Third Quarter Recap
Tariffs and trade continued to be the topic du jour during the third quarter, with a stalemate over NAFTA leading to a new trade agreement between the U.S., Canada, and Mexico in the final week of the September. Conversely, the Trump administration went forward to raise tariffs on $200 billion of imported Chinese goods, taking the tax rate from 3% to 10%, with threats made to raise it further. In spite of the concern over the friction new tariffs might cause, the U.S. economy continued to perform well, with third quarter GDP growth increasing at a 4.2% rate. This represented its fastest level of growth in four years. As a result, U.S. equities continued to perform well, with the S&P 500 returning 10.5%, YTD, through the third quarter. The start to the fourth quarter has been a sharp contrast though, with stocks falling in the last week as fears over rising interest rates have come to the forefront.
While broad market performance in the U.S. has been strong, there has been a wide divergence between value and growth. The Russell 1000 Growth index, dominated by the FANG stocks, has jumped 17% this year through the end of Q3, while the Russell 1000 Value Index, comprised of financials and defensive stocks, has risen just 3.9%. International and emerging market stocks, which trade at discounted valuations to U.S. stocks, have also lagged in the return column this year. This is partly due to trade concerns as well as a decline in major currencies vs. the U.S. dollar. Simply put, equity exposure outside of the growth sector has been a drag on a diversified portfolio, in spite of headlines trumpeting new all-time highs in the Dow Jones Industrial Average.
Within fixed income, the Barclays U.S. Aggregate Index, a broad measure of bond market performance, has fallen (1.60%) as the Federal Reserve has raised rates. Weak performance in the bond market has also been a detractor to diversified portfolio returns this year. The upshot of rising rates though is that areas of fixed income, which for years have yielded next to nothing, are now providing both reasonable coupon returns to investors and will serve as a stabilizer to overall portfolio returns should equity markets weaken over the next year. We will touch on this further in our outlook.
4th Quarter Outlook
The Pessimism to Euphoria Cycle
Sir John Templeton once said that “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” In our outlook for 2018, we noted that in spite of a strong year of positive returns across nearly all asset classes, we didn’t see much euphoria in the investment market landscape. The one exception we noted was Bitcoin, which closed 2017 at $13,480. Today, it sits at $6,537, an unsurprising decline of 52%, YTD. Templeton was on to something with that quote.
Of course, we did not risk our client’s money in something as speculative as Bitcoin; however, since we have seen market cycles follow similar if less-pronounced paths it begs the question where are we in the “pessimism to euphoria” cycle for the stock market?
In our view we are certainly beyond the point of skepticism and most investors have been pretty optimistic about the market lately, though it seems a bit early to say euphoria has set in. Part of the reason we feel this way is that though the market has enjoyed significant returns since the market low in 2009, rising 331% in total, it has also seen significant spikes in volatility along the way. Some examples include the flash crash in 2010, the debt ceiling showdown in 2011 which saw a stock market correction of around 20%, the oil market crash in 2016 which brought another double digit correction to stocks, and finally the volatility that has surrounded the ascent of the Trump administration, both immediately after the election and in the early parts of this year as tariff wars have started.
Though the U.S. stock market has performed well, these steady pockets of volatility through this bull market go a long way towards resetting investor expectations, preventing them from getting too euphoric about future equity returns, and keeping valuations in check. We are at a point of optimism now with some pockets of exuberance as the U.S. market rose 20% last year followed by 10% gains this year. Consumer confidence, a closely correlated signpost with the market, is near an all-time high. This is a good thing, as the U.S. is a consumer economy and depends on people opening up their wallets for goods and services to keep economic growth moving along. However, it also raises the question of how much better can it get, when unemployment is at multi decade low levels, profit margins are at multi decade high levels, and credit balances are starting to increase?
This is our concern as we consider portfolio construction and head into year end and the first quarter of 2019. Earnings growth has been strong and economic optimism is high, but is much of that already priced into the stock market with an 18% year over year gain for the S&P 500? It is likely that many institutional funds and pensions are now overweight U.S. equities and underweight bonds, which have substantially lagged the stock market this year. The Fed’s steady rate hikes have put interest rates at a more attractive level than a year ago. 2 Year Treasury bonds now yield 2.81% compared to a yield of just 1.47% a year ago.
