2018 Investment Outlook & Market Commentary
Our Thoughts on Current Market Volatility
As of the time of this writing, global markets have experienced a fairly meaningful selloff through mid-October, with the S&P 500, Developed Market Equities, Emerging Market Equities and US Fixed Income having fallen ~5%, ~7%, ~8% and ~1%, driven partly by the sudden spike in the 10-year yield to ~3.25% and fears of slowing global growth. As we head into Q4, we believe that corporate forward guidance during the earnings season underway, mid-term election results in November, trajectory of tariff/trade talks, and the Tax Rally hangover will shape where we end for the year. Thus far, earnings season has begun on a mixed note, with ~70% of companies beating earnings expectations but only 60% of companies having beat forward-looking revenue expectations and only slightly over 50% revising up earnings expectations, clearly less bullish than in Q3.
Several major indices trade well below their highs in late January and even below the end of Q3. For instance, the S&P 500 index is trading at historical median valuations (15x) on a price-to-forward-earnings basis, vs. two turns above in January and in Q3; Emerging markets and Developed markets are more attractively valued, trading reasonably below 25-year-median P/E multiples respectively, and while Emerging Markets have seen a fairly meaningful sell off in part due to trade wars and slowing growth, we believe the investment case for EM over the next 5-7 years remains credible although this asset class could endure more short-term drawdowns. With earnings season under way, consensus expectations call for corporations across most major global markets to post reasonable earnings growth for the remainder of 2018, but the outlook globally seems to be pricing in a slowing of growth in 2019.
Third Quarter 2018 Market Update
The third quarter of 2018 was a mixed quarter of sorts, depending on one’s specific portfolio positioning and perspective; much like the second quarter, we saw a continuation of trends that began in 1H18 intensify into Q3, both on the downside and the upside, while we saw a reversal of others. While rising inflation fears in the US persisted along with the tug of war between fundamentals and the trade/tariff war impact on sentiment, leading US equities to continue their outperformance vs. the rest of the world, large caps in the US reversed their underperformance vs. small caps with a couple of the large cap tech companies among the FAANGs suffering a bit of a hiccup due to a mismatch between investor expectations and fundamentals. International markets were a mixed story, with Developed Markets up modestly for the quarter while Emerging Markets fell as their currencies continued to weaken against the US dollar and tariffs impacted sentiment on major markets like China.
As seen in the above chart from JP Morgan, Q3 2018 featured a few key themes:
US Large Caps trounced small caps by nearly 4%, which we attribute in part to a risk-off approach from investors that had previously enjoyed strong gains from small caps
Emerging markets suffered even as larger EM markets like China were impacted by escalating trade tensions with the US, and smaller markets like Venezuela and Argentina suffered from currency devaluations and stagnating growth
YTD, Technology, Healthcare & Energy equities have led the way in the US along Floating rate bonds, while Industrials and traditional bonds have lagged
Value Equities have continued to underperform Growth Equities with the lag in Small Cap Value and Small Cap Growth reaching double-digits
Our Brief Take
We continue to believe that the pace of growth worldwide has slowed worldwide including in Europe where Purchasing Managers Index (PMI) indicators have turned and Emerging markets, where talks of synchronized global growth have been replaced by concerns around trade tensions between the US and China, higher debt levels (especially $-denominated debt) and currency devaluations in countries such as Argentina. Below chart illustrates how global markets and the global economy can periodically disconnect from each other.
In the US, we continue to move from an environment of accelerating growth/low inflation to slowing growth/higher inflation. Under Federal Reserve Chairman Jerome Powell, we believe rates are headed higher, potentially once this year and a couple of times next year, but this might be predicated on continuing growth and minimal growth slowdowns caused by trade tensions/tariffs. With the most recent interest rate increase, the yield spread between the 2-year and 10-year Treasury notes (also referred to as the “2’s vs ‘10’s” in the industry has hovered around ~25 bps (the lowest in over 10 years), not yet indicative of inversion; typically, an inverted yield curve presages a recession within the next 6-18 months. Still, should rates continue to rise in the US thereby strengthening the dollar, this stands to attract capital away from International Markets and into the US. While this has already occurred in 2018, we believe consequently that valuations in emerging/developed markets are more attractive than in the US, with EM a better bet over the next 5-10 years.
Portfolio Positioning - S&P 500 Envy & Asset Allocation Discipline
We believe prudent asset allocation, periodic rebalancing to bring assets back into their target portfolio weights and ongoing due diligence/selection of investments is key to achieving superior long-term portfolio performance. All too often, especially this year, we have heard clients ask us why global portfolio diversification matters, especially when indices like the S&P 500 have far outperformed most international markets. Reflecting on the past several years, we believe it is a fair point given that the S&P 500’s outperformance over the past 10 years, and we refer to this investor behavior as “S&P 500 envy”.
Highlighting the importance of asset allocation is a chart from JP Morgan below, which illustrates best-to-worst performing asset class performance annually across global markets over a 15-year period starting in 2003 and ending in Q3 2018. Upon close scrutiny, we observe a constant rotation in the best and worst performing asset classes from year-to-year, suggesting continual mean reversion. This chart also illustrates why we rebalance portfolios periodically to ensure that your overall portfolio mix is in line with broader objectives of a globally diversified portfolio, thereby preserving investment discipline and avoiding getting whipsawed by volatile markets.
