Turning the Page
As I enter my 27th year in the investment business, my appreciation for the importance of having experienced multiple market cycles grows with every bit of noise or new context being promoted by the omnipresent media. At the risk of sounding like an elder statesman, the many market “at-bats” have helped my ability to filter out the noise, providing some level of clarity regarding relevant longer term trends. While I am not suggesting that I have been inoculated from the influence of headlines and current events, I continue to make efforts to create a mental space - or separation - between my decision-making process, the data points, and their weighting in terms of building a mosaic of the future.
My focus for the quarter is this: We need to be aware of and digest the secular trends that can meaningfully impact our world from a political, social and economic perspective. Over the past few months I have been wrestling with the implications of the prescient work put forth by William Strauss and Neil Howe entitled, “Strauss–Howe Generational Theory” . Their book entitled, “The Fourth Turning,” published in 1997, has had a marked influence on my thinking.
The authors define a turning as a “generational cycle” lasting approximately 20-25 years which is marked by certain attributes based on the generational archetypes and where each is in their evolution. They observed that the U.S. has gone through several cycles consisting of four turnings, with each having similar characteristics. Here is a summary of the nature of each turning taken directly from Mr. Howe’s website, “LifeCourse Associates” .
- The First Turning is considered a “high”: this is an era when institutions are strong and individualism is weak. Society is confident about where it wants to go collectively;
- The Second Turning is “awakening”: this is an era when institutions are attacked in the name of personal and spiritual autonomy. Just when society is reaching its high tide of public progress, people suddenly tire of social discipline and want to recapture a sense of personal authenticity
- The Third Turning is defined as the “unraveling”: the mood of this era is in many ways the opposite of a “high”. Institutions are weak and distrusted, while individualism is strong and flourishing and
- The Fourth Turning is defined by “crisis”: this is an era in which America’s institutional life is torn down and rebuilt from the ground up—always in response to a perceived threat to the nation’s very survival. Civic authority revives, cultural expression finds a community purpose, and people begin to locate themselves as members of a larger group. In every instance, Fourth Turnings have eventually become new “founding moments” in America’s history, refreshing and redefining the national identity. The most recent Fourth Turning began with the stock market crash of 1929 and climaxed with World War II.
Today, there are three generational archetypes influencing the current we now find ourselves in—the Fourth Turning. They are:
- Baby Boomers who are transitioning from societal leadership roles to retirement;
- Generation X’ers who are assuming their mid-life family and leadership, professional and policymaker roles; and
- Millennials who are in the early stages of their careers and personal evolution.
All three archetypes co-exist within this fourth turning and it is the confluence of their aspirations, frustrations, framed from their childhood and early adulthood, and stage of life that shapes the mood during this part of the generational cycle. We will discuss more about the implications of this clash of generations later in the commentary. Before we go any further, let’s discuss Q3 2016.
Q3 in Review
Well, we seem to have had yet another quarter marked by investors shrugging off risks and continuing to embrace and enjoy the marvels of asset price levitation as a result of central bank benevolence, hubris, ignorance, and fear. Yes, you heard me—ignorance and fear. The world’s central bankers are mostly academics and operate in a world that cares more about sounding smart than understanding the practical implications of their actions. Additionally, they fear that a change in policy to one that supports emergence from the zero interest rate policy (ZIRP) and negative interest rate policy (NIRP) traps will result in market turmoil and recession. While I believe we may be on the cusp of a tsunami of fiscal initiatives as populist movements around the world gain louder voices and more representation in their respective governments, I question the long term return on investment for each dollar (or, for that matter, euro or yen) spent by feckless politicians (as a side note, social media picked up Governor Pence’s repeated use of the word “feckless” and I am glad he brought one of my favorite words to the public’s attention!). Surprisingly, the quarter lacked the volatility one would have expected, especially given the tumultuous end of the second quarter when markets were digesting “Brexit.” One of the ways we measure volatility is the number of trading days that the S&P 500 rose or fell 1% or more. During Q3 there were just six such days; by comparison there were six consecutive volatile days to end Q2 alone, a total of 12 for that quarter, and a remarkable 25 during Q1. This again just proves to me that the market is still full of surprises. 
During the quarter, many of our thematic ideas worked well, including strong rebounds in our real assets exposures, especially those exposures that had experienced challenging environments in 2015. Additionally, our decision to take advantage of wider credit spreads in the high yield market earlier in the year proved to be meaningfully accretive to portfolios given strong performance in Q3.
We don’t believe in resting on our laurels, and will review the exposures in portfolios that did not perform as well. Our over-emphasis to U.S. Large Cap Equities, while the sector performed well, did not help portfolios as much as the smaller exposures we had in Small Cap, Emerging Market, and Developed Market Equities. Additionally, our risk management strategies, Liquid Multi-Strategy and Dynamic Allocation Strategy, treaded water with marginally positive returns while our newest addition to the mix, Forefront Analytics Impact Resiliency Strategy, a strategy that invests in mutual funds and exchange traded funds that incorporate environmental, social and governance factors (ESG), performed better than its traditional counterparts.
Overall, we have been cautiously positioned this year given our concerns regarding overvaluation across asset classes, the slow growth environment, unknown implications of +$13 trillion on bonds trading at negative yields  (can you imagine the rush to the exits if rates spike?), and the proliferation of geopolitical and economic risks on our radar screen. As such, we do not make any excuses for the absolute performance in portfolios year-to-date. As I see it, portfolios have generally done well when viewed from a risk-adjusted perspective, and that is what is most important to investors, whether they realize it or not. If you had told us at the beginning of the year that most portfolios would be in the positive single digits through September 30, 2016, we would have signed up for that investment plan, especially given the market turmoil we experienced coming out of the gates this year.
