The third quarter of 2018 (3Q18) saw a favorable environment for financial markets despite the tug of war between headlines and more fundamental drivers of financial returns. The United States, Mexico and Canada finalized a new trade agreement, but risks of a trade battle with China persist. Growth in the U.S. continues, with gross domestic product (GDP) registering 4.1% for 2Q18. Internationally, economic growth continues, but there are some notable exceptions.
In financial markets, U.S. equities shrugged off any worries and led the way forward, with large-cap stocks (S&P 500 Index) returning 7.71% and small-cap stocks (Russell 2000 Index) returning 3.58%. International developed stocks (MSCI EAFE Index) were up for the quarter by 1.35%, but emerging market equities (MSCI EM Index) lagged with a return of -1.09%.
On the fixed-income front, 3Q18 U.S. performance was slightly positive as the Barclays Government Credit Index, a proxy for the broad U.S. fixed-income market, produced a return of 0.06%.
We remain committed to time tested strategies of diversification, which reduce volatility and risk. There has been a long period of positive returns, so we must be cognizant of late-cycle risks such as rising interest rates.
Finally, we would like to highlight a recent study of the Pension Boards Annuity Plan options by outside investment experts Northern Trust, which provides PBUCC with global custody services; investment account and reporting services; and treasury services to ensure assets are well protected, and stock and cash positions are accurately recorded. For a more detailed market commentary, please visit the Pension Boards’ website at www.pbucc.org.
Thank you for your confidence in us.
The return of market volatility in 2018 does feel different than the straight up market of 2017. Continued economic expansion, earnings growth, and still-accommodative monetary policies are the pillars for the market, but geopolitical risks and policy uncertainties, especially the confusing tariff talks, have resulted in near-term caution in market thinking.
All that said, U.S. equities were quite positive recently, as evidenced by U.S. large-cap stocks (S&P 500), which returned 3.43%, and domestic small-cap stocks (Russell 2000 Index), which returned 7.75% for the quarter. In contrast, international developed stocks were down for the quarter by 1.24%, and emerging market equities, after a year-long period of outperformance, lagged well behind with a negative return of 7.96% for the three-month period.
On the fixed-income front, the Barclays Government Credit Index, a proxy for the broad U.S. fixed-income market, produced returns of -0.33% for the period. Bank loans performed as expected in 2Q18, with a positive return of 0.70%, even as interest rates rose. Emerging market debt, like emerging market equities, was the weakest asset class performer for the quarter, down 7.02%.
Generally, we continue to implement thoughtful diversification designed to benefit from positive valuation and improving fundamentals in both equities and fixed income. We will continue to be vigilant in investing on your behalf, and will provide commentary on market conditions and outlook monthly, and as warranted, on the Pension Boards’ website at www.pbucc.org.
Thank you for your confidence in us.
Environmental, Social, and Governance (ESG) factors are strongly considered by the Pension Boards as potential investments are evaluated on behalf its members. Notably, fixed-income investments that embody ESG factors are becoming more prevalent in the marketplace as bond issuers, bond underwriters, and bond investors recognize the return and environmental/social impact benefits of sustainable investing.
The Pension Boards places a special emphasis on “sustainability” in its approach to Corporate Social Responsibility, so investing in sustainable bonds is a natural fit. Sustainable bonds are ESG-related, fixed-income securities where the proceeds of a bond’s issuance (the money borrowed by issuers from investors in the form of a bond) will be used exclusively to finance or refinance green, social, or impact projects. They also earn a market rate return. Sustainable bonds are an integral part of the Pension Boards’ fixed-income investment program and are specifically chosen by the Pension Boards’ in-house fixed-income team for their appropriateness and appeal in regard to both its investment and Faith and Finance policy.
Green Bonds
Within the ESG framework, green bonds are the most commonly issued type of sustainable bonds, which aligns nicely with the United Church of Christ’s objective of investing in climate solutions that reduce carbon intensity. Green bond project categories include renewable energy, energy efficiency, pollution prevention and control, clean transportation, sustainable water, wastewater management, green buildings, and others. Green bonds are standard bonds with “Green” as a bonus feature—they offer investors the opportunity to participate in the financing of Green projects that help mitigate climate change.
