“We really can’t forecast all that well, and yet we pretend that we can, but we really can’t.”

& Alan Greenspan, Chairman of the U.S. Federal Reserve from 1987 to 2006

Fortune favors the bold

It’s that time of the year again when Cinderella stories are made, when David can defeat Goliath, and when heroes are born. No, we are not talking about the presidential election, but about one of sport’s most popular events, the annual NCAA Men’s Division 1 Basketball Tournament, better known as March Madness.

Being heralded as one of the nation’s greatest sporting events and renowned for jargons like ‘brackets’, ‘buzzer beater’ and ‘all chalk’ (meaning you are betting on the favorites), the tournament’s popularity is not confined to merely lovers of the game but is likewise fueled by Americans’ passion for betting. The American Gaming Association estimates that bettors filled out more than 70 million brackets and wagered an estimated $9 billion on this year’s event. By comparison, neither presidential candidate in the 2012 election garnered close to 70 million ballots! Then again, given the political divide in our country that’s hardly a surprise.

While March Madness played out in arenas and on television sets around the nation, the madness was by no means confined to the basketball floor.

Wall Street, for one, has suffered its fair share of madness this year: Following a scary start to the year - the worst start to a calendar year in history - during which the Dow Jones Industrial Index plunged almost 2,000 points in the first three weeks, stocks staged an explosive rebound that erased those initial losses by mid-March and lifted the indices into positive territory. The turnaround was mainly driven by

a spike in oil prices, easing concerns about an impending U.S. recession and assurances by Federal Reserve policymakers that global uncertainty justifies a slower path of interest rate increases. For the quarter, the Dow Jones Industrial Average eked out a 1.5% gain, while the S&P 500 rose 0.8% in what can only be described as a volatile roller-coaster ride (see chart).

Investor madness reigned in Brazil, where stocks soared 20% in March on hopes that the current

government will be removed from power. The embattled leader, President Rousseff, whose popularity has plunged amid corruption scandals and Brazil’s worst recession in decades, could be impeached in the coming months. Some experts believe however that the dichotomy between the

stock market and the economy might be short-lived, as investors will have to grapple with dimming prospects for corporate profits and an economy that is mired in the worst recession since the 1930s.

In the U.S., election madness was the order of the day on the presidential campaign trail, where at this stage of the race a self-avowed socialist, a brash billionaire and a candidate who is under federal investigation are still viable contenders for the office. Anything is possible in an election year, and the real madness hasn’t even started yet.

And sadly, in what can only be described as a reprehensible act of madness, radical Islamic jihadists once again committed a series of horrific terrorist

attacks in Europe – this time in Brussels, Belgium. Stock markets in the U.S. and Europe

essentially shook off these deadly terror strikes as they have become more common and usually don’t result in a sizeable hit to the global economy.

Yet the ultimate madness was on display in the boardrooms of the Bank of Japan (BOJ) and the European Central Bank (ECB). In a desperate attempt to stimulate lending and light a fire under inflation, both central banks resorted to the most aggressive monetary policies in history, namely to introduce or expand the use of a Negative Interest Rate Policy (NIRP).

Trapped by persistently slow economic growth and at serious risk of price deflation, highly unconventional monetary policies by central banks have become the norm throughout the developed world. While they might have averted economic catastrophe during the dark days of the global financial crisis in 2008/09, they have so far failed to ignite inflation or induce long-term sustainable growth in the real economy.

Faced with a fragile global economy and slow overall growth, the ECB in 2014 became the first major central bank to venture into the once uncharted territory of negative interest rates (as in “depositors are actually charged to keep their money in an account”). A number of smaller European monetary authorities, namely Switzerland, Sweden and Denmark quickly followed. Then, in yet another sign that even unorthodox policy options (quantitative easing, or QE; zero interest rate policy, or ZIRP) have proved ineffective, the BOJ announced in January that it, too, will implement NIRP. Never before have interest rates below zero been used in so many economies on such a large scale. No worries right? What could possibly go wrong?

The theoretical aim of deploying negative interest rates is to stimulate economic growth by encouraging banks to lend more aggressively, corporations to borrow and invest, and consumers to borrow and spend. They also force income oriented investors to seek alternative, riskier investment strategies to achieve their income goals. An unspoken goal of NIRP is to gain an economic advantage by weakening the domestic currency, which should boost exports and potentially raise inflation by making imports more expensive.

However, theory does not always translate into practice. In fact, the BOJ’s recent move to NIRP has proved that the exact opposite is often true. The Japanese Yen’s unexpected appreciation and the stock market’s steep plunge in the days after the announcement highlight the risk of unintended consequences from pursuing such absurd and untested policies.

Surging sales of old-fashioned household safes to store physical currency at zero percent rather than having to pay for the privilege of storing money in a bank is just one example that the central bank’s strategy might backfire. After all, negative rates were supposed to drive money into consumption and investment, not safes and mattresses.

