.S. Index represents the performance of large and mid-cap securities across 22 of 23 developed-market countries (excluding the U.S.) and 24 emerging-market countries. With more than 2,100 constituents as of December 2018, the Index coves approximately 85% of the global equity opportunity set outside of the U.S. Unless otherwise noted, all non-U.S. equity return data is cited in USD terms.
All MSCI indexes and products are trademarks and service marks of MSCI or its subsidiaries.
Investment-grade bonds: The Bloomberg Barclays Aggregate Bond Index is an unmanaged, market-value weighted index composed of taxable U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate, asset-backed and mortgage-backed securities between one and 10 years. High-yield bonds: Bloomberg Barclays U.S. Corporate High Yield Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
BLOOMBERG, is a trademark and service mark of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries.
Terms and definitions: Definitions for various valuation ratios (Price/Earnings, CAPE, EV/EBITDA, Price/Sales, Price/Book Value, and Price/Cash Flow) are provided in a table on page 10 of the full publication. Earnings Growth refers to the growth rate of a company’s net profit. Yield to maturity is the total return anticipated on a bond if held until it matures. Yield to worst is the lowest total return anticipated on a bond with callable, puttable or other features (i.e., the "worst" outcome between yield to maturity, yield to call, yield to put, etc.).