- Trade war and rising interest rate uncertainties have continued to weigh on equities, as the contradiction between the strong economy and the market continues to widen.
- Yield curve inversion has sparked recession fears, but concerns may be a bit premature and must be taken into context.
- Fixed income securities experience a rare positive month as investors shed riskier assets and flocked towards safer bonds, driving longer maturity yields lower.
- Our key themes for 2019: More volatility, rotation towards higher quality securities and value, and focus on investment discipline and strategic allocations.
What Piqued Our Interest
While the U.S. economy is firing on all cylinders, the same certainly cannot be said about the stock market. As we have written numerous times over the past months, the U.S. is experiencing its lowest unemployment rate in 50 years, confidence and optimism indicators are at multi-decade highs, and corporate earnings are growing by double-digits annually. By almost any measure, the U.S. economy is performing at the highest level, fueled by government spending, tax cuts, and deregulation. Despite this, the dichotomy between the strong U.S. economy and the sluggish stock market has never been more evident, as trade war concerns, rising interest rates, and fading international growth all have weighed on markets. We like to remind our clients that the economy and the stock market, though invariably tied together, are two different entities that can and will behave extremely different at times. The market is always forward looking and reflecting changes in sentiment and forward projections, which have recently shifted towards a more cautious outlook. It is becoming apparent that we may be in for a very volatile market for the months ahead.
One recent observation, the market effects of the ceasefire agreement between President Trump and China’s President Xi Jinpeng at the G20 meeting in Argentina didn’t last very long, as the President essentially undermined his own efforts by tweeting that he is a “tariff man”. These conflicting messages have led to growing investor anxiety that the trade war could escalate, as Trump has threatened to raise existing tariffs on $200 billion of Chinese goods. The back and forth between the world’s two largest economies has weighed heavily on stocks, even after Fed Chief Jerome Powell backed off his hawkish stance last month by stating rates were “just below” neutral, which boosted the market late last month. We believe that despite the G20 agreement, trade uncertainty will prevail well into the new year and is likely to outweigh most of the positives in the U.S. economy.
In other news, the yield curve has finally inverted…so is it time to panic? Well, just to clarify, the inversion occurred between the 3 and 5-year yields, as opposed to the commonly quoted 10/2 year spread. With the 10-year yield currently back down at 2.86%, and the 2-year yield at 2.75%, the 10/2 spread is now 11 basis points. While barely in positive territory, the same cannot be said about the 3-5 year spread, which recently inverted at rates of 2.76% and 2.74% respectively. It is well known and often heralded by the financial media that an inverted yield curve has preceded every recession for the past 60 years. Stocks in the financial sector were punished upon the news, as banks in general are obviously more profitable when they can borrow short at low rates and lend for longer periods at higher rates. However, we caution investors not to overreact to news of the flattening yield curve, and not to confuse causation and correlation when comparing the yield curve to recessions. The yield curve is just one of many indicators which helps identify where we are in the business cycle, and historically the curve has flattened many months (if not years) ahead of the bull market peak. This has and will continue to be on our radar as we look towards 2019.
As the market has tussled with the dual implications of trade war concerns and rising interest rates, returns have been especially volatile in the 4th quarter. After a tumultuous October, the S&P 500 was up 1.96% in November, only to get whipsawed in the early days of December. The large-cap US equity index is now down 0.23% YTD as of December 7, while small caps have fared even worse. Once up by over 13% this year, the Russell 2000 Small Cap index is now down 4.92%, falling by 18% which almost puts the index into bear market territory. International stocks continue to trail the U.S. as they have for much of the year, although both the developed and emerging market indices have fared better over the past month, only down 4.35% and 1.61%, respectively. For the year however, the All-Country ex USA index is down by almost 12%, as international stocks have been hammered by the rising U.S. dollar and trade war fears, as well as isolated crises in Argentina, Turkey, and elsewhere.
Fixed income indices have experienced a rare positive month, as investors have shunned risky assets and flocked towards safer bonds. The U.S. Aggregate Bond index was up 0.60% in November, and up 1.56% for the 30 days ending December 7. Municipal bonds have fared even better, as the index is up 2.03% over the past month and is now in positive territory on the year, up 0.8%. This return is pre-tax benefits, so the after-tax return is even greater. Riskier, high yield bonds sold off along with equities, negating their subtle positive returns for the year.
Regarding alternative investments, the results have been largely mixed. The listed-REIT index has been positive as of late and is now positive 3.2% through 12/7 after a shaky start to the year. (Note the NFI-ODCE index, which tracks the performance of private open-end real estate funds, was +8.68% through the end of the 3rd quarter, with notably less volatility.) Commodities on the other hand are down -3.56% on the year, as trade war fears have dampened global demand. Crude oil, once up over 26% on the year, has fallen over 31% from its peak. Oil is now trading around $52 per barrel as OPEC members grapple with their decision whether to cut production and reduce supply.
