A Time for Caution

The curtain closed at the end of the first quarter to the cheering of the market, rallying 3.5% in March alone, as the government rode to the rescue of Silicon Valley Bank (SVB). A classic bank run at SVB, combined with the fallout in venture capital and office real estate in the  quarter, marked the end of Act I for this play. Whether we are part of a Greek tragedy, Shakespearian comedy or modern drama is to be determined.

Over the past two quarters, the S&P 500 has rebounded, coming back from a level of 3,586 on September 30, 2022, to 4,109 by the end of March 2023. This equates to a 14.6% price increase, and the market has continued to drift higher early in the second quarter. In fact, it seems as though the market has taken the collapse of SVB in stride as it tries to recover from the selloff last year.

A great deal has been written about why SVB collapsed, much of it focusing on idiosyncratic reasons specific to SVB. Less has been written about the systemic conditions that sowed the seeds for the bank’s sudden demise. We refer to the first quarter as the end of Act I because we expect the systemic change in short-term rates to have profound impacts beyond where pain has been felt to date.

The Three-Act Play Analogy

The first act of a three-act play is the introduction to the situation. Here, for example, before SVB’s collapse, it was widely believed that rising rates were positive for banks due to increasing net interest margins. Act I introduced us to the issue that rates can have a negative effect on current balance sheet assets, and not just be a positive benefit on future income. Act II in a play is usually about rising action and confrontation, which we think is an appropriate analogy. Act III is one of crisis and resolution. We expect much more to come for the audience in this drama.

While we do not have a crystal ball, we do know that higher rates are decidedly negative for long-duration assets. The market has written the narrative it wishes this play to follow, that is, a soft landing. The market expects the Federal Reserve to reduce interest rates into the back half of this year in response to a drop in growth to a level that will be sufficient to bring inflation within the Fed’s target range. Market participants’ expectations are informed, in part, by analysis of recent patterns around historical averages, but their actions currently are as much based on hope and faith that we see the best result from a range of possible outcomes. Hope and faith in the future are important human qualities that get us through times of crisis, but they do not change the need to be prepared to weather even the worst storm.

Every day, we see hope and faith in the actions of market participants. For example, strong venture capital-backed companies that expected to issue an initial public offering have delayed fundraising, assuming a better market environment will materialize over the next couple of quarters. Weaker companies with negative cash flows are laying off employees and hoping  market conditions may change in order to access new equity capital. Many real estate loans coming due are being extended. Real estate borrowers and lenders know that borrowers today cannot refinance at current rates, so both borrowers and lenders have decided to extend maturities in the hope that interest rates begin to fall.

Portfolio Effects

What does this mean for our portfolios? We continue to be fully invested, as we have a long-term positive outlook on the economy and on companies’ abilities to navigate the current storm. However, every decision we make is, on margin, cautiously optimistic. For example, in the strong growth rally of the past six months, we are rebalancing our gains more quickly. We are discussing with managers their understanding that cash flow will be more important than revenue growth going forward. And on margin, we are more focused on researching international equities, which have underperformed over the past decade but offer more compelling valuations and broaden our opportunity set to navigate the next decade.

The Vast International Toolbox

In college, I was a cultural anthropology major. Throughout history, from even the smallest groups of individuals up to and including entire societies, people have defined “our” group and the “other” group. In finance, this phenomenon occurs as a strong persistent home-country bias. We have the good fortune to be U.S. investors due to where our institutions were founded. In public equity markets, the U.S. currently provides 59% of the global investible opportunity set as defined by the MSCI ACWI All Cap Index as of March 31, 2023. That is $41.3 trillion in market capitalization across 3,698 public companies from which we can build portfolios. When you include private equity, real estate and fixed income markets, the opportunity set is much larger.

Points About International Investing

A U.S. investor does not need to invest outside of the U.S. to build a fully diversified portfolio to meet financial objectives. Because we do not “need” international investments, this plays into our natural human bias to define international equities as “other” and nurtures the perception that international investing is somehow riskier.

I would like to make two key points about international investing:

1. International assets are a set of tools that can be used to increase returns and reduce risk in a portfolio, if wielded by an experienced craftsman.
2. The opportunity set in international equities is vast and cannot be defined narrowly since there are many different types of assets in international markets, all with varying returns and risk characteristics.

Returning to public markets, if you exclude the U.S. from the MSCI ACWI All Cap Index, what remains is an opportunity set of 22 developed  and 24 emerging countries, representing 11,977 public companies with a market capitalization of $32.8 trillion. Including private equity, real estate and fixed income, the international market is much richer with investment opportunities.

Role of Active Management

We are strong believers that active management can add value to a portfolio through the ability of a manager to find investments that are underpriced relative to intrinsic value. We also believe that most investment assets are priced appropriately as markets tend to be efficient. The U.S. market is the world’s most competitive investment market and therefore the most efficiently priced. Relative to international markets, there is a much smaller opportunity set for active managers to add value. As legendary investor Charlie Munger from Berkshire Hathaway points out in discussing investing, “The first rule of fishing is ‘fish where the fish are.’” In the U.S., this leads us to search for inefficiently priced securities in smaller capitalization stocks and private investments. Outside the U.S., there is a greater number of inefficiently priced securities across the entire market as specialized knowledge is required to compare valuations across countries. Our goal is to provide Glenmede clients with a higher rate of return for a given level of risk based on our ability to allocate assets and hire skilled investment managers. This draws us toward private markets and international markets as they provide us a more expansive opportunity set.

In future newsletters, we will share our in-depth views of the different tools within the international investment toolbox and how we successfully combine skilled managers across the globe into a portfolio for your organization. A portfolio that fully utilizes the international toolkit captures a more diverse set of returns from manager skill and a broader level of economic growth than that found in the U.S. alone. We believe this can help us achieve for an organization a higher and smoother level of total portfolio returns over market cycles. After all, the victor at the end of the play often differs from the favorite at the start.