The Pension Boards, a “Green Bond Principles” Member
In 2017, the Pension Boards became a member of the “Green Bond Principles,” a consortium of investors, underwriters, and bond issuers that are working together in the bond market to promote and support projects with environmental benefits. As of this writing, the Pension Boards has invested nearly $200 million in sustainable bonds, mostly green bonds. Sustainable bond investments are held throughout the Pension Boards’ investment portfolios including the Balanced Fund, the Bond Fund, the Stable Value Fund, Targeted Annuitization Date (TAD) Funds, and both the Participating and Basic Annuities. Importantly, this focus on investments that help address ESG factors has taken place without changing the risk profile of an investment portfolio or sacrificing return. Additionally, Wall Street banks, bond underwriters, and Green Bond issuers recognize the Pension Boards as an investor that is serious
about climate change.
GREEN BONDS
Offer investors the opportunity to participate in the financing of “green” projects that help mitigate climate change.
Some notable Green Bond issuers held by the Pension Boards’ investment portfolio include:
African Development Bank (Waste Management)
Proceeds of this green bond will support the
financing of low-carbon and climate-resilient projects that include climate change mitigation and adaptation projects in the field of renewable energy generation and energy efficiency; biosphere conservation; waste management; fugitive emissions; and carbon capture.
Bank of America Corp. (Solar Panels)
A bond issued as part of Bank of America’s $125 billion environmental business initiative, whose proceeds will be used to finance renewable energy projects including solar, wind, and geothermal energy. For example, at Antioch Unified School District in California, solar panels were purchased and installed, as was energy efficient lighting equipment and HVAC
upgrades at 24 school sites.
Fannie Mae 2017 M10 AV2 (Green Buildings)
A securitization of 20 apartment building mortgages originated under the Fannie Mae Green Financing Business, where the underlying buildings have received either a green building certification such as Leadership in Energy and Environmental Design (LEED); Energy Star; Green Globers; or were targeting 20% or more reduction in energy or water
consumption.
Nacional Financiera SNC (Wind Farms)
The first green bond transaction undertaken by a development bank in Latin America whose proceeds will be used to fund loans to renewable energy projects in Mexico, including wind energy generation and infrastructure for the transmission of wind energy projects.
Regency Centers Corp. (LEED Certified)
Since 2009, two-thirds of this real estate investment trust’s real estate projects via green bond proceeds have received certification from the U.S. Green Building Council’s LEED program.
Toyota Auto Receivable 2016-B (Hybrid Vehicles)
Proceeds to Toyota Motor Credit Corporation will be applied exclusively to finance future originations of loans and leases for gas-electric hybrid or alternative fuel Toyota/Lexus vehicles. Although the focus of the Pension Boards’ sustainable fixed-income investments has been green bonds, in the spirit of effecting socially-beneficial change via the public fixed-
income markets, the Pension Boards also invests in social/impact bonds as profiled below:
BNG Bank (Focus on deprived neighborhoods)
Through BNG, a Dutch bank, social bond proceeds will go to improve living conditions and social inclusion for people experiencing poverty.
International Finance Corporation (Women-owned business)
Social bond proceeds will be used to finance women-owned enterprises, as well as lend to companies that incorporate people who earn extremely low incomes.
Starbucks (Fair treatment of workers)
Impact bond proceeds will ensure that coffee is grown and distributed in a sustainable way using ethical sourcing standards regarding treatment of workers and the use of pesticides.
SOCIAL/IMPACT BONDS
Finance projects that address social issues for targeted populations and that provide beneficial social or environmental impact alongside, or in lieu of, a financial return.
The year 2018 started with a strong equity rally in January, as investors around the globe cheered the synchronized economic expansion. However, the optimism quickly turned into concerns of faster monetary policy normalization under the robust job and wage growth. Then, the combination of tough tariff talks and geopolitical tensions added further confusion to the market.
After the big zigs and zags, U.S. large-cap stocks (S&P 500 Index) ended the first quarter of 2018 with returns of -0.76%. International developed stocks (MSCI EAFE Index) were down 1.53%, and domestic small-cap stocks (Russell 2000 Index) were down 0.08% for the quarter. Encouragingly, the emerging market index (MSCI EM) generated a positive return of 1.42%.
On the fixed-income front, there was no shortage of volatility, either. The Barclays Capital Government Credit Index, a proxy for the broad U.S. fixed-income market, was down 1.58% for the first quarter. Other fixed-income sectors, such as emerging markets debt and bank loans, provided positive returns. The Federal Reserve (Fed) raised its benchmark rate (federal funds rate) in March to 1.50%-1.75%, and seems on track for further rate hikes in 2018.