And it’s not only individuals that are hoarding cash. The Association of Bavarian Savings Banks recently sent a memo to its 71 member institutions, encouraging them to hoard cash in their vaults, rather than depositing it at the ECB and having to pay the

negative -0.3% interest rate on the reserves.

Such behavior is a classic indication that central bankers’ efforts are suffering from the law of diminishing returns and that confidence in their ability to stabilize financial markets has further eroded. Likewise, the recent rise in the price of gold - up 16% in Q1 2016 -

conceivably reflects the public’s preference of owning physical commodities as a traditional store of value over the cost of holding cash at banks.

Investment implications The investment environment has clearly been getting more volatile and complex in recent years, in part because lower yields have altered investor behavior. With monetary policy heading through uncharted waters, investors need to realize that the forward looking risk-return profile has been skewed – mainly due to declining yields on the fixed income portion.

Traditional asset allocation is based on diversification among various asset classes in order to achieve the best risk-adjusted long-term returns. Bonds have long been used to diversify a stock portfolio since their returns historically have not moved in the same direction (low correlation). That allowed investors to reap decent returns without taking too much risk.

Yet in recent years, artificially low interest rates have impacted various asset classes in such a way that correlations have turned positive, which means that adding bonds to an equity portfolio has become a much less effective tool to reduce the overall risk profile.

Since central banks provide a benchmark for all borrowing costs, negative rates have quickly spread to a range of fixed income securities. Today it is estimated that some $7 trillion of global government debt outstanding has a negative yield – that is almost 1/3 of the world’s entire sovereign bond market! Investors buying these bonds and holding them to maturity are guaranteed a loss. (See chart on the previous page for an illustration of the negative yield curve in German and Japanese bonds).

As a consequence, savers and retirees - the victims of the QE/ZIRP/NIRP ‘madness’ - who need positive cash flow are forced to move even further out on the risk spectrum, both in the fixed income and equity space, since there literally remains no way to generate low-risk income.

U.S. Treasury yields posted their largest quarterly drop in nearly 4 years as prices soared during the first quarter of 2016. The U.S. Treasury bond market posted a 2.94% return in the first quarter, and investment-grade corporate debt returned 3.62%. While U.S. bond yields remain attractive in relative terms, we believe that the imposition of NIRP by certain central banks will continue to put downward pressure on domestic interest rates as foreign buyers, enticed by attractive yields, will remain large buyers.

Artificially low or even negative interest rates tend to boost all asset prices. That was once again evident last quarter when Fed policymakers dialed back their outlook for interest rate hikes. That shift in focus boosted stocks, bonds and commodities, and was the main reason that stocks rebounded off this year’s low. And while the combination of abundant global liquidity and extremely low bond yields could help the stock market to grind higher in coming months – “don’t fight the Fed” -, we believe that the upside will be limited as a lot of headwinds remain.

The main headwind is flat or falling earnings. First quarter earnings for S&P 500 companies are forecast to slump 8.5% from the same period last year, according to FactSet. That would mark the index’s first

four quarter streak of declines since the financial crisis. Earnings aren’t expected to rise until the second half of the year. As we have repeatedly pointed out: earnings, not the economy, are the fundamental driver of stock prices. Without the benefit of meaningful earnings growth, it will be difficult for stocks to climb to new heights.

Another headwind is valuations. The bull market officially celebrated its 7th birthday on March 9, 2016, making it the third longest in the past 70 years. During that period, the S&P 500 gained 194%, leaving its current valuations somewhat stretched – particularly with the decline in earnings. According to FactSet, the S&P 500 is trading at a trailing price/earnings ratio of 18.2, which is above its historical 10-year average of

15.8 (see chart). Stretched valuations are no reason to become ultra-cautious on equities – we are not –, but we believe that investors should expect more muted returns and higher volatility for stocks going forward.

It’s no secret that the Fed policymakers are concerned about the strength of the U.S. dollar, which has hurt sales and

earnings of many large U.S. multinationals. A strong dollar can also be directly attributed to weakness in Emerging Markets and is the prime culprit in stymying commodity markets. Although the U.S. dollar index fell 4.1% in the first quarter, we believe that the broad trend for the greenback is likely to remain up, as interest rate differentials and a more robust domestic economy could spur additional demand for the currency.

Other sources of headwind include the unpredictable U.S. presidential election and global terrorism.

To close with a basketball analogy, the saying goes that ‘offense wins games, defense wins championships’. This principle extends to investing as well: Warren Buffett will tell you that the first thing he looks to do is protect his downside risk (play defense).

Fortune truly favors the bold in the current market environment, which is highly addicted to central bank stimulus. However, the effects of QE/ZIRP/NIRP cannot last forever, and unless we see an improvement in the underlying corporate fundamentals (profits, cash flows), we remain cautious and very selective. APRIL 2016