Second Quarter Recap
Trade threats dominated the headlines in the second quarter, leading to continued volatility in the stock market, with value, international, and emerging market stocks getting hit the hardest. While most investors brushed aside the initial round of tariffs that the Trump administration announced on steel and miscellaneous items like washing machines, the market took more seriously the threat that $200 billion of Chinese goods would face heightened tariffs.
The increase in volatility has led to a dispersion in stock market returns to close out the first half of the year. The S&P 500 has returned 2.65%, YTD, through the end of June, while the Russell 1000 Value index has fallen -1.69%. Emerging market stocks, the best performing equity asset in 2017, have fallen 6.51% through the first half of the year. Small cap stocks have performed well, with the Russell 2000 increasing 7.66%. This sector of the market has benefitted from the tailwinds of tax reform, as well as a perceived lower risk from trade, since the majority of small company revenues are domestically oriented rather than sourced abroad.
Bond markets have not proven to be a safe haven in 2018, as the Barclays U.S. Aggregate Bond index has fallen 1.62%, YTD. The Federal Reserve has hiked rates twice this year and is projecting two more rate hikes before the end of the year. At present, interest rates are at 2.0% and will likely end the year at 2.5% if the Fed continues on their trajectory.
Commodities, like many areas of the market, have seen varied performance among the different sub sectors. Heading into the summer driving season, higher gas prices are most notable with oil hitting $74 a barrel. Yet other commodities, such as gold, have been weak, with the precious metal falling 4%, YTD. Overall, the Bloomberg Commodity Index ended the first half of the year unchanged.
3rd Quarter Outlook
Trade Tantrums and Global Equity Markets
We began our last quarterly commentary focusing on trade and will continue with that theme in our outlook here as the escalation in threats is the topic du jour for investors. Though underlying economic growth in the U.S. and corporate earnings guidance continue to grow at favorable rates, trade has caught the market’s attention and won’t let go for the foreseeable future. Tit-for-tat tariff announcements are likely to be the primary source of volatility and will dominate headlines until major agreements are reached between the U.S. and its trading partners. The most difficult part for investors to discern is whether or not the opening pronouncements made on tariffs by the Trump administration are the starting point for negotiation or whether they are truly the end goal.
As illustrated by the graphic below, the initial round of actual implemented tariffs represented a very small hit to global trade, with an effect on just 0.3% of world imports. However, where pending and threatened tariffs came into play ratcheted the effect up to around $800 billion in goods, or 4% of world imports.
China and the U.S. are the two largest cogs in the global economic engine and the prospect of higher costs and greater uncertainty for business executives will lead to a slowdown in growth forecasts. A recent analysis by JP Morgan suggested that if the pending tariffs go through, but threatened tariffs are withheld, there would be a 0.5% reduction in global growth forecasts. For context, they currently forecast global economic activity to grow at a 3.3% rate in 2018 and a 3.2% rate in 2019, so the reduction is material. Despite President Trump’s tweet proclaiming that “trade wars are good, and easy to win,” the initial verdict from the stock market begs to differ. A prolonged, public sparring match between the U.S. and China will continue to lead to volatility, greater inflation, and reduced confidence from corporate C-suites. For instance, the proposed 25% tariff on imported cars could raise the price of a $30,000 car by over $5,000. Corporations will bear the brunt of lower demand and consumers will bear the brunt of higher prices.
Yet, just as quickly as volatility has re-entered the market, it could disappear if there is an agreement reached by the U.S. with the EU and China, with respect to proportionate tariffs. At present, Europe currently charges a 10% tariff on U.S. cars while the U.S. only charges a 2.5% tariff on European cars. Meeting the 10% tariff currently implemented in the EU would not be disastrous and may lead to greater production within the U.S. The fact that many German SUVs are already made in Alabama and other parts of the U.S. seems lost on the administration, but we digress. The same dynamic applies in China, which was charging a 25% tariff on imported U.S. cars, but recently dropped the tariff to 15% as a way to ease trade tensions. China has traditionally been a much more closed economy whereas the U.S. has been more open, hence the significant imbalance in trade (we buy around $500 billion in goods from China compared to them buying $130 billion from us). A greater balance could be achieved that would give Trump a “deal win” while not reaching the disastrous starting levels that he has pushed for.