Our list of concerns, related to both market factors as well as economic indicators, has grown. For one, we are concerned about the aggregate level of corporate debt, most notably the overall size of the BBB rated universe. According to Doubleline Funds’ Jeffrey Gundlach, the size of the BBB market is now 2.5 times the size of the high yield market and could flood the high yield bond market if those bonds are downgraded to junk. He also pointed out that yield spreads for corporate bonds are historically low (which means prices have a long way to fall), even though the level of corporate debt-to-GDP is at a multi-decade high. The fear of course is that these bonds are really of lower quality than their BBB rating warrants, based upon their high leverage, and that the corporate credit market could be in for a rude awakening once the rating agencies reflect the true level of risk.
Our worries don’t end with high levels of debt. The ultra-tight labor market, along with rising wages leaves little room for further GDP growth, as we may have seen a cyclical peak in the 2nd quarter of 2018. We are continuing to see issues in the housing market with new building permits on the decline, declining price growth, and higher mortgage rates which will only exacerbate the problem. Overseas, BREXIT and Italian budget negotiations are primary concerns in Europe, while contagion fears from the trade war have spread across Asia/Pacific. And then there are a myriad of unanswered questions to ponder. How many more rate hikes will there be? Where will the 10-year yield be one year from now? What happens to oil and other commodities if global demand continues to fall? These are just some of the key questions which drive our investment thesis as we head into 2019.
Key Investment Themes for 2019
- Volatility is here to stay. Expect more sell-offs and rebounds as the market grapples with late-cycle dynamics of slowing growth and signs of overheating. While we still favor equities in the short-to-medium run, looking towards the 2nd half of 2019 we are more skeptical.
- Rotation from growth to value. Growth stocks, led by technology and consumer discretionary companies, have vastly outperformed value stocks over the past 4 years. We believe we are at an inflection point and value stocks may resume leadership for the next several years.
- Focus on high quality across asset classes. In fixed income, mitigate credit risk and focus on short term bonds, treasuries, and cash proxies. In equities, increase exposure to conservative and lower volatility stocks, and lower exposure to momentum and cyclical stocks.
- Avoid value traps and position strategically for the long run. It may be tempting to “buy low” after a dip, but market timing strategies rarely work out for most investors. Now is the time to allocate your portfolio for the next stage of the cycle, with a focus on income and capital preservation.
- Watch the Wild Card. President Trump knows that the market will be a major factor towards his 2020 re-election bid and will likely try to sway markets by cutting a deal with China, influencing the Fed, or by providing even more fiscal stimulus into the economy. Whether right or wrong, whatever your opinion of the President, we cannot ignore or doubt his ambitions.
What this all means for your portfolio
Around this time last year, we mentioned that the global economy was about as good as it gets, and that the market should continue to reflect the solid fundamentals. The U.S. market did just that as it was up around 10% on the year before the last correction which began in early October. After two sell-offs in the same calendar year, we are now basically right where we were to start in 2018. In the short run, we predict that the market will continue to test the October lows, but will eventually grind higher early next year. Beyond that, our conviction in equities lessens as we anticipate more rate hikes and ongoing uncertainty from the U.S.-China trade spat. We believe the Fed will raise the short-term rate to 2.25-2.50% in December, but we may only see one or two more hikes next year. As we work towards the middle of next year, we think that global recession risks will increase, as the aggregate level of central bank balance sheets is reduced, and we move towards a less accommodative monetary environment. Of course, the markets could get a significant reprieve if trade war fears dissipate, but our base case is that uncertainty will persist well into 2019.
We are not market timers, nor do we make big bets in any of our models. Instead, we believe the more prudent approach is to insulate the portfolio from idiosyncratic risks to the greatest degree possible, while aligning the overall allocation in line with an investor’s objectives. We do such by building a core of low-cost, transparent, and tax-efficient exchange traded funds (ETFs) and complimenting those with opportunistic mutual funds that add alpha at various points in the market cycle. From our research we know that over 90% of a portfolio’s variability can be explained by its asset allocation, which is one of the key determinants in long term investment performance (Brinson, Hood, Beebower, 1991). We also know that active management plays a key role as well, both in the selection of high-quality fund managers, as well as adjusting the portfolio to modify the overall level or risk relative to the market. In 2019, those adjustments will center around our themes highlighted above: higher quality, value over growth, lower volatility, and risk-mitigation; all of which will err on the side of conservatism as we prepare to enter the final stage of this market cycle.