Consumer confidence is at its highest level since 1999, and short-term bond yields have risen significantly over the last year
It would not be surprising to see institutional rebalancing out of equities and into bonds at the end of the year and early into 2019 which would lead to outflows from U.S. equity market and inflows into the fixed income market. Given the pricing washout that has occurred in many areas of fixed income, with floating rate being the one exception, we are looking to incorporate a greater amount of high quality bonds into client portfolios to take advantage of higher yields while simultaneously locking in gains that have come in equity market positions over the last two years.
You can see in the chart above that from 2 years to 30 years on the maturity curve, the yield curve is almost flat, indicating investors are getting little extra return from reaching further out on the maturity spectrum. For investors in 12 month T-Bills, they are getting 2.82% yield for each unit of duration (interest rate risk) that they take. For investors in 30 Year Treasuries, they are only getting 0.18% yield for each unit of duration; a stark disadvantage compared to the front end of the yield curve.
Compare this to three years ago, when fixed income investments were not offering value at either the short or the long end of the curve, beyond the principal protection provided if held through maturity. This is not to say that short term yields are as attractive as they were in the 80s, when Treasuries had double digit coupons. Yet if the Fed continues on their plan to hike rates 3-4 times over the next year and bond coupons are at substantially higher levels than they have been in the last few years, we believe it makes sense for investors to start looking at the short maturity space within high quality fixed income holdings.
The Sequel to the Sequel
Like the horror movie villain that just doesn’t seem to die, the threat of trade wars continues to be a specter for international and emerging market stocks. Canadian and Mexican stock markets have been hammered as President Trump railed against NAFTA since taking office, and investors have assumed the worst possible outcome, particularly in Mexico. For instance, the iShares Mexico ETF (EWW) dropped (10.3%) in 2016 vs. a 10% gain in broad emerging market equities. Last year, Mexican stocks rose only 14% in 2017 compared to a 37% jump in the emerging market equity index. Yet as tensions eased and the Trump administration struck a new deal with Mexico and reformulated NAFTA into the U.S. Mexico Canada Agreement (USMCA), Mexico has been one of the best performing emerging markets this year, rising 2.7% compared to a 8% decline in the emerging market equity index. It would have been a brave 2018 outlook that pegged Mexico as a potential top performance amongst its peers given President Trump’s derision towards the country. Yet Mexican stocks have been a relative safe haven among emerging market countries this year. We draw this example out to illustrate that there may be a light at the end of the tunnel beyond these trade negotiations that seem to deliberate in perpetuity.
China has been in the crosshairs of the Trump administration lately and the iShares MSCI China ETF has fallen 12%, YTD. Due to the threat of increasing tariffs, like Mexico a year ago, it’s hard to see the positives of owning any investment in the East Asia region given the crosshairs placed on our trade agreement with them.
Yet there are a underlying currents which are shifting in the right direction. For starters, China’s trade committee is set to visit Washington this month to negotiate further (despite both parties saying they are at an impasse). Second, China has started to stimulate its economy in response to some of the economic turmoil that is being inflicted by higher tariffs. Their central bank has started lowering rates, personal income tax cuts will be rolled out this month, and new construction projects are being approved at an accelerated rate. China is attempting to reinflate their economy and typically when this has happened, it has coincided with a bottom in emerging market stock prices.
Trade negotiations may continue on without much positive news in the near term. President Trump may continue to be openly hostile towards China because the deficit we have with their economy is so large and he knows they have little further room to respond with tariffs of their own. However, China likely knows this as well and could be willing to make concessions on key items such as U.S. business investments in China. This includes U.S. auto exports into China, and perhaps most importantly, cyber security. There is a strong potential for tariff negotiations to follow a page from his playbook with our NAFTA partners, which is to charge hard out of the gate, gain some concessions but keep the broad status quo in tact, then praise all of the involved parties while giving himself points for striking a “great deal.” We acknowledge that it is often difficult to stomach the volatility in emerging markets and the current geopolitical climate does not allow for much optimism; however, we believe there are reasons to be optimistic as evidenced by other countries that have worked through the impasse and struck a deal.