Though the stock market has reacted to heightened trade rhetoric, the underlying trajectory of the economic growth has not changed. Some estimates place global economic activity growing at a 4.4% rate as of the end of June, above the long-run average growth rate of 3.8%. Corporate earnings growth is very strong, thanks in part to U.S. tax cuts. Corporations have also been returning capital to shareholders in record rates, with share buybacks hitting all time high levels in Q1.
It is easy to think that trade tensions have taken their toll on corporate expansion plans and to be certain, if trade hostilities remain elevated for the next year, they will adversely affect corporate sentiment. However, in the background of all the headline news, capital expenditures have hit their highest level in the last two decades. In our view, maintaining international and emerging market equity exposure (rather than reducing) in the face of tariffs is the right position. As we’ve noted in past commentary, President Trump has a tendency to start at an extreme position then at least move a bit more moderately (see his threats of ‘fire and fury’ at North Korea and followed by a rather friendly summit with Kim Jong Un).
The headline threats against China have been extreme but from the conversations we’ve had with various managers abroad, the Chinese administration is keen on negotiating to level the playing field through back channels. Emerging market equities have fallen sharply this year, with an 7% decline through the first six months, but a snap back rally on any positive news can happen very quickly. During the most recent bout of emerging market volatility, in January and February of 2016, emerging market stocks were down about 6% on concerns about China devaluing the yuan before jumping 13% in March of 2016 and posting impressive gains throughout the next year. Similarly, European stocks have been hit hard but seem to be pricing in too much negativity at the moment. For instance, there is a 20% discount in forward valuations for the MSCI EAFE Index vs the S&P 500. The following chart from JP Morgan shows just how difficult it is to time being in and out of the market around tariff announcements, as a rebound in the market usually follows a decline.
Long-term, the drivers for growth are still in place for emerging markets, with middle class growth well exceeding the developed world and demographics in a much younger and more advantageous position. Though the EU and Japan do not have these same tailwinds, and their banking and auto sector have been hit hard with tariff discussions, what is interesting is that they may be poised to pick up more favorable trade terms with China as the U.S. moves to a more isolationist stance. There are a lot of uncertainties over what the long-term effects of this trade spat will be, but what seems to be a growing certainty is that China is seeking to fill the void that the U.S. is leaving. China recently met with EU leaders to discuss ways to increase trade and they have stepped in to the Trans Pacific Partnership (TPP) trade deal to reshape it once the U.S. exited the deal. Though costs to do business with the U.S. may increase for the EU, those costs may improve with China. Given how quickly President Trump can change his mind, combined with the sharp negative reaction and the potential for an equally sharp positive reaction to any good news, we believe maintaining the current allocation to international and emerging equities is prudent.
Federal Reserve Policy and Fixed Income Market Notes
Current Federal Reserve chair Jay Powell has largely governed in a manner that is similar to Janet Yellen in that he has made moderate moves on interest rate policy. While Powell has highlighted the current strength of the U.S. economy, the Fed has also noted that it would not be concerned with any continued rise in inflation and likely view it as temporary, which would allow them to keep a modest approach to raising rates.
While we believe the Fed will continue to take a moderate approach to raising rates, one prevalent risk that we are monitoring closely is if they move more aggressively to tighten interest rate policy. As we have noted in past commentaries, the U.S. economy is built on both spending and leverage, by both consumers and corporations. A rise in the cost of leverage, and a decline in the availability of it, kicks out a key support for the economy. To be certain, the Fed has not tightened interest rates to levels that are restrictive. Even if interest rates are at 3% in a year from now they would be relatively accommodative from a historical perspective. What worries us most though is that if the Fed seeks to preemptively cut off excess leverage in the system or combat an unexpected jump in inflation, and hikes rates more rapidly than the market expects.