Turning the Page to Tomorrow…
With that said, we are growing increasingly concerned with the outlook going forward. With central bank balance sheets holding nearly 50% of the $43 trillion in developed world government bonds and nearly $14 trillion in bonds trading at negative yields (meaning investors are buying bonds and expect to get less than par at maturity), doesn’t it seem like the financial world appears more like Bizarro World?!  Whether you are focused on the U.S. election or elections and referenda outside the U.S. that will occur over the next 18 months (Italy’s referendum is just around the corner), there’s been an emergence of strong populist trends representing a growing populace dissatisfied with their socioeconomic circumstances and, as a result, advocating for a radical change in leadership style, focus, and substance. I think Neil Howe summed up our current circumstance best in saying,
“The world has fundamentally shifted over the last decade, especially since we’ve emerged from the Great Recession. We are seeing slower demographic growth, overleveraging, a productivity slowdown, institutional distrust, policy gridlock, and geopolitical drift. But the professional class has been very slow to understand what is going on, not just quantitatively but qualitatively in a new generational configuration that I call the Fourth Turning. They don’t accept the new normal. They keep insisting, just two or three years out there on the horizon that the old normal will return – in GDP growth, in housing starts, in global trade.
But it doesn’t return.” 
As we find ourselves in the Fourth Turning, again, I need to provide a quote from Mr. Howe as he assesses implications that are exceedingly relevant at this point in history.
“In the fourth turning, the supply of order is still absent that the demand for order grows. So we now have a demand for order and no supply. That creates the unusual dynamics of a fourth turning -- kind of like we had in the 1930’s. People suddenly feel that no one is in control and that enormous events are overtaking their society which no one of leadership age has any idea how to confront or how to manage. And it goes without saying today we look up to Gen Xers and Boomers and we see leaders who couldn’t organize their way out of a shoe box.” 
Combine these big picture concepts with current factors such anemic global growth, slowing global trade, increased calls for protectionist policies which could result in tariffs and trade wars, U.S. corporate earnings experiencing five consecutive quarters of year-over-year declines , and the signs of the U.S. recovery slowing down. Also, why is the financial media downplaying Germany’s largest bank, Deutsche Bank, cracking at its very foundation? Deutsche Bank is the poster child for “too big to fail”, accounting for $46 trillion derivatives’ book (as of December 31, 2015) or approximately 12% of the total notional value of derivatives outstanding worldwide ($384 trillion) . The growth picture is challenged in a world that seems to be facing obstacles to its extension.
As mentioned many times in this commentary, when the data points and headlines point in one direction, we need to search vigilantly for evidence of catalyst for a change in another direction. So, “Where’s the ‘positive’ Beef?” Well, the good news is we can find some signs of stronger growth across the world.
- U.S. unemployment numbers are remaining at record low levels, although one is compelled to question these numbers given participation rates at historic lows. Most importantly, the employment of Millennials increased +3.7% year-over-year versus employment figures that do not include Millennials at +1.1% year-over-year.  In previous commentaries I have highlighted the concern that this population cohort had been left behind. I have also pointed out my concern regarding the quality of the jobs this group is securing—more investigative work is necessary to determine whether this employment pick-up is of a high quality or low quality.
- With stability in the dollar and the commodity complex, emerging market growth is poised to accelerate in 2017.
- China appears to be emerging from a slower growth period but risks still remain given the reliance on a manufacturing-based economy and an explosion in debt levels.
- Russia and Brazil appear to turning the corner and emerging from severe recessions.
- The Eurozone economy seems to be gaining positive momentum albeit from a very low base.
- And, try this on for size, perhaps the world’s economists and statisticians have been underestimating global gross domestic product as they base it on production and fail to account for utility value associated with the increasing presence of technology that improves our lives in so many ways.
While I have yet to draw precise investment implementation implications, I believe that Howe and Strauss, 19 years ago, identified a major shift in today’s social and political environment that should have dramatic effects on our economy and, as a result, the capital markets. While their original focus was on U.S. history, Mr. Howe’s more recent work has identified similar trends outside the U.S. Given the populist movements in much of the developed world, it is difficult to refute the validity of their thesis. The punchline for me is—we are in the midst of a seismic generational shift that should increase economic and market volatility. In the U.S., regardless of your political affiliation, be prepared as there is a high risk of a failed presidency. Secretary Clinton represents the old order-institutions that should be and will likely be torn down during this Fourth Turning and, as a result, and may not be able to pivot radically to adjust to the mood during this Turning. And, if Mr. Trump wins—well, he is the ultimate Known Unknown. Risk management is the order of the day with an eye toward the opportunities that can arise from downside market volatility.
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 Source: Bloomberg
 “Eye On The Market,” Michael Cembalest, J.P. Morgan, September 27, 2016
 http://www.mauldineconomics.com/outsidethebox/the-big-picture, February 12, 2016
 http://www.zerohedge.com/news/2015-03-16/neil-howe-what-expect-fourth-turning-were-now, March 16, 2016
 “Schwab Market Perspective: Crunch Time,” Charles Schwab, September 30, 2016
 http://fortune.com/2016/09/27/deutsche-bank/ (Bank for International Settlements)
 ISI Daily Economic Report, October 7, 2016