The return of market volatility in 2018 feels different than the straight up market of 2017. While economic expansion, earnings growth, and still-accommodative monetary policies are the pillars for the market, geopolitical risks and policy uncertainties are unfortunately more than just noise.
We will continue to be vigilant in investing on your behalf, and will provide commentary on market conditions and outlook monthly, and as warranted, on the Pension Boards’ website at www.pbucc.org.
Thank you for your confidence in us.
Market Update by David A. Klassen, Chief Investment Officer
With the Dow Jones Industrial Average, the S&P 500 index, and other global equity markets now selling off after a strong January, we wanted to provide our perspective on both the price action and the pickup in volatility.
First, what happened?
The selloff began with a rise in interest rates, and bond prices began to decrease. This action resulted from good news of strong employment and wage growth. The concern is that the U.S. Federal Reserve (Fed) would speed up their rate hikes and cease the abundant monetary support in place since the crisis. Investors began to be concerned that higher wages meant that company profit margins will go down, especially if productivity does not show a corresponding increase. At the same time, some earnings disappointments materialized from a few giants, including Google, Exxon Mobil, Chevron, and Visa.
Then there is politics and policy. We are coming up to the expiration of the extended government funding, which raises concerns that the government will shut down again. Although an interim solution will likely be found, the market finds uncertainty tough to handle. The Republican FBI memo was released as well, casting a shadow over AG Deputy Rod Rosenstein, whom Mueller reports to.
Finally, and perhaps most importantly, many quantitative and technical strategies in some markets using relatively new exchange traded funds (ETFs) had wagered that low volatility is here to stay. As volatility increased suddenly, these strategies have been forced to unwind, with a resulting disruption in equity markets that has been both speedy and profound.
Will the market continue to go down?
It is premature to say this yet, as market fundamentals remain relatively strong. We still believe that equity markets can deliver positive returns, but acknowledge that returns should be lower than last year. What we do believe is that higher volatility is a certainty for 2018.
As of Tuesday morning, global equities are even for 2018. The anomaly, we believe, is the low volatility experienced over the past year, when the largest selloff was less than 3% for all of 2017! Our approach in these markets is twofold: 1) be diversified into markets other than the U.S., and 2) keep an eye out for opportunities in your portfolios that can accrue to your long-term benefit, when possible. Rest assured we will keep you apprised as events unfold over the next number of weeks and months.
We use this space to provide market commentary, but would also like to take the chance to highlight investment managers who make up the Pension Boards investment program. By so doing, we aim to explain our decision- making process, and provide additional transparency into your investment options.
As such, we would like to spotlight William Blair, an Equity Fund manager for the Pension Boards since 2011. William Blair was founded in 1935 and is headquartered in Chicago. William Blair has more than 1,200 employees and manages more than $77 billion on behalf of clients.
William Blair's asset management organization invests money in what can be best described as Quality Growth-style strategies. In a nutshell, they have been focused for us on finding favorable returns from the universe of U.S. small- and mid- capitalization (SMID) public companies that are growing at a rate above the general level of economic growth, but which hold promise to sustain that level of growth over time. In addition, they pay a huge amount of attention to quality of management, quality of earnings, and quality of businesses. William Blair's style differs from most other managers because they incorporate both quantitative and fundamental styles; most managers utilize one or the other. The quantitative factors that make up the Blair model in this case are: Quality (40% of the overall score), Valuation (30%), Earnings Trend (20%), and Momentum (10%). William Blair is continuously refining and reevaluating the model to make sure it is optimal. Once the model has helped narrow the universe to make it manageable, the analysts take over and study each company by researching the industries, speaking with the management teams, and making recommendations to the portfolio managers, who then construct the final portfolio.
How have they done? Over the three years ended June 30, 2015, the William Blair SMID portfolio has returned 21.93% (net of management fees) versus 20.355% for their index, and versus 17.31% for the Standard and Poor's (S&P) 500 index of common stocks.
Maybe just as importantly for the Pension Boards, William Blair also incorporates Environmental, Social, Governance (ESG) factors in their analysis. Companies are ranked on ESG issues and these scores can be integrated into final rankings. William Blair conducts some of the ESG analysis themselves but they also use the latest data available from third-party experts. Additionally, Blair is a signatory to the United Nations Principles for Responsible Investing (UNPRI).