A Look at Preferred Stocks
As interest rates have risen, income oriented securities have sold off in response. We noted at the outset of this commentary that a broad index of bond investments, the Barclays US Agg Index, has fallen around 2%, YTD. Preferred stocks are a hybrid investment with stock and bond characteristics that have also fallen, with a price decline of around 4.5% this year.
Though preferred stocks have underperformed traditional equity benchmarks like the S&P 500, we think the decline, due to rising rates, makes the asset class more attractive for client portfolios. Looking at a broad index of preferreds, proxied by the iShares US Preferred Stock ETF (PFF), the asset class offers a current yield of 5.71%, which compares well to Treasury bond yields of 2-3%. Most preferreds we have analyzed and incorporated into client accounts are trading around par and will experience little to no capital appreciation, so in essence we are looking at them to provide income generation and volatility dampening to portfolios at a time when equity market returns may be a bit frothy. Unlike other income-oriented securities, such as MLPs or convertible bonds, there is significantly lower volatility associated with investing in preferred stocks. Lastly, income from preferred stocks is often taxed at a lower rate than traditional bonds, with interest being treated as a long-term capital gain rather than ordinary income.
The vast majority of preferred stocks are issued by financial institutions such as JP Morgan, Citi, and Wells Fargo, to name a few. Some utilities and energy companies also issue preferreds, but we have generally looked closer at financial institutions primarily because balance sheet strength within the financial sector is improving due to rising interest rates and a strong economic environment. On average, preferreds have a credit rating of BBB, putting them in investment grade territory. However, they yield about 1.5% more than investment grade rated corporate bonds do.
Combine the favorable yield spread over investment grade corporate bonds with the preferential tax treatment for clients in higher income brackets and we think an allocation to preferreds makes sense in a diversified portfolio.
We do want to note that there is interest rate risk embedded in preferreds, as they are often long maturity instruments. If interest rates rise rapidly, there could be additional price risk within the sector unlike a short maturity bond that will mature at par in a few years. However, we are looking to mitigate this interest rate risk by specifically owning preferreds that have a combination of floating rate features and prices near or below par. On the floating rate feature, some preferreds pay the higher of a fixed coupon (6% for example) or LIBOR plus a set interest rate. Should interest rates spike, the fixed-to-floating preferred stock will be forced to pay a higher interest rate to its holder and thus in turn lowers the interest rate risk that we are seeking to avoid.
With three quarters of 2018 in the books, large cap U.S. stocks continue to lead the way, with growth companies in particular having performed very well. U.S. value stocks have provided positive returns to investors but are up just around 3% when benchmarking against the Russell 1000 Value Index. Outside of the U.S., international developed and emerging market stock markets have fallen into negative territory as trade tariffs and political instability has created headwinds for asset appreciation. The performance discrepancy compared to the U.S. has been a hard pill to swallow, particularly as U.S. economic growth has been strong and the Dow Jones Industrial Average and S&P 500 are hitting new highs. We continue to monitor these investment areas closely to ensure that the fundamental reasons for investing there are still intact. With respect to emerging markets in particular, we believe that the trade impasse will end, and that better returns are in store, particularly as China’s efforts to reinflate their economy are underway.
Fixed income markets have continued to struggle as the Fed has raised interest rates to 2.5%. The Barclays U.S. Aggregate Bond Index has fallen 1.6%, YTD, through the end of September. As yields continue to rise within the fixed income space and prices fall, we believe areas such as TIPS, short-term corporate bonds, and preferred securities warrant increased allocations within a diversified portfolio. In addition to the better return prospects they offer now with higher yields, we believe they will provide lower volatility to the overall portfolio should there be a drawdown in the equity market.
We continue to believe stocks will provide positive returns to investors going forward, yet we are cautious about the amount of optimism that is currently being priced into equity levels. Economic data has been strong but may lack substantial catalysts to accelerate even further from its current trajectory. Though we don’t believe a recession in the U.S. is imminent, we are keen to acknowledge that the current cycle has been going on for quite some time now and it’s better to prepare before the slowdown starts than after.
Investment Advisory services offered by Independent Financial Partners (IFP), a Registered Investment Advisor. WhartonHill Investment Advisory and IFP are separate entities. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All data is via Morningstar, Bloomberg, and the Wall Street Journal as of 9/30/2018 unless otherwise noted.