2019 Investment Outlook/Market CommentarySubmitted by Jodi Vleck , Beta Wealth Group on January 18th, 2019
Our Thoughts on Ongoing Market Volatility
As of the time of this writing (early January), global markets have rebounded partly in 2019 from their 4th Quarter 2018 selloff when most asset classes dropped precipitously, leaving the S&P 500 at year-end down 6% for the year (4% including dividends) and Developed Market and Emerging Market Equities down between 10-20%. Typically, when most Economists/Investment Strategists lay out their year-ahead market outlooks and end-of-the-year price targets, we see universal optimism such as we saw at the beginning of 2018; conversely, what we are seeing/hearing now are calls for higher recession probabilities, negative investor sentiment and higher mutual fund/ETF outflows. While we (like all clients) feel the pain, we point out that falling markets also open up more opportunities especially when investor sentiment is bearish and valuations are reasonable. As we navigate the Q1 earnings season, we believe that the future market trajectory will rely on a few key drivers:
- Global corporate revenue/earnings guidance for 2019
- Trajectory of US-China trade talks
- Ongoing Federal Reserve commentary (dovish or hawkish) on the likely trajectory of future interest rate hikes.
Given most global indices in late December were close to bear-market territory, defined as a 20% pullback from the highs (set in August-September 2018), most major indices trade at or below historical median valuations (see chart from JP Morgan below). For instance:
- The S&P 500 index now trades below historical median valuations (14x price-to-forward-earnings)
- Emerging markets and Developed markets are even more attractively valued, trading ~20% below 25-year-median P/E multiples respectively
- Emerging Markets have sold off due partly to the impact of trade wars, but we believe the investment case for EM over the next 5-7 years remains valid though investors could potentially endure more short-term declines before they see the light at the end of the tunnel.
- With 4th quarter earnings season under way, consensus expectations call for corporations across most major global markets to speak to slowing economic growth in 2019.
2018 – A Year to Forget
Running in stark contrast to a great 2017, 2018 was an eminently forgettable year, regardless of an investor’s point of view. Regardless of how an investor was positioned, the year ended up being the worst since 2008 for most global markets with the pain widespread among most asset classes globally; by one measure, the breadth of negative returns across asset classes was the worst in nearly 80 years, with Cash, Ultra-Short-Term bonds, Munis and Utilities being among the few exceptions. Typically, when stocks zig, bonds zag; however, in 2018, few asset classes were spared.
2018 featured a few key themes:
- Value Equities continued to underperform Growth Equities in the US, with the lag between Small Cap Value & Small Cap Growth Equities in the low single-digits, while the lag in Large Cap Value & Large Cap growth Equities was in the high single-digits
- US Large Cap performance noticeably trumped that of small caps, which was a significant reversal from earlier this year when small caps were thought to be immune from the impact of tariff imposition; we attribute this partly to a risk-off environment for investors after they endured one of the worst quarters over the last 10 years: by sector, Healthcare and Utilities led the way while Energy and Industrials lagged
- Emerging markets suffered the most with larger EM markets like China down over 20%, led by slowing growth and escalating trade tensions with the US; Developed Markets such as Europe also suffered double-digit negative returns impacted by slowing growth, stalled Brexit talks & budget deficits in economies such as Italy
- After a stretch of unusually low volatility in 2017, 2018 saw a return to higher volatility especially in Q4; for instance, 2017 saw a max drawdown (peak to trough) of 3%, zero down months and 5 days of +/- 1% moves in the S&P 500 whereas 2018 saw a max drawdown of 20% (in only 3 months), 4 down months & 60+ days of over +/-1% moves.
Our Quick Take
Consistent with our views last quarter, we believe that the pace of growth worldwide has slowed. In the US, we have recently seen a slowing of manufacturing PMIs and weak consumer confidence numbers, and while GDP growth has held up in the 3% range, we may have seen GDP growth peak and hence will likely be moving into an environment of slowing growth/lower inflation. In Europe and Emerging Markets, economic indicators also point to slowing growth.
