Third Quarter 2019 Update

November 25, 2019

Market Performance Summary
Worldwide economies continue to slow, some are already in recession, and GDP growth in the U.S. is expected also to continue its decline.  Third calendar quarter U.S. GDP growth was 1.9%, down from 2.0% in the second quarter of 2019, and was slightly higher than estimates, mainly due to a solid increase in federal government spending. Business investment declined 3% annualized, which followed a 1% decline in the second quarter. The 1.9% third quarter GDP growth is down from the more than 3% reported in first quarter.  Consensus estimates for the fourth calendar quarter and into 2020 continue to anticipate a continued slowdown. The current consensus is for quarterly GDP growth to bottom at approximately 1% in 2020 before rising again in 2021.

Recent economic data has been mixed. For example, the Institute for Supply Management (ISM) manufacturing index of 48.3 in October remains below the 50 threshold that separates expansion from contraction, and the Chicago Purchasing Manager Index dropped to 43.2, hitting a nearly four-year low.  However, recent jobs reports, by contrast, were more positive. The Labor Department reported that 128,000 jobs were added in October, well above the expectation of 75,000. The unemployment rate fell (0.2%) to 3.5% in September, a 50‐year low, yet even with the positive surprise, job growth remains below previous levels and below the average monthly rate of more than 160,000 in 2019.

Consumption growth slowed to 2.6% from 4.6% in the second quarter and with job growth slowing from previous levels, further moderation is expected.  Perhaps a harbinger of things to come, US retail sales fell in September for the first time in seven months.

Central banks around the world, including the US Federal Reserve Bank, have shifted to an accommodative stance. The Fed lowered the federal funds rate a quarter of a percent last week to a range of 1.50% to 1.75%, the third cut this year, following similar cuts in July and September.  At the time of this writing, 71% of the S&P 500 companies have reported quarterly earnings and 76% of them have exceeded analysts’ expectations, but corporate earnings have declined for the third consecutive quarter. On average, corporate earnings for the third quarter are 2.7% below last year’s level.

Meanwhile, despite the continued slowdown in global growth and a steady stream of mixed economic news, equity market returns strengthened in September and into October as investors continue to climb the proverbial “wall of worry”. There is still plenty to worry about: slowing global growth, trade tensions, geopolitical tensions, political gridlock, political infighting globally, and military escalations in the middle east, to name just a few. Yet the S&P 500 index is making regular new all-time highs, while international equities are likewise rebounding.  Bond yields are off their lows for the year (the 10-yr hit 1.47% in September), but these ultra-low levels (negative in some geographies) continue to indicate a lack of confidence in the global markets.

At the PRIM Investment Committee meetings in July and in October, we identified several reasons to remain cautious, and we recognized a divergence between economic sentiment and expectations versus actual economic performance.  Markets eventually react to mismatches of data and expectations, so we will be watching closely in the coming months for confirming data to support the recently rising equity markets.  Something to watch closely is the widely held belief that the consumer (the driving force of economic growth in the U.S.) is healthy, but there are already some worrisome signs:  average hourly earnings are down, average weekly hours are down, retail sales were down in September, and monthly employment growth, while still positive, is slowing.

We think of the recent strength of equity markets in terms of three possibilities:

Scenario 1: The recent strength in equities is a counter-trend move.  When trades become as one-sided as they were by late-summer, markets can try out the opposite scenario. In other words, perhaps the market weakness in the summer months was too extreme, and the recent bounce is merely a reversal.

Scenario 2: The recent strength in equities is an early indication of a stronger global economy. Changes in equity sector performance can be a first sign of regime change. If something really different is developing in the global economy, there will need to be evidence in orders and in spending. So far, global conditions are still deteriorating. This could change with confirming data.

Scenario 3: Shares that powered the U.S. market to rebounds from sell-offs in 2018 and 2019, and held it at high levels since, have more recently faltered. We highlighted the historic, but temporary reversal into value stocks recently at the PRIM Investment Committee meeting.  If new leadership is not sustained, if the strength in the markets continues to be the result mainly of a narrow group of high performers, then equity markets are still vulnerable.

