How The Fund Works

Investments & Performance
Investment Review
For the Quarter Ended December 31, 2018
Overview

Santa Arrived Late. Often, equity markets rally in December and into the new year. This year, this so-called “Santa Claus rally” failed to materialize pre-Christmas. In fact, December was a brutal month for equities, capping off a miserable fourth quarter of 2018. In the fourth quarter, no traditional asset classes were safe from the increased level of volatility and the resulting sell-off. Virtually all equity markets sold off. US equities, which had broadly been spared from the global equity sell-off throughout the first three quarters of 2018, suffered the most.

Overall, 2018 was a tough year for investors. Most asset classes detracted in 2018, many substantially, and the few that did generate positive returns eked out tiny gains. Santa did arrive on Christmas, however, and US equities markets advanced nearly 7% through year-end and an additional 8% in January, the best January since 1987.

Markets. At the end of the third quarter, US equities was the only major market to have generated a positive return in 2018, but that success did not persist through year-end. Despite the Santa Claus rally in the fourth quarter, US equity markets were hit hard as the S&P 500 declined 14% and the Russell 2000 fell a staggering 20%. International equities weren’t spared from the Q4 sell-off but did fare better than US equities. However, international equities underperformed in 2018, with many registering double-digit losses in contrast to the S&P’s -4.4% total return for 2018. Commodities also experienced a punishing 2018. The price of oil, for example, fell nearly 40% in the fourth quarter, resulting in a 25% decline in 2018.

Causes of the Sell-off. The sell-off in the fourth quarter was likely due to increasing signs (and fears) of a slowing global economy, continued tensions (trade, technology, and intellectual property) between the US and China, and central banks continuing to move from expansionary to contractionary monetary policies. According to the IMF, global growth for 2018 is estimated at 3.7%, the same level as 2017, and is expected to slow to 3.5% in 2019 and 3.6% in 2020, both below earlier projections. One driver of the lower-than-expected growth rates is the negative effects of the still-escalating trade war between the US and China. Other political concerns weighing on the markets have been the uncertain outcome of the Brexit referendum in 2016, deficit negotiations in the eurozone, the “yellow vest” protests in France, and the partial US government shutdown. It seems likely that this higher volatility regime will persist as uncertainty continues around future global growth and ongoing Fed policy.

THE FUND’S PERFORMANCE FOR THE QUARTER

The Fund’s Returns. Against this backdrop, the Fund experienced a tough quarter, losing 6.0% (shown net-net, after all management fees and the Fund’s investment-related costs, as are all return figures shown herein). As a long-term investor, we pay more attention to longer periods. Over the last seven and ten years, for instance, the Fund has generated annualized returns of 7.3% and 8.4%, respectively.

While we primarily focus on absolute returns, relative returns (versus a benchmark of similar investments) can be a helpful data point as well. During the quarter ended December 31, 2018, the Fund underperformed against our customized Composite Benchmark by 52 bps. This underperformance was primarily driven by our equity book, particularly US and developed market (DM) ex-US equities. Within US equities, our small-cap and growth tilts hurt as large-cap and value stocks outperformed. Within DM equities, our overweight industrials exposure and small- and mid-cap tilts hurt as industrials underperformed and large-caps outperformed. Over the longer periods of five, seven, and ten years, we have outperformed this benchmark by 11 bps, 57 bps, and 64 bps, respectively. Nevertheless, over the last year, we were 66 bps ahead of this benchmark.

When one factors in higher discount rates on future earnings and cash flows, it still appears to be difficult for many retirement plans (such as ours) to find attractive generic opportunities to earn long-term returns that approximate the rate at which their liabilities grow. In light of this, all of us at the Fund are continuing to work to structure a distinctive portfolio that we believe gives us the best chance of meeting our investment objectives.

In January, we estimate the Fund gained ~4.4%, recovering ~75% of the damage done in Q4.

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, cycles, and even decades) while maintaining defensive characteristics to safeguard our pension promises.

The core elements of our investment philosophy for achieving our mission include the following:

  • Building a diversified portfolio in which the several asset classes behave in a different and not highly correlated fashion under different economic conditions.
  • Seeking to complement our predominantly equity-market-influenced sources of return with other return drivers, thereby diversifying the Fund’s sources of returns and positioning the Fund to fall less than stocks when equity markets decline over an extended period.
  • Allocating capital to exceptional investment managers whom we believe can produce superior returns through full market cycles.
  • Capitalizing on the Fund’s long-term horizons to accept some illiquidity by investing in private investments in several asset classes in exchange for higher expected returns.
MACROECONOMIC AND MARKET ENVIRONMENT

While 2017 was a year of strong, globally synchronized growth, we started seeing divergences in early 2018. Although 2018’s global GDP growth remained healthy at 2017’s pace of 3.7%, the economic outlook for 2019 and 2020 has dimmed. Growth in the US remains strong, largely due to fiscal policy reform. The effects of the trade war seem to be taking their toll on China, whose economy only grew by 6.6%. While this may seem like a high nominal number, it is China’s lowest rate of growth since 1990. Even slower growth for China is anticipated in 2019.

