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Investment Solutions For Captives
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It has been almost 100 years since the U.S. mainland witnessed a total solar eclipse. As we approach the August 21st phenomenon, towns and cities across America that are lucky enough to be in the “path of totality” are girding for the influx of eclipse watchers (see map).
On that Monday in late August, the moon will completely block the sun, leaving viewers to admire the sun’s previously invisible (to the naked eye) sparkling co-rona. The path of totality slices diagonal-ly across the U.S. from Oregon to South Carolina and suffices as a solid starting point for any model that tried to predict the outcome of the 2016 U.S. presidential election.
As excited Americans finalize their travels plans, this summer’s total solar eclipse is a reminder that while events, experiences, and outcomes can feel intensely unique and impactful, it is easy to misinterpret cause and effect. As we sift through the daily barrage of financial information and data, we too need to routinely step back, take a breath, and ask ourselves, are fundamentals and data changing prevailing market trends and sentiment or are investors backing into theories based on price movements?
July 25, 2017
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BermudaSouth Carolina Vermont
Performa Market Perspective
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Investment Solutions For Captives
Just the other day, our Charleston office ordered special eclipse viewing glasses so everyone can look directly at the eclipse without damaging their retinas. Along that narrative, it feels to us that many investors must be looking at the current investment landscape similarly – viewing the markets with a special type of lense that blocks out any negatives and highlights the beauty of an always rising equity market. Alas, the reality is that after an almost decade long expansion, we have a few concerns when we examine today’s landscape. Namely, record levels of consumer debt, muted productivity, an aging population, underfunded pensions, and political uncertainty. Non-financial corporate debt is at record highs as leverage metrics have increased dramatically (see chart 1). Moreover, external factors such as Brexit and other potential geo-political events pose additional risks.
Additionally, investors have enjoyed years of excessive-ly easy monetary policy, and the multiyear long grab for yield has multiple markets looking frothy, or in some cases, overvalued. This list should be long enough to cause even the most optimistic of investors pause – but that certainly is not the case today.
In this Market Perspective, we further examine current market dynamics and explore whether it is finally time to plan ahead for the next economic downturn?
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Since the American Civil War, there have only been two economic expansions longer than the current one (see chart 2).
For some, the duration of the current expansion alone is enough to spark concern. However, we caution against this view since imbalances and shocks are the greatest factors in spurring recessions, not length. Just as some people may believe that a total solar eclipse portends a negative life event, there are plenty who argue that since the economy has been growing for so long, a recession must be around the corner. Both opinions miss the point. In the case of eclipses foreshadowing a negative life event, the more likely explanation is a well-documented cognitive theory called confirmation bias. More specif-ically, the human brain associates two events, and then assigns some sort of causality between them. If one be-lieves that a total solar eclipse is a precursor to something bad happening, then when their cat dies a month later, clearly the total solar eclipse was the triggering factor. The confirmation bias here is that business cycles have ends and therefore the duration of the cycle portends the end. Under the rules of logic, there is certainly some-thing missing. When this business cycle ends it will go down as one of the longest on record, but it’s not going to end because it was too long.
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Chart 2: Longest U.S. Economic Expansions
Source: Performa Limited (US), Bloomberg
DecadeSource: Performa Limited (US), Bloomberg
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So where are we in the business cycle? What is the state of the U.S. economy? Are there imbalances? Should we be worried about recession?
To start, looking at economic fundamentals and finan-cial data, we do not think there is a high probability that the U.S. economy is in imminent danger of falling into recession over the next 12 months. To provide a framework, we list some key financial and econom-ic indicators in the table below for three time periods: June 2006, June 2008, and June 2017. These dates rep-resent the U.S. economy prior to the 2008 credit crisis, during the crisis, and the current environment.
At the moment, equity markets remain a source of wealth; the yield curve has flattened (but nowhere near inverting); the labor market is solid; and, gas is cheap. On the corporate front, both the manufacturing and non-manufacturing sectors are reporting growth. While the excitement over fiscal stimulus and tax re-form promised after the 2016 election has turned to frustration and a bit of disappointment, the general tone on earnings calls continues to be cautiously op-timistic. This is not exactly what we’d expect to be hearing from companies if their leaders were worried about the economy falling out of bed tomorrow. So if a recession is not around the corner, what part of the cycle are we in?
Clearly we passed the mid-point of the current economic expansion. U.S. auto sales peaked in December of 2016 at 18.29 million units before falling 10% and stabilizing during the first half of 2017. Additionally, the labor mar-ket has fully recovered from 2008, and we are four rate hikes into the first stage of the current monetary policy tightening cycle.
In summary, we’re definitely not at the beginning of the cycle, we’re past midway, but a recession is not imminent. This puts the current expansion around the 7th inning, with plenty of ballgame left. As the expansion continues to unfold we will continue to monitor labor market data closely, as we feel it has done the best job describing the true underlying momentum of the U.S. economy during this expansion.
As we have previously stated, one of our main theses about the current economic cycle is that it can be viewed in slow motion – extraordinary monetary policy accom-modation has distorted the cycle to approximately dou-ble the historical normal length. Under this methodolo-gy, halfway through 2017 represents the 8th anniversary which points to a third to a quarter of the cycle left (i.e. 2019-2021 when the exhaustion finally tips the econo-my).
