2018 Investment Outlook/Market CommentarySubmitted by Jodi Vleck , Beta Wealth Group on January 19th, 2018
First Half 2018 Market Update
The second quarter of the year was in many ways a continuation of the first, and in the case of certain asset classes, we saw trends that began in Q1 intensify in Q2, mostly to the downside. While rising inflation fears in the US persisted, and the outperformance of large cap tech companies (especially the FAANGs) continued without nary a hitch, the threat of tariff imposition became more of a reality between the US and both China as well as developed European markets, which caused US large caps and small caps to be the only equity asset class to end the first half in positive territory. International markets still enjoyed a favorable macroeconomic backdrop but continued rhetoric and follow through from the current administration about tariffs on European countries and China weighed on sentiment and took the steam out of most overseas markets, with the EAFE suffering low single-digit declines YTD and emerging markets faring worse, down 8% through June. Unlike 2017, when global volatility was at its tamest levels in over 25 years, the first half saw continued high volatility which we now view as more of the norm going forward.
As seen in this chart from Alliance Bernstein, in contrast with last year, Q2 2018 was a downbeat quarter for most global equity markets with the exception of US markets which were up, with notable negative dollar-denominated returns across global markets. Of note were certain themes:
- Volatility in the first half of 2018 remained elevated as evidenced by the prominent swings in most prominent indices
- US Small Caps trounced large caps, consistent with the notion that these firms were helped by tax cuts and not hurt by tariffs given their modest international exposure
- Technology and Healthcare equities and Floating rate bonds outperformed Cyclicals such as Industrials and the Barclays Aggregate continued its negative run
- Emerging markets suffered due to tariff news and a strengthening dollar
Our Brief Take
We continue to believe that the tone of the market has changed since 2017, from one of unrelenting optimism to one of caution; while global growth continues to be good, the pace of growth has slowed especially in geographies such as Europe. We have moved from an environment of accelerating growth/low inflation to slowing growth/higher inflation. Under Federal Reserve Chairman Jerome Powell, we are in an environment that will likely see rates head higher 1-2 more times this year. Much has been made of 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) compressing, since narrowing of the spread could be seen as leading to an inversion of the yield curve. While this spread has shrunk to ~25 bps (the lowest in over 10 years), we see an inverted yield curve as less a causative factor of a recession relative to excessive Fed tightening, and more as a symptom; hence, it is too early to suggest that the narrowing spread will automatically lead to a recession. Still, with diverging Central Bank policy around the globe, investors will have to tune portfolios for a regime of rising rates/higher inflation.
In the ongoing debate between active and passive investing, we believe a blend of active and low-cost passive assets is appropriate in most portfolios. In our quest to generate robust risk-adjusted returns over a market cycle, we believe actively managed funds or individual securities, especially in categories such as International & Small Cap Equities or Long/Short Equities complemented with passive vehicles, makes sense. In a world where volatility is likely elevated, investor sentiment is waning and dispersion between highest and lowest quality assets is bound to rise, active management should add value. Case in point: Our individual large cap holding, Automatic Data Processing (ADP), which we added earlier last year, and the Loomis Sayles Senior Floating Rate Bond Fund, which are two investments that have been able to demonstrate their value in an environment generally unfavorable to most equity market sectors & fixed income investments in 2018.
Portfolio Positioning – Asset Allocation & Sector Considerations
We believe prudent asset allocation, periodic rebalancing especially as assets stray away from their target portfolio weights and ongoing due diligence and careful selection of investments is key to achieving superior long-term performance.
Illustrating the importance of asset allocation is a graph from JP Morgan, which illustrates best-to-worst performing asset class performance annually across US and International markets over a 15-year period starting in 2003 and ending in 1H2018. Upon examination, we notice a constant shift in the best and worst performing asset classes from year-to-year. This chart helps to explain 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 the markets.
As we remain mired in the classic later stages (read middle to end of the 8th inning) of what is the second longest market cycle to date (over 112 months and counting) in the US, we believe it can help to overweight or underweight sectors or asset classes that have characteristically outperformed or underperformed broader market indices at similar stages in prior market cycles. To us, this has meant the following:
- Favoring growth-oriented sectors such as Technology and Healthcare over defensive sectors such as Telecom, and later stage sectors such as Financials, which benefit from stronger loan growth, higher net margins with interest increases, the easing of financial regulations and strong economic growth
- Favoring asset classes that exhibit lower market correlations and at-times superior-to-public-market returns such as global infrastructure assets and private real estate
- Favoring non-traditional yield-oriented private investment vehicles and floating rate bond funds over traditional fixed income
We continue to fine tune our investment portfolios versus completely overhauling them, consistent with our long-term (read 3, 5 and 10-year) horizons and our patient approach to growing/preserving your capital. This process requires that we allow our investments and investment managers time to prove their mettle; for instance, the notable outperformance of growth over value has hurt our developed market and long-short equity funds this year, but we continue to monitor these with an eye toward potentially upgrading our portfolio periodically. This has recently meant traveling to visit both AQR Capital Management and Legg Mason, our long-short equity and total return bond fund managers, and to conferences to seek private investments in areas such as global infrastructure, private equity and private real estate, while adding fundamentally-sound equities of high quality companies.
Our Parting Thoughts and our Mid Year 2018 Market Outlook
As we progress further into 2018 and remain amid the 10th year of this market cycle in the US, we seek not to make precise forecasts, but rather handicap a few possible outcomes amongst several potential ones. We see global growth remaining strong, but possibly slowing relative to last year, especially if trade wars intensify and global central banks especially the ECB move into a tightening mode at the same time, which would put a damper on growth. In the US, while we have heard CEOs of corporations speak to benefits of tax reform, and the consensus view expects a modest boost to 2018 GDP growth, it is becoming clearer any positive impact of the stimulus from tax cuts such as buybacks/dividend increases/higher capital investments will be short lived. At this juncture, it is fair to assume that the US markets might remain in a funk until the mid-term elections in November, which has been the case historically, before continuing their upward momentum.
While the US has continued to progress further into its late-cycle mode, developed and emerging markets seem to hover between early and mid-cycle growth mode. Clearly, trade wars, especially those between the US and China will gather the most attention though extension of tariffs to the European Union (EU), Canada and Mexico have also had impact. For instance, companies such as German automakers and Harley Davidson have signaled the need to shift production overseas or lower their profit outlooks due to imposition of tariffs, hence raising valid concerns about the lasting market damage that an all-out trade war would entail. 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 than this year.
At the time of writing, several major indices trade well below their highs in late January. For instance, the S&P 500 index is trading at historical median valuations on a price-to-forward-earnings basis, vs. two turns above in January; Emerging markets and Developed markets are more attractively valued, trading reasonably below 25-year-median P/E multiples respectively with the former offering more upside potential notwithstanding the strong dollar and the specter of trade wars. With the 2nd quarter earnings season under way, consensus expectations call for corporations across most major global markets to post strong earnings growth for the remainder of 2018, but the outlook internationally has moderated somewhat with European PMI indices retreating from heady levels in 2017.
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. 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, US markets might be viewed as a safer haven than earlier, hence we take a slightly more defensive stance than earlier this year. 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 the biggest wildcards exist in the form of intensifying trade wars especially between the US and its trading partners especially if partners hit back at 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.
As we continue to explore atypical investment solutions in a rising rate environment, we continue to invest in or research:
- 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.
CEO, Wealth Manager
Senior Portfolio Manager