United States
At the end of the third quarter, the S&P 500 had generated a strong 10.5% return on the year. After the fourth quarter’s sell-off, the S&P 500 had a -4.4% return for 2018. This loss marked the first calendar year of negative performance for the S&P 500 since the global financial crisis in 2008. Unsurprisingly, the global equity market sell-offs caused investors to seek safety, which caused the 10-year Treasury yield to drop to 2.7%, down from over 3% at the start of the quarter. Equity price declines and rising earnings make multiples more attractive, unless a recession is on the horizon. An impending recession is not yet apparent, although the economic indicators are mixed.

Third-quarter earnings for the S&P 500 grew 26%, the highest earnings growth since the third quarter of 2010. Inflation, which had been rising throughout the year, fell to 1.9% in December, down from 2.2% in November and from the highs of 2.9% in June and July. Wage growth remained solid in 2018 at 3.2%, the largest full-year increase since 2009. The number of job openings remains high at 6.9 million, keeping the unemployment rate at a near-historic low of 3.9%. GDP growth slowed in the third quarter to 3.5% from the second quarter’s 4.2%, which is still the second-highest reading since 2014. However, the consumer confidence index fell to an 18-month low in January 2019. Additionally, pending home sales, a forward-looking indicator of home sales, slowed 2.2% in December, signaling a potential slowdown in the economy.

While the near-term outlook for the US is largely positive, there are several concerning developments. The US government shutdown has stretched into late January. This may hurt the economy in the near term, but the effects on the long-term GDP are expected to be minor. The trade war with China persists but shows signs of easing as a 90-day truce was struck on December 1 after the G20 summit in Buenos Aires.

Rising rates also remain a concern after the Fed hiked rates four times in 2018. However, it seems the Fed is poised to slow down the pace of its hikes. Fed chair Jerome Powell remarked in January 2019 that the Fed will be patient on future rate hikes and that the two currently projected rate hikes were “contingent on a really strong outlook for 2018,” indicating there may be fewer than two hikes in 2019. The level of interest rates is a concern because it is the rate at which the government borrows money, which matters because the United States’ budget deficit continues to increase. It is projected to grow to $985 billion for fiscal year 2019, a notable increase of 18%. This increasing deficit, coupled with rising interest rates, results in more money going to interest payments on government debt, with less available for infrastructure and other government programs. This remains a looming problem.

Europe
European equities detracted double-digits in the fourth quarter but still managed to outperform other DMs. The cause is partially the outperformance of UK stocks despite continued political tension on the upcoming March 2019 Brexit deadline. A strong positive development in the quarter was the European Commission coming to an agreement with the Italian government on its 2019 budget, which had been a point of contention throughout 2018 after the populist Five Star Movement won the majority of seats in Parliament in the March election.

Europe’s outlook remains mixed but largely negative. At the end of 2018, the European Central Bank (ECB) finally ended its historic €2.6 trillion asset purchase stimulus program. The ECB also maintains that it will hike interest rates this summer, the first hike since 2011. However, this measure may not occur, as third-quarter GDP growth sagged to 0.2%, a four-year low. The main cause of the decline was a slowdown in Germany’s economy, which contracted 0.2% in the third quarter due to weak industrial production, lower foreign demand, and soft private consumption. Political concerns also weigh on many investors’ minds, with the continuation of Brexit negotiations and the yellow vest protests in France. On a positive note, earnings growth remains high at over 10% quarter over quarter, the unemployment rate continues to tick down, and inflation remains contained at 1.6%.

Emerging Markets
In 2018, for the first time, the aggregation of twenty-three countries’ markets, known collectively as emerging market (EM) equities, outperformed the US and other DMs in the fourth quarter. However, they still detracted in the quarter and remain in bear-market territory, which is when a market experiences a -20% decline in price. Negative performance in the quarter and year was largely driven by China, as its economic data continues to disappoint and the trade war with the US continues. In response to the continued economic slowdown and market weakness, China introduced additional monetary and fiscal measures in October. China also pledged in late December that significant cuts to taxes and fees would be enacted in 2019. There were also some bright spots in EMs in 2018: Brazil outperformed as the prospect of a more pro-business government led the country’s equity markets and currency to advance. In addition, India and other net oil importers benefited from the sharp fall in the price of oil.

OUTLOOK

As has been the case for a few years now, Management views few asset classes and investment strategies as attractively priced for buyers. This makes for challenging times as we seek to protect and grow the $7 billion of pension assets with which we are entrusted.

Many institutions that 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 previously.

During the Fund's ninety-six years, broad and index-like exposure to stocks and bonds has been sufficient to fulfill the Fund's mission. We do not believe that this will remain the case over the next decade. As a result, 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 maintaining 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.