However, this analysis does not take into account cer-tain factors particular to this expansion nor do external shocks feed into the model. How does one reconcile a still expanding economy with the laundry list of concerns that we highlighted earlier? The amount of debt in to-day’s system is frightening. Corporations have taken ad-vantage of the low interest rate environment, refinanced, increased leverage, and showered shareholders with in-creasing payouts to both make them happy in a low yield-ing environment as well as make earnings growth look
Source: Performa Limited (US), Bloomberg
Carrier June 2006 June 2008 June 2017
S&P 500 1270 1280 2423
2’s - 10’s Spread (bps) -1 135 92
Fed Funds Rate 5.05% 2.47% 1.06%
WTI Oil ($/BBL) $73.93 $140.00 $46.04
Initial Claims 4-week m.a. (thou) 307.75 315.75 243.50
US Auto Sales saar (mln) 16.40 14.07 16.41
ISM Man # Industries w/ Growth 14 9 15
ISM Non-Man # Industries w/ Growth 14 8 16
New Home Sales 3-month m.a. (thou) 1,094 509 616
Consumer Confidence 105.37 50.97 118.90
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solid (even though it is superficial). Similarly, consum-ers have begun to lever up as total consumer debt, as a percent of gross domestic product, has reached fresh all-time highs (see chart 3) with student loans becom-ing a serious hindrance to future growth.
Additionally, economies are always susceptible to negative growth shocks. China remains a source of considerable uncertainty and is playing an increasingly important role in the global economy. Thus, any un-expected negative news out of China will have bigger implications as it ripples through the rest of the world, as seen during the late summer of 2015. Meanwhile, geo-political shocks stemming from a Brexit break-down, ISIS, North Korea or other such events could be equally detrimental to growth trends and are even harder to predict.
These risks and imbalances are real, potent, and should not be ignored even though investors currently see nothing through their eclipse glasses. This is evi-denced by the sizeable drop in global asset volatility and a remarkable run of risk asset price gains without any meaningful pauses. Perhaps once those glasses are removed, the markets will become fixated on negative news, data, and/or events that typically have influence on investor sentiment.
The objective for us is to be able to recognize misplaced confirmation bias and see through the noise. In other words, while a market pullback is certainly in order, that does not mean it is the beginning of the end. This eco-nomic cycle is far from over, but it is essential to pay attention to the sign posts up ahead that will assist us in guiding our client portfolios through the remainder of this expansion and the next recessionary period. While August 21st represents the first total eclipse viewable from coast to coast since 1918, few realize that total solar eclipses occur fairly regularly over the rest of the globe. An increasingly connected global economy can both hin-der and help the speed of localized economic cycles. As the U.S. enters a sensitive part of the business cycle, it is increasingly important to evaluate each emerging trend and new piece of market data in this global context. Being too narrowly focused and reactionary to each individual piece of incoming data can be detrimental to portfolios and performance over the long run.
Cognizant of today’s risks and imbalances, yet humble enough to know that unforeseen shocks can destroy even the best analysis, we maintain a defensive position within client portfolios. It is not time to pack up shop and insu-late portfolios for the next economic downturn. Howev-er, given the current landscape, we feel it is prudent to dial back exposures. The current goal is to capture a good portion of the potential available remaining upside, while making sure that no harm is done should the cycle end sooner than expected or a Black Swan event derail global growth and markets.
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CONTRIBUTORSDavid Kilborn, CFA - Chief Investment OfficerScott Mildrum, MS - Economic & Macro Strategist
ABOUT PERFORMACombining our extensive knowledge of the insurance industry with the institutional expertise of our investment team,
Performa has been managing assets on behalf of captive and other insurance clients for 25 years.
Our capabilities include asset allocation, active fixed income and equity management through diversified mutual funds or separate account portfolios. With offices in the world’s largest captive domiciles, including Bermuda, Vermont and South Carolina, we are focused on delivering customized solutions to meet the unique investment objectives and liquidity require-ments of our investors.
We are 100% employee-owned and currently manage $3.8 billion in assets worldwide representing more than 65 captive client relationships as of June 30, 2017. Our investment philosophy is value driven and long-term in nature. Whether ap-proaching asset allocation, fixed income or equities, our ability to be nimble, contrarian and decisive sets us apart from our peers and promotes capital preservation.
CONTACT US
Hamilton, Bermuda
25 Church Street, 2nd FloorHamilton HM12, Bermuda
Hugh BaritChairman & CEO(441) 295-6754
Megan MarshallClient Service Associate
(441) [email protected]
Charleston, South Carolina14 North Adgers WharfCharleston, SC 29401
David T. Kilborn, CFACIO & President(843) 297-4130
Warren MillerUS Client Relationship Manager
(843) [email protected]
Burlington, Vermont3 Main Street Suite 215Burlington, VT 05401
Sandi PrescottHead of Client Service
(802) [email protected]
John James Head of US Business Development
(802) [email protected]
This article is provided for general informational purposes only. The information compiled is from sources deemed to be reliable but Performa does not warrant its completeness or accuracy. Opinions, estimates and assumptions expressed herein reflect our judgment as of the date of publication and are subject to change without notice. This material should not be construed as formal investment or financial planning advice nor as a solicitation to purchase or sell specific securities or investment strategies. Investors should always seek professional financial advice regarding the appropriateness of investing in any investment strategy or security, whether discussed here, or otherwise. This material must not be distributed to any third party without prior written consent.
Any statements regarding performance may not be realized and past performance is not indicative of future results. Investors should note that the value of any investment strategy or security may fluctuate and underlying principal values may rise or fall.
Performa includes P.R.P. Performa Ltd and its US affiliate, Performa Limited (US), LLC. P.R.P. Performa Ltd. is licensed to conduct investment business by the Bermuda Monetary Authority. Performa Limited (US), LLC is an SEC registered investment advisor. This registration does not imply that the SEC or BMA has approved or disapproved of Performa’s services, products or strategies.
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