While the consensus prior to December 2018 was 2-3 rate hikes in the US by the Federal Reserve in 2019, we now believe we might see just one or no rate hikes this year. Fed Funds futures have begun to price in no rate increases with the recent asset market selloff/slowing economic data indicators. While long rates have declined from the low 3’s to the mid 2’s over the past few weeks, the yield curve spread between the 2-year and 10-year Treasury notes has narrowed to around ~20 bps (the lowest in over 10 years), not yet indicative of a recession; typically, an inverted yield curve foreshadows a recession within the next 6-18 months. Still, interest rate differentials between the dollar and other major currencies continue to be wide enough thus keeping the dollar strong, though if this were to reverse on a rate hike pause, Emerging Markets would stand to benefit.
Portfolio Positioning – Asset Allocation Discipline & Reversion to the Mean
As 2019 approaches, and with US stocks outperforming non-US stocks in recent years, some investors have again turned their attention towards the role that global diversification plays in their portfolios.
While there are many reasons why a US-based investor may prefer a degree of home bias in their equity allocation, using return differences over a relatively short period as the sole input into this decision may result in missing opportunities that the global markets offer. While international and emerging markets stocks have delivered disappointing returns relative to the US markets over the last few years, it is important to remember that:
- Non-US stocks help provide valuable diversification benefits
- Recent asset class performance is not a reliable indicator of future returns
We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the above period in global markets from 2000–2009. During this period, often called the “lost decade” by US investors, the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of –9%, whereas conditions were more favorable for global equity investors as most equity asset classes outside the US generated positive returns over the course of the decade (See above Exhibit from S&P Global & MSCI). Expanding beyond this period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the US market outperformed the world
market in five decades and underperformed in the other six. This further reinforces why an investor pursuing superior longer-term returns should consider a globally diversified portfolio.
Highlighting the importance of asset allocation is a recent chart from JP Morgan above, which illustrates best-to-worst performing asset class performance annually across global markets starting in 2003 and ending in 2018. Upon close scrutiny, we observe wide fluctuations in the best and worst performing asset classes year-to-year, suggesting continual mean reversion. This chart also illustrates why we rebalance portfolios periodically to ensure that your overall portfolio mix is consistent with broader objectives of a globally diversified portfolio, which helps preserve investment discipline and helps investors take advantage of volatile markets.
For instance, we did tweak 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 Preferred Income and High Yield Bond Fund holdings with short-duration bond funds from JP Morgan and Blackrock, which currently yield north of 2.5%, exhibit a much shorter duration (few months to a year vs. a few years, hence less impacted by rising rates) and own mostly investment grade bonds.
- We also exited your Blackrock equity holding consistent with what we believe is negative investor sentiment/outlook for asset managers consistent with declining markets.
- We added to your holdings in ADP, the largest US-based payroll processor, which tends to exhibit defensive characteristics in volatile times.
- Initiated small positions in Schwab (a market leading online US brokerage/asset management firm) and Alibaba (one of the global e-commerce leaders).
What Lies Ahead: A Growth Slowdown, Higher Volatility, Opportunities & Risks
After this recent violent bear market into December, the biggest question on most investor minds is whether we are in the midst of a typical non-recession bear market or heading toward a garden variety recession. While it is nearly impossible except in hindsight to truly know which way the market winds are blowing, a few indicators (the yield curve which has yet to invert, the Fed Funds
Rate-CPI differentials, narrowing/widening in credit spreads) do not point us YET to a recession and suggest we are more likely in the midst of a violent bear market.
As we enter the 10th year of this market cycle in the US, we see valuations being more reasonable across the globe but also higher risk aversion, which is evident from the recent outperformance of defensives (such as utilities or consumer staples) over global cyclicals, and the recent outperformance of US treasuries/cash over high yield or investment grade bonds. We see global growth slowing across most geographies especially if trade wars intensify and global central banks (including the European Central Bank) move into a tightening mode at the same time, which would remove the protective Central Bank put underneath markets; in a break from his 2018 comments, Fed Chair Powell recently indicated he would be open to reconsidering future rate hikes if economic growth indicators continue to worsen.