We believe that inflation will continue to increase as we head in to the summer, particularly as energy prices are high, the jobs market is strong, and positive effects from tax reform continue to flow through to consumers. Though the ultimate results of initial increases in tariffs are unknown, what is a given is that the cost of doing business globally is going to move higher as suppliers pass on cost to the consumer. These factors have caused us to increase our position in short maturity Treasury Inflation Protected Securities (TIPS), which have low interest rate sensitivity (to protect against continued rate hikes) and will produce a higher return to investors due to the embedded CPI component.
As inflation expectations have increased, and investors are anticipating the Fed to continue on their path of four rate hikes a year, more opportunities have opened up within the fixed income market. Generally speaking, municipal bonds have fared well while vanilla corporate bonds have seen spreads widen. This has created the opportunity for short and intermediate investors to reallocate from municipal bonds to corporate bonds as spreads widen.
To compare, at present the average short-term (2 years) municipal bond is yielding just 1.64%. For an investor with a total 40% tax rate, this is a tax-equivalent yield of 2.73%. By comparison, the average short-term corporate bond is yielding 3.27%.
As you go further out on the maturity curve to intermediate maturity bonds, corporate bonds are yielding 4.38% compared to a 3.33% tax-equivalent yield for municipal bonds. Yields for corporate bonds have risen considerably from their levels of 2.5% two years ago.
Another area within fixed income markets that has suffered from rate hikes is the emerging market bond asset class. Through the first six months of the year, dollar denominated emerging market bonds have fallen 6.46% while emerging market local currency bonds have fallen 8.16%. Over the last five years, returns from dollar denominated EM bonds have been respectable, returning 4.17%, annually. Though the asset class has more volatility than traditional bonds, it has outperformed the Barclays US Aggregate Bond Index (Agg) five year return of 2.27% by nearly two percentage points, annually.
We highlight dollar denominated emerging market bonds for a few reasons. First, we believe the current sell-off has provided an investment opportunity for income oriented investors with the additional potential for a rebound in price returns. Second, emerging market bonds are often thought of as extremely volatile but perhaps not to the degree that investors think. Over the last ten calendar years, they have had negative returns in three years (2018, 2013, and 2008) whereas the Barclays Agg has had negative returns in two calendar years (2013 and 2018). When the emerging market bond index was negative, it was down on average 5.46% compared to an average decline of just 1.82% for the Barclays Agg index. Yet following years of negative returns, emerging market bonds have rewarded patient investors and effectively doubled the returns of the Barclays Agg. Following 2008, EM bonds returned 12.63%, annualized, from 2009 to 2012 while the Agg returned 6.12%, annualized. Following 2013, EM bonds returned 6.59%, annualized, while the Agg returned 3.16%, annualized.
Given that emerging market bond coupons and pricing is closer to where it was in 2014 than 2009, we would expect returns to be more in the 6% range rather than 12%. We are not advocating a wholesale shift into emerging market bonds as the additional degree of potential volatility compared to traditional bonds can be hard to stomach. However, the long-term return potential and income spread above traditional bonds justifies an allocation in a diversified fixed income portfolio. On average, emerging market bonds yield 3.7 percentage points more than similar maturity treasuries, a valuation that is cheaper than the historical average spread of 3.19 percentage points.
An Update on MLPs
Master limited partnerships – energy infrastructure companies which transport oil and gas – have been a roller coaster asset class for investors over the last five years, with strong performance in 2013 (up 26%) followed by disastrous performance in 2015 (down 33%), a rebound in 2016 and a drop 2017 while other equity markets rallied. YTD, the asset class has been effectively flat, with the Alerian MLP Index returning 0.22% through the first six month so the year. The whipsaw nature of the asset class has been trying, but the long-term potential for strong returns is still present.