Recently, the Investment Committee of the Pension Boards, informed by staff and consultant recommendations, also approved William Blair to manage part of our emerging markets allocation in the Equity Fund. Blair began managing this allocation in July of 2015.
William Blair's Small-Mid and Emerging Markets strategies are now both part of the Equity Fund. As such, they are also parts of the Balanced Fund, and the Target Annuitization Date (TAD) Funds.
We hope that you have found these Pension Boards' manager details interesting!
"In the middle of every difficulty lies
an opportunity." –Albert Einstein
What is happening?
The recent slide in global equity markets in the quarter ending September 30, 2015, focused around emerging markets and China, has reminded us of the volatility in 2008 and 2011, when difficulties were centered around the U.S. and Europe, respectively.
In our update to you at the end of August, we wrote, "Bottom line: we don't believe that domestic economic data indicates impending doom for the U.S., and figures and sentiment seem to indicate that it's less likely that stocks are in for a more significant retrenchment, as of now. A few specifics: the U.S. economy is very unlikely to enter a recession with housing and job improvement so healthy. Interest rates are low, lower inflation benefits the consumer, and lower commodity prices can benefit the broad economy. Globally, leading indicators of growth in Europe and Japan are also positive, despite a weaker emerging world, and China."
While the third quarter was negative for global stocks and other risk assets, it does appear that much of the damage has been done, and subsequent rallies in October have been significant. While it is too early to tell whether this rebound will hold, and while China may remain a continual source of anxiety for global markets, accommodative monetary policy around the globe continues to support markets. Additionally, as we pass through the traditionally difficult periods of September and October, it is likely we are set up for a year-end rally.
What have we been doing?
In August, we wrote: "Our mission is to invest for your retirement, and not for the next month. When prices are volatile in the short run, caused by short-term investors and participants, we should keep calm, carry on, and add value for you. Our partner managers must be nimble enough to pick up bargains to benefit your performance versus the markets...that's why we engage them on your behalf. Most importantly, they should help us take the longer view when markets become too focused on the short-term noise, or fear."
In the summer issue of Employee News and Views, we highlighted William Blair, a domestic equity manager focused on finding favorable returns from the universe of U.S. small- and mid-capitalization (SMID) public companies. Through September, Blair is one of two managers to produce positive results for the year, up over 2% with the S&P 500 down more than 5%.
We have met recently with a number of other Pension Boards' equity managers – San Francisco- based Dodge and Cox, a Pension Boards manager since 2006, and Edinburgh-based Walter Scott, a Pension Boards manager since 2003. Combined, the two firms manage over $200 million on behalf of Pension Boards participants and have registered significant outperformance, net of fees, over the long term for our Funds. Historically, we have used in-person meetings to gauge the manager's conviction and risk-reward optimism for markets and their positioning. Although Walter Scott's portfolio is down 6% for the year through September and Dodge and Cox is down 12%, we remain confident in their expected positive future contributions. Both managers take a long-term investing approach, and we came away from the meetings newly convinced that the strategies in place, and opportunistic repositioning in the recent period, will be beneficial to results going forward. In broad market selloffs, it is too easy to get consumed by the immediacy of negative headlines and sentiment; during these periods, it is important to remain committed to a thoughtful approach augmented by thorough analysis oriented to making sure managers are staying the course and not succumbing to short-term concerns. We are confident with the suite of managers working hard to position your retirement funds and with the steps undertaken before, and during, the recent sell-off.
As always, we remain committed to working diligently on your behalf, and will continue to keep you informed.
Reversal of Fortune and the Long View
The very sharp rebound in equity markets in March has contributed to positive returns for most assets year-to-date. We said in January, “In broad market selloffs, it is too easy to get consumed by the immediacy of negative headlines and sentiment. A thoughtful approach to opportunities, rather than succumbing to short-term concerns, still remains the optimal approach.” So far, so good.
Within markets, there is another “reversal” story. Former winners are losing, and previous laggards have risen to the top for the period. Emerging market equities and debt are winning, value stocks and managers are winning, and growth stocks and managers who like the “nifty nine” stocks (Facebook, Amazon, Netflix, Google, etc.), which contributed the totality of the markets’ return last year, are down.
