Market & Economic Review - Fourth Quarter 2018
The third quarter embodied what we would expect to see in an environment where corporate earnings are strong and interest rates are moving higher due to a robust economy. U.S. stocks continued to dominate as growth and especially technology stocks led the way. Overseas markets lagged with developed markets marginally higher and emerging markets down for the quarter. The 10-year U.S. Treasury Bond increased in yield by 20 basis points to finish above the 3% level at quarter end for the first time since the end of 2013. The U.S. is currently the lone economy firing on all cylinders as the rest of the world is seeing their economies grow at a slower pace. Because of this strong growth, we have continued to see the dollar rise in value relative to most currencies, which in turn causes international, and especially emerging markets to continue to struggle. Strong growth in the U.S. is a result of lower taxes and government spending, which is likely to taper off in 2019 and beyond. At the end of the quarter, there was much angst about the flattening of the yield curve and asset valuations. The Fed has indicated they are likely to raise rates 3 or 4 times over the coming year, and U.S. stocks typically stall out when we are near the end of a tightening cycle.
We saw the S&P 500 index reach a new all-time high, recovering from the lows earlier in the year. U.S. stocks continued to lead the way as the spread between U.S. stocks and international stocks continued to widen. The spread between growth stocks and value stocks approached its widest since the 2000 tech bubble. Both divergences are examples of what we have been describing as “alligator mouths”. The term is from the shape that appears on a chart (below) in which one asset diverges from another in a dramatic form that resembles the shape of a wide-open mouth of an alligator. The chart also signals a warning that the mouth can quickly shut, as the leading asset falls and the lagging one rises. In 2001, we saw growth stocks fall dramatically as investors dumped technology stocks and rotated into the previously boring value stocks. U.S. stocks benefited from tax cuts and the continuation of strong earnings.
*Rising (falling) line indicates that the index is outperforming (underperforming) the S&P 500.
Source: Standard & Poor's and Haver Analytics
International stocks, especially China and other export oriented economies, continued to decline with tariff policy announcements that will affect $200 billion in mostly Chinese goods. The combination of increased tariffs, higher interest rates, and repatriation of overseas cash has continued to push the dollar higher. As the dollar increased, we saw emerging market stocks fall even further. From a peak in late January through the end of September, emerging markets are down right at 20%, which is representative of being in a bear market. We continue to prepare our equity allocations for a much slower increase in prices, by tilting more towards higher quality balance sheets and steadily increasing active exposure. The most promising areas of active management appear in emerging markets and long-short hedge funds.
At this point in the cycle we would typically see inflation picking up and the Fed attempting to cut it off from accelerating too much. We have experienced moderate inflation as U.S. CPI has only increased a little over 2% on an annualized basis. Housing, the largest component of core CPI, has been up around 3% over the past year. With interest rates up significantly, it is hard to imagine that the increase in housing costs won’t slow. There is great debate on which way inflation will go with one side seeing the Federal Reserve’s continuation of rate hikes causing asset prices to fall significantly. The other camp sees the historical pattern of easy money pushing up asset valuations and eventually wages, and the Fed being behind the curve. When analyzing the components of inflation and the desire to normalize central bank balance sheets, we tend to lean toward the camp that believes higher interest rates are likely to affect housing and corporations that are highly levered. Whether we see increased inflation now or later, it is likely that the economy won’t be able to withstand more than a couple of more rate hikes in the next year.
With the curve remaining flat we see good opportunity in the short to intermediate duration securities in quality corporate, U.S. Treasury, and municipal bonds. We see the most vulnerability in those areas that have higher correlations to equity markets. High yield and emerging market debt have attractive yields, but behave more like equities when markets turn down. While the lure of higher yield is appealing, it can be a determent to portfolio diversification when it is really needed.
Source: Bloomberg, FactSet, ICE, J.P. Morgan Asset Management. Data as of 7 July 2018. International fixed income sector correlations are in hedged US dollar returns as US investors getting into international markets will typically hedge. EMD local index is the only exception – investors will typically take the FX risk. Yields for all indices are in hedged returns using three-month LIBOR rates between the US and international LIBOR. The Global ex-US aggregate is a market-weighted LIBOR calculation. Data as of 27 September 2018.
In client meetings, we are reinforcing the disciplined strategy of investing for the long term and being prepared for more uncertainty and volatility in the markets. We have laid out our plan and how it translates into portfolio construction. The first fact is that markets are on the very high end of historical valuations. The second fact is that it is nearly impossible to predict when they are too high and begin to adjust downward. Trying to time the market is a pointless exercise and comes at a very high cost. Research by BNP Paribas showed that between 1961 and 2015, the buy and hold investor would have earned an annualized return of 9.99%. If that investor missed the best 25 days or .16% of those days, their return would have been reduced to 5.74%. It is also true that being out of the market would see a similar increase in return, but that is before any taxes. What has also been seen is that the best 25 days were clustered close to the worst 25 days. What is more prudent is to have more cash on hand to take advantage of the volatility we are likely to see. We would define that as having 5%-12% in cash. Within equities, we have exposure to more quality holdings and managers who have a valuation discipline. Companies with significant leverage have benefited tremendously since 2009, but are likely to be more vulnerable as interest rates move higher. Passive investing has been the best place to invest over that period as well, and going forward active management is likely to provide more downside protection.
Hedge funds, who are the most active, have the most opportunity with their ability to be both long and short investments. In the period we see ahead, winners and losers will become more apparent rather than everything moving up and down together. The intangible part of the economy, where most of the innovation and growth is happening, will continue to need private equity to fund their growth. The companies that are the most innovative and growing aren’t part of the traditional lending and debt world. They are reliant on private equity funds and family offices to continue to invest. While we see many investors moving more towards private equity, we don’t necessarily see it as being crowded yet. One area where we see an opportunity for diversification is in the metals and mining space. We don’t hear much about this space as growth stocks and bitcoin have gotten most of the attention. Adding gold or silver and possibly some mining stock exposure is something we are researching. As we have stated in most of our previous letters, we continually strive to build the best overall portfolio that we can, and many times that can be investing in areas that aren’t as widely known or popular. Historically markets have been volatile even though the last couple of years don’t feel like it. We continue to focus on the long term and compounding returns regardless of markets going up or down in the short term.
Synovus Family Asset Management Investment Team
Michael S. Sluder, Chief Investment Officer & Sr. Portfolio Manager
Andrea R. Parker, Senior Portfolio Manager
Zachary D. Farmer, Senior Portfolio Manager
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