Crude oil and natural gas production are set to hit record highs in 2019, which increases volume flow for MLPs. With changes in exporting law, the U.S. is set to become a net exporter of energy products, which provides additional traffic for MLPs to take advantage of. Total oil and natural gas production have increased over 100% from 2009 as technology has lowered costs and made drilling more efficient.
In addition to increased production and volumes, valuations remain attractive, both relative to historic MLP averages and relative to other sectors in the market. At present, MLPs yield 9%, which is well above the ten year average MLP yield of 7.2%. Yields are currently 620 bps above Treasuries compared to a historic average of 463 bps.
They trade on an Enterprise Value to EBITDA multiple of 10.4x vs. compared to a historic average of 12.5x, a discount of 17.5%. Compared to other sectors within the market, MLPs are one of the few sectors trading below historic average valuations. For example, other energy sectors such as refiners and exploration and production companies are trading above their historic average valuations. Utilities, REITS and the S&P are also above their historic average valuations.
If volumes are growing, the U.S. economy is in relatively strong shape, the investment yields 9%, and valuations are attractive, why have MLPs not performed as strong investors would expect? First and foremost, there has been a large scale shift in how the business model is approached. Formerly, MLPs would pay out the lion’s share of income to shareholders and then issue more shares to fund CAPEX. Any cut in a dividend or reduction in dividend growth was seen as a sign of financial weakness and a reason to sell shares. However, after energy funding markets dried up in 2015, the business model needed to change. Now, more MLPs use their cash flow to both pay out dividends and finance growth. Dividend growth is not as strong as it used to be and while this lowers the attractiveness of the asset class to income oriented investors, it ultimately leads to a healthier financial picture and better long-term stability as companies are less dependent upon capital markets. While this shift is positive for the long-term, it leads to murkier earnings reports in the short-term as investors change the paradigm with which they have viewed earnings reports from MLP companies.
Second, the ownership base has shifted from retail to institutional shareholders. Retail investors, which at one point made up 76% of the MLP ownership base, have been prone to indiscriminate selling and are more likely to head for the exits upon an announcement of cuts to dividend growth. Retail investors now make up around 50% of the investor base, with institutions making up 40% and insiders accounting for the remaining 10%. As more ‘strong hands’ step into the MLP space via institutional accounts and sovereign wealth funds, we would expect that performance would even out and volatility would diminish. All things considered, MLP returns have been disappointing relative to other areas in the market but we believe the long-term thesis for strong outperformance remains intact.
The second quarter of 2018 continued to witness volatility across the stock market and a wide disparity between underlying sector returns. Within the U.S., tech stocks continue to lead the way, while areas like consumer staples and telecom fell sharply. International and emerging market equities were hit by trade fears, with EM stocks taking the brunt of President Trump’s threats for increased tariffs. Though the continued threats of a global trade war are concerning, the market could easily tip higher if there is resolution to the current spat. International equities have already priced in a significant discount to U.S. stocks (20%) and emerging market equities have fallen nearly 20% from their recent peak.
Fixed income markets ended the quarter in negative territory, with broad proxies for bond investments closing the second quarter down 1.62% for the year. Corporate and emerging market bonds have seen their yields increase to 4-6% as a result of increasing inflation expectations and rising spreads over Treasury bonds. We believe these areas, in addition to TIPS, offer compelling relative value within the fixed income market and are worthwhile areas to build out in a diversified fixed income portfolio.
Lastly, MLPs have been plagued by increased volatility and underperformance relative to the broad stock market in the last three years but are undergoing a reformation process that will put them in a stronger position for future growth. Valuations are trading at very compelling discounts and yields of 9% are significantly higher than any other area of the market. Though the whipsaw nature of how the asset class has traded in recent years is hard to stomach, we see a long-term outperformance opportunity within this space.
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 as of 6/30/18 unless otherwise noted. All MLP valuation and graphical information from Salient Investment Partners