For instance, we did fine tune your investment portfolios modestly of late, consistent with our long-term (read 3, 5 and 10-year) horizons and our patient approach to growing/preserving your capital but in recognition of recent changes in market conditions.
For instance, we replaced your longer-term core bond holding with a shorter-duration cash instrument from Blackrock, which currently yields 2.5% and has a much shorter duration (3-4 months vs. a few years). We also exited your Las Vegas Sands equity holding consistent with slowing global gaming revenue growth trends in Macau, but added to your holdings in Mondelez, a global packaged food company with multiple billion $ brands and a play on growing snacking demand worldwide, as well as ADP, the largest US-based payroll processor which tends to exhibit defensive characteristics in volatile times. This year, the notable outperformance of growth over value has hurt our developed/emerging market and long-short equity fund holdings this year, but we continue to monitor these with upcoming due diligence meetings over the next several weeks by both Jodi and Giri. Typically, our investment process requires that we allow our investments and investment managers time to prove their mettle while researching new investments that could upgrade your portfolios; for instance, we recently traveled to visit Pimco, our US and global bond fund manager, and to an Alternatives/ESG conference to meet with a variety of Environmental, Social & Governance (ESG) asset managers as we experience greater client demand for socially-responsible portfolios.
Our Parting Thoughts and Market Outlook – Why Investor Discipline Remains Crucial
As we enter a seasonally-strong fourth quarter and remain amid the 10th year of this market cycle in the US, we see more signs of a stretched market and risk aversion, which is evident from the recent outperformance of defensives over cyclicals. We see global growth continuing albeit at a slower pace, especially if trade wars intensify and global central banks (including the ECB) move into a tightening mode at the same time, which would remove the protective put underneath markets. In the US, while we have seen corporations benefit from tax reform and GDP growth tick up, it is becoming clearer that the market has priced in much of the positive impact of tax cuts and the boost to capex/earnings from higher capital investments and buybacks/dividend increases. With mid-term elections around the corner, it is fair to assume that the US markets might remain in a funk until then; historically, markets rise over the 12 months following such elections. Currently, the base case is for a split Congress, with the Republicans maintaining control of the Senate and the Democrats regaining control of the House.
While the US keeps progressing further into late-cycle mode, developed and emerging markets seem to hover between early and mid-cycle mode. While fears of an inverted yield curve abound, we remind clients that even if the yield curve inverts and presages a recession, that usually takes about 6-15 months, suggesting a recession is more likely in 2019 or later. Clearly, trade wars, especially those between the US and China are impacting EM markets, which are also impacted by a host of other factors including country-specific factors (slowing China growth, Argentina’s policy woes and Turkey’s credit-fueled growth slowing) and global tightening (especially the rise of the dollar). Still, while we do not believe EM troubles presage the end of this cycle & EM valuations are attractive, we believe EM markets need a catalyst, which could either be US-Chinese governments reviving trade talks post mid-term elections, or the Chinese government introducing structural reforms to offset trade risks.
As we have highlighted during our recent mid-year market outlook event and countless investor meetings over the past year, we seek to build globally diversified portfolios with a nod to high quality and value even though it is often tempting to invest entirely in the US. We believe the case for international markets has not diminished despite their declines this year, and still favor Emerging Markets over Developed Markets given higher historical trend growth, more favorable demographics, mid-cycle fundamentals and cheaper valuations relative to trend growth. However, if rhetoric and recent actions by the US and its trading partners does not subside and global growth slows, US markets might be viewed as a safer haven than earlier, hence we selectively might take an even more defensive stance than earlier this year. Below chart illustrates how International stocks have historically outperformed US stocks in the trailing 12 months before the yield curve inverts; this is not meant to be a predictor but rather, illustrative of historical returns in global equity markets prior to yield curve inversions.
Given an investing environment that will likely see higher rates and rising inflation, we prefer high quality equities broadly over traditional fixed income, though as rates rise along with discount rates, the opportunity cost of not investing in dividend paying equities becomes lower even as multiples get compressed as future cash flows are discounted at higher rates. We believe that the biggest wildcards exist in the form of intensifying trade wars especially between the US and its trading partners especially if there is retaliation on industries that are already on the wrong end of the business cycle such as industrials. While a spike in inflation is still a wildcard despite stagnation in wage growth even within a tighter labor market, Washington rhetoric at least until the midterm elections might dominate market sentiment.
In recognition of the fact that we are in a higher-volatility, late-cycle environment where there are few certain outcomes, we continue to put our clients top-of-mind when presenting alternate strategies including:
Private Real Estate Investments. For illustration purposes, below is a historical chart that illustrates how Private Equity can outperform Public Equities over a longer time period, which is important in the context of the decline (at least in the US) in the number of publicly-listed companies.
Covered Call, Put Write and other Equity Complement Strategies
Global Infrastructure Investments
Convertible Securities and Floating Rate Funds
Non-traditional long-duration yield vehicles in the private investment realm that exhibit less correlation with the broader public equity markets.
As always, feel free to reach out to us with questions, comments or observations.
Jodi Vleck
CEO, Wealth Manager
Giri Krishnan
Senior Portfolio Manager
Gabe Adams
Wealth Advisor