Bottom line:  We will be watching closely for confirming data to support the recently rising equity markets and we continue to believe that the carefully constructed PRIT Fund asset allocation will enable strong performance in any of these potential scenarios.

Last quarter, we highlighted that the largest component of the relative underperformance for the trailing 12 months was due to the “Actual v. Target Weight Divergence Effect.” This divergence is caused by being unable to precisely match the actual PRIT Fund assets to the target allocation of illiquid alternative investments. This was still the case in the September quarter.  We were overweight poorly performing global equities as a result of being underweight the target private equity allocation, which performed strongly. This was the major source of the underperformance reported relative to the PRIT Fund’s benchmark.

The PRIT Fund benchmark is based on its target asset allocation and not on the actual allocation.  It is not always advisable, practical, or even possible, to identify and invest in PRIM’s high-performing, illiquid alternative investments such as private equity quickly enough to match the target allocation, particularly in volatile market environments. The current comparison to the target allocations penalized us during the last 12 months for not being able to invest quickly enough in PRIT’s higher-performing, illiquid alternatives – Private Equity in particular.  We will be addressing this divergence effect with a possible solution for consideration during the next Board meeting in February, but the real news here is good, namely that the PRIT Fund’s target allocations are performing well, it just takes time to reach the targets.

The other much smaller contributor to underperformance for the 1-year period was due to weakness in a few specific strategies that we have discussed for several quarters, such as Real Assets, the Put Spread Collar strategy (Equity Hedged program), Real Estate, and Private Debt.  We understand the reasons for the underperformance, we believe that they are temporary in nature, and in all cases, we have taken necessary steps to address these underperforming areas. In fact, each of the underperforming areas had a much stronger September quarter, and the PRIT Fund’s longer term 3-, 5-, and 10-year performance remains strong.

PRIT Fund Performance Summary

  • For the one-year as of September 30, 2019, the PRIT Fund was up 4.7% (4.3% net), underperforming the total core benchmark of 5.6% by 89 basis points (133 bps, net).
  • This performance equates to an investment gain of $3.5 billion ($3.2B, net of fees).
  • Net total outflows to pay benefits for the one-year ended September 30, 2019 were approximately $960 million.

Organizational Update
With the increase in assets under management and the increase in the number of clients, PRIM is continuing to add to its staff.  PRIM currently has eight job openings for which we have received more than 2500 applications.  We recently welcomed one new employee.

Minching Kao joined the Real Estate and Timberland team in October as an Investment Analyst.  Most recently, Minching was with Beacon Capital Partners in Boston as a Senior Acquisitions Analyst. Prior to Beacon, Minching held positions at the Boston real estate advisor, GFI Partners, and at National Valuation Consultants, in Denver, CO.  Minching holds a bachelor’s degree in Finance and English from Tung Hai University and an MBA and Master of Science in Real Estate and Construction Management from the University of Denver.

In the area for recognition for PRIM staff members, Qingmei Li, PRIM’s Finance Reporting Manager, was awarded the Treasurer’s 2019 Citation for Outstanding Performance.  Those selected for this honor have made notable contributions to the office of the Treasurer, its agencies, and the citizens of MA.  In early June and for the 14th consecutive year, PRIM was awarded the GFOA’s (Government Finance Officer Association’s) Certificate of Achievement for Excellence in Financial Reporting. This award recognizes the completeness and timeliness of PRIT’s Comprehensive Annual Financial Report, the CAFR.  Qingmei manages the production of the CAFR and an increasing number of audits that have dramatically increased in complexity in lock-step with PRIM’s innovative investment program.  She is the driving force behind PRIM’s financial statements consistently having clean audit opinions.

Michael McGirr, CFA, has accepted an invitation from the Institutional Limited Partners Association, ILPA, to join its newly created Content Committee.  This committee is responsible for creating and curating content that will be beneficial for the ILPA’s membership, which includes more than 500 international institutional private equity investors from peer public pensions, corporate pensions, endowments and foundations.

And last, PRIM’s Executive Director and Chief Investment Officer, Michael Trotsky, CFA, has been awarded the Lifetime Achievement Award from Institutional Investor.  He will receive this honor at the annual Allocators’ Choice Awards on December 3, 2019 in New York City.