We expect US growth to slow in 2019 vs. 2018 (and converge with the rest of the world) as we run tough year-over-over economic growth comparisons, due partly to the impact of less fiscal stimulus and the diminishing impact of last year’s tax cuts. With the mid-term elections resulting in a split Congress, it is fair to assume there will be increasing political gridlock.
While the US is clearly in late-cycle mode, developed and emerging markets seem to lag the US and while valuations are compelling, these markets need a catalyst to revive growth/reverse sentiment. For instance, in China, the government has injected a modest amount of stimulus into the economy through measures like dropping the reserve requirement for banks, which helps inject more capital into the system; since the Chinese markets/economy have suffered more than the US, Chinese Premier Xi also has every incentive to strike an agreeable trade deal with the US.
Clearly, the biggest determinant of where global growth is headed into 2019 are the trade wars between the US and China. While rising rates in the US and better growth prospects have resulted in dollar strength, we believe that as the Fed pauses rate hikes and US growth slows, conditions are in place for the dollar to weaken, which would help Emerging Markets that have dollar denominated debt. In Europe, while GDP growth is likely to stay sluggish, the big determinants of market direction include the likelihood of an agreeable Brexit deal, trade tensions and the ECB’s policy on rates and while valuations are more compelling, we have fairly low expectations for a growth pickup here. Hence, we expect events in the first half of 2019 (especially the first quarter) such as trade talks/Fed Policy/Brexit deals/earnings growth trajectory to be a key determinant of whether markets globally will bottom, and pave the way for a smoother second half.
As we have highlighted through 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, especially after a year like 2018. In a market environment that has more uncertainty than we have seen over the past several years, making predictions near impossible, we believe US equities might still be viewed as a safer haven, although if we get a meaningful trade agreement between the US and China, and reasonable tariff agreements with Europe in areas like autos, International Markets (especially EM over DM given more favorable demographics, cheaper valuations and potential EM currency strength should the dollar reverse course on Fed rate hike pauses) have a higher probability of outperforming. 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.
Given that we are in an extremely volatile investing environment that will likely see higher geopolitical/economic risks and modestly higher rates, we prefer both high quality, fairly valued dividend-paying equities/undervalued equities with high free cash flow/low debt levels and equity managers that invest in them broadly over traditional fixed income in growth-oriented portfolios, and shorter-duration fixed income instruments over traditional bonds in more conservative income-oriented portfolios. Should the Fed pause rate hikes or scale them back, a possibility they seem more
open to recently, dividend paying equities/equity funds become more attractive than fixed-coupon bond instruments.
In recognition of the fact that we are in a higher-volatility, late-cycle market environment such as in 2018, where any public market exposure can result in big corrections/bear markets driven often by negative investor sentiment rather than fundamentals, we continue to favor a higher mix of alternate investment 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. Private Real Estate Investments
- Covered Call, Put Write and Hedged Equity Strategies
- Global Infrastructure Investments
- Private investments that exhibit less correlation with the broader public equity markets.
On a separate topic we wanted to let everyone know we are moving (only a ¼th mile away) in March. After almost 10 years, we have officially outgrown the space. The remodel did help for a couple of years but was still limiting. Mike (my husband) and I have been looking in the Rancho Bernardo area for a building to purchase for nearly four years. Our goal was to find a small space that was easy to maintain and manage. After countless hours and tours, we finally found a standalone building that is approximately 5,000 square feet. The space allows us to use one half and the other half to be rented out. Thinking like a financial steward, it is worth noting that acquisition/use of the building will help hedge rising costs of rents, since our rent at our current space has nearly doubled over the past 10 years. We are excited for the move-which should be around the end of March. We plan to host our Economic Outlook and Grand Opening on April 25th. Mark your calendars! The new office address is 11421 West Bernardo Court.
As always, feel free to reach out to us with broader questions, comments or observations during these volatile times.
Jodi Vleck, CFP® Giri Krishnan
CEO, Wealth Manager Senior Portfolio Manager