Investing on your behalf, we do not have a preference. We maintain a diversified manager roster in both equity and fixedincome asset classes, and rebalance portfolios when appropriate in order to not skew too far from one style to another.
The other tool? Retain good managers who are acutely focused on the long term, for members’ benefit. One such manager is Walter Scott, a Pension Boards manager since 2003. Founded in 1983, they are headquartered in Edinburgh, Scotland, and maintain a focus on international developed markets like Europe and Japan.
Walter Scott employs a fundamentally thorough, research driven, stock-by-stock process with one premise: high and consistent returns benefit their clients’ goal of wealth creation over the long term. Walter Scott seeks companies that control their own destinies, have sustainable profit margins, strong balance sheets, and management teams with a proven track record. They are patient, long-term investors in a world of fast traders.
How have they done? In the first three months of 2016, Walter Scott has outperformed its index by over 4%. Since being selected for the Pension Boards’ investment portfolio in 2003, the Walter Scott portfolio has returned 8.05% (net of management fees) versus 6.33% for its index, an impressive annual outperformance. Walter Scott is part of the Equity Fund. As such, it is part of the Pension Boards’ balanced funds, including the Target Annuitization Date (TAD) Funds and the Participating Annuity.
We hope that this commentary has been helpful to you. Please visit the Pension Boards’ website at http://bit.ly/PB_Investments for more information.
Early 2016 Market Update
The resumption of selling in global equity markets (including the U.S.) in 2016 has tripped up investors over the short term. This market action extends a lackluster calendar year 2015, which offered only a few positive pockets of return to support diversified portfolios.
Slowing global economic growth (below the long-term average of 3.5%) has been a source of anxiety for equities and related “riskier” strategies, like high yield bonds. Geopolitical concerns in North Korea, Iran and elsewhere are worrisome, as are Chinese officials’ attempts to “control” markets and their slowing economy as it rebalances. Finally, the U.S. Federal Reserve (Fed) has begun to raise interest rates, a policy that diverges from Europe and Japan, where accommodative monetary policy remains supportive.
Over the first seven trading days of 2016, a sharp selloff moved the Standard & Poor’s (S&P) 500 Index into negative territory by over 7%. U.S. bonds have moderated that shortfall in balanced funds, and added positive returns in bond funds.
To us, current market action reflects a return to a more normal environment. The former lack of volatility, especially in U.S. markets, was an anomaly caused by a hypersupportive monetary policy established by the Fed. During that period, the equity markets, especially in the U.S., had more than tripled from the 2009 lows.
Economic growth in the U.S. has held up relatively well. Earnings growth, admittedly helped by share buybacks and select technology outperformance, has held up except for commodity companies, and profit margins are high. The labor market also continues to improve, with the unemployment rate now down to 5%. The flip side, of course, is that wages have started to expand, and this development, while positive for workers, may slow corporate earnings growth.
As a result, while we believe the market could be more volatile, we do not expect a bear market, and believe that global equities in particular have a favorable risk reward after the selloff. This outlook depends on avoiding a U.S. recession.
While core U.S. bonds remain attractive from a diversification perspective, their total return potential, based on current valuations, appears limited compared to recent history. We do not expect a rapid rise in interest rates, and thus believe that price risks to core bonds are not high, but their return potential should remain low.
What have we done?
Equity Funds: We have recently highlighted, in prior issues of ENV, a number of Pension Boards’ managers charged with picking securities with the best prospects. We are overweight developed markets (including the U.S.), and underweight emerging markets, although we recently added two managers to take advantage of selected opportunities. We also hold 8.5% in hedged strategies built up since 2013, designed to protect principal and lessen volatility during these periods.
The Global Sustainability Index Fund is up and running as of November 1; this additional equity option focuses on index like returns with additional environmental, social, and governance (ESG) screens.
Balanced Funds: Our Target Annuitization Date (TAD) Funds adjust the mix between stocks, bonds, and stable value assets to become less risky the closer you are to retirement. In the Balanced Fund, we can alter the mix between stocks and bonds based on forward-looking market projections, and will take advantage of disproportionate selloffs when prudent.
Bond Funds: We have added select diversifying strategies, and continue to have a 10% allocation to bank loans, for example, which we believe can offer 5-6% returns per year over the next few years. In broad market selloffs, it is too easy to get consumed by the immediacy of negative headlines and sentiment. A thoughtful approach to opportunities, rather than succumbing to short-term concerns, still remains the optimal approach.