In recent years, we have discussed how the environment of low interest rates, low inflation, and low growth augured low investment returns, and offered that little on the horizon seemed likely to change things. Now our tone is different. Recent political events have shaken things up in terms of the economic outlook for interest rates, inflation, and growth, with credible reasons for thinking each could rise.
A populist sentiment—perhaps summarized as when things are so frustrating for so long, any change from the status quo may be welcome—seems to have taken hold. In the polls, this gave rise to the Brexit in late June, Donald Trump’s victory in early November, and the defeat of the Italian referendum in early December. This populist sentiment also seemed to have grabbed hold of financial markets during the last eight weeks of 2016. Equity markets moved higher, often to record levels. Interest rates may have reached their cyclical lows and have risen decisively, even if by only a small fraction of how much they had fallen in recent years, let alone decades.
Nevertheless, even with the potential for an improved economic outlook, when factoring in the now higher equity prices, it still appears to be difficult for many retirement plans like ours to find attractive generic opportunities to earn returns approximating the rate at which their liabilities grow. In light of this, the Fund continues to work to structure a distinctive portfolio that we believe gives us the best chance of meeting our investment objectives.
Against this backdrop, however, your Fund enjoyed a strong quarter, growing 1.4%. The Fund is up 5.7% for the first six months of Fiscal Year 2017. As a long-term investor, we pay more attention to longer periods; over three-, five-, and seven-year periods, for instance, the Fund generated annualized returns of 3.7%, 7.8%, and 7.4%, respectively, net of fees. These five- and seven-year numbers are encouraging, as they meet the threshold required to match the growth of our liabilities.
Some Perspective: Our Goals and Core Strategy
The Fund's mission is to empower YMCA employees to achieve economic security, resulting in loyalty to the YMCA Movement. To help achieve this mission, the Fund seeks to build a portfolio that generates attractive long-term returns (over many years and even decades) while also maintaining defensive characteristics in order to safeguard the pension promises.
The core elements of our investment philosophy for achieving our mission include:
Building a diversified portfolio in which the several asset classes behave in a different and not highly correlated fashion under different economic conditions
Allocating capital to exceptional investment managers who we believe can produce superior returns through full market cycles
Capitalizing on the Fund’s long-term horizon to accept some illiquidity by investing in private investments in several asset classes in exchange for higher expected returns
Seeking to complement our predominantly equity-market-influenced sources of return with other return drivers. This diversifies the Fund’s sources of return and positions the Fund to fall less than stocks when equity markets decline
Macroeconomic and Market Environment
As mentioned, U.S. equity markets rallied strongly in the wake of the U.S. presidential election on hopes of slashed taxes and of increased government spending that might stimulate growth, inflation, and a rise in interest rates. A rate rise would be welcome because most asset returns are thought to be a function of the “risk-free rate” (approximated by short-term U.S. Treasuries), with additional returns possible only insofar as one takes on additional risk. Interest rates have been at extraordinarily low levels for the last eight years, and 2016 was the lowest point in recorded history, as some developed countries even brought their rates into negative territory, previously thought to be highly unlikely, if not impossible.
Unfortunately, interest rates are still well within the ultra-low range of the last eight years, and last quarter’s rate rise was still smaller than the rate rises of the 2013 “Taper Tantrum” and the 2015 “Bund Tantrum.” It remains to be seen by what amount Congress and the Trump administration will be able to cut taxes and otherwise provide fiscal stimulus and by what amounts that will affect aggregate demand, inflation, and the supply-demand for U.S. Treasury securities.
Last quarter, there were also rallies in the assets of other Developed Markets. The Italian constitutional referendum failed, driving the Italian market upward. Governments proved willing to rescue their banks, as Germany continued to support Deutsche Bank and Italy announced a bailout of Banca Monte Dei Paschi. The ECB announced a continuation of its asset purchase program through 2017, and Eurozone markets broadly rallied.
Japan’s rally continued from the previous quarter, driven by Japan’s shift toward stimulative fiscal policy coupled with the commitment of BOJ Governor Kuroda to the Yield Curve Control Program.
However, problems still loom on the horizon as the details of the U.K.’s exit from the European Union must be worked out, as many European banks still struggle with bad balance sheets, and as there continues to be unrest around immigration. Moreover, the longer-term outlook for the Developed Markets is uninspiring due to persistent negative population growth, which weighs on the gross GDP.
Economic data, overall, has been improving modestly over the last 12 months. Post-election, there has become widespread expectation that fiscal stimulus may come soon and in size, including a combination of: (a) cuts in personal and corporate tax rates and perhaps big changes in tax structure and even the tax code; (b) a decrease in certain regulations that may encourage activity and growth in several sectors; and, (c) perhaps even the long awaited infrastructure spend. The hope is that some combination of labor force growth and productivity growth will allow for higher GDP growth, while not hurting corporate profit margins and earnings.
Along with these possible growth-inducing changes comes more than the usual amount and variety of uncertainties: (a) changes in immigration that could have profound and uncertain economic and societal implications; (b) tariffs and trade disputes with key trading partners, including, Mexico, Canada and China, that could threaten to lead to a contraction in global trade and GDP; (c) uncertainty in certain industries about legislative changes and possible interference by the Trump administration; (d) the potential for social and congressional backlash; and, (e) heightened global tensions and the risk of conflict as has accompanied past periods of increased populism, nationalism and militarism.
December Quarter Portfolio Performance
Your Fund had a modestly positive quarter and a satisfyingly positive six months in absolute terms, returning 1.4% (5.7% annualized) and 5.7% (11.7% annualized), respectively. We focus primarily on absolute returns, since these are ultimately what is required in order to meet the Fund’s objectives and obligations. However, relative returns (as opposed to a benchmark of similar investments) can be a helpful data point as well. During the quarter, for instance, the Fund outpaced the Composite Benchmark by +4 bps. Over longer periods of 3, 5, and 7 years, we have generally outperformed the benchmark, with differentials of -15 bps, +60 bps, and +47 bps, respectively.
December Quarter – By Asset Class
The Fund's Public Equities as a whole gained 2.0% during the quarter. Our Developed Markets managers continued to perform quite well, partly because of their regional biases within Developed Markets, and partly because of their stock-picking within those regions. Meanwhile, the U.S. was a source of strong absolute performance and weak relative performance, while Emerging Markets were the reverse, generating a strong relative performance while experiencing a negative absolute performance.
The Rates portfolio, the mainstay of the Fund’s defensive allocation, declined by 2.5%. Its holdings of fixed-rate U.S. Treasury securities, which aim to reduce the Fund's risk and volatility, declined, as fixed rate, low-risk securities always do in rising rate environments.
Directional Hedge Fund Strategies underperformed, partly due to an overweight in healthcare securities. Many healthcare companies released earnings and guidance that surprised negatively, and the U.S. election introduced great uncertainty to the sector.
Diversifying Strategies performed satisfying well, returning 2.4% while maintaining limited market exposure.
In addition to the “risk-on” tilt of markets, which tend to benefit the Fund generally, the portfolio also continued to benefit from the continued increase in energy prices. Our Natural Resources portfolio gained 4.0%, and the energy manager in our Credit portfolio returned 6.1%. This is a strong reversal of the commodity weakness of 2014 and 2015.
Like most investors, the Fund's key risk factor is a sustained decline in global equity markets. Management has been taking the following steps, among others, as part of its ongoing effort to reduce—although certainly not eliminate—the Fund's exposure to equity market declines:
Maintaining exposure to U.S. government securities in our Rates portfolio
Increasing our allocation to certain diversifying strategies (some, but not all, of which are in hedge fund structures) whose portfolios are designed to generate acceptable and/or attractive returns over a cycle and generally perform differently from equity markets
Increasing our exposure to certain underperforming sectors, such as health care, after weakness in share prices over the last year
Allocating to various opportunistic strategies, including private direct lending, that should provide attractive returns in most environments, but with some degree of downside protection
As has been the case for a few years now, Management views few asset classes and investment strategies to be attractively priced for buyers. This makes for challenging times as we seek to protect and grow the $6+ billion of pension assets with which we are entrusted.
Many institutions we respect share this view, including Cambridge Associates, our investment consultant, which evaluates most asset classes as being either overvalued or fairly valued. The result: few compelling options for investors, and hence the potential for—and even likelihood of—lackluster returns going forward, as discussed above.
During the Fund's 95 years, broad and index-like exposure to stocks and bonds has been sufficient to fulfill the Fund's mission. However, we do not believe this is so today. Therefore, Management is working diligently to add exposure to other sources of returns, while also enhancing the Fund's ability to perform relatively well if market conditions deteriorate. We remain focused on having and refining a well-diversified portfolio that is built for the long-term and that tilts, when appropriate, to sectors of more attractive risk-adjusted returns.