In many ways, 2018 was the reverse of 2017. In 2017, almost all sectors within both the stock and bond market generated positive returns. In 2018, stocks suffered their worst calendar year return since the 2008 crisis. Even high-quality bonds, which usually act as a buffer for portfolios during times of volatility, provided negative returns to investors over the last year. 93% of asset markets posted a negative return in 2018, making it a worse year for investment markets than even 2008. We noted in our last commentary letter, which we sent out in December, it was a difficult year for diversified portfolios, with bonds suffering modest losses and stocks falling significantly. At WhartonHill, we favor value stocks for multiple reasons, including the fact that they often pay higher dividends and carry a greater margin of safety vs. their growth-oriented peers. This margin of safety usually provides better insulation during periods of volatility. However, in 2018, that was not the case. Value stocks, as displayed by the left column in the 2018 return table, fell anywhere from -8% to -13% last year, with the bulk of those declines occurring in the fourth quarter.
International equity markets, which trade at cheaper valuations than their U.S. counterparts, fell substantially as well, with declines of 13.4% for the MSCI EAFE index and a drop of 14.2% for the MSCI Emerging Markets index. Cash and high-quality municipal bonds were the only areas that generated positive returns, and even then, they were negative when adjusting for inflation. What this means for your many diversified portfolios is that returns this last year were disappointing, even those that favored time tested strategies of buying investments trading at discounted valuations and diversifying across markets in an effort to mitigate risk.
In light of that, we want to focus on two things within our recap and outlook: first, it is necessary to maintain a focus on long-term investing and not let a year where markets did not behave as expected derail a strategy that is designed for a multi-year, or even multi-decade, time horizon. Second, we are taking measures to address areas in the portfolio that underperformed more than expected.
On the first point, it’s important to note that markets often experience volatility similar to what was seen in 2018. On average, there is an intra-year drop of 13.9% in the S&P 500 during each calendar year. In 2017, that drop was only 3%. Last year, the peak to trough decline of 20% was greater than average and also compounded by the fact that the lion’s share of losses occurred in last month of the year, making it the worst December since 1931.
It was also unusual that the 2018 stock market decline occurred with the U.S. economy coming off the heels of its strongest two quarters of growth in the last decade. Typically, equity market volatility accompanies some significant growth scare or a reduction of high valuations, as it did in 2015 or 2011. Heading into the fourth quarter, valuations were trading close to historic averages and as we have noted in our ongoing commentary, economic growth has been strong. Suffice it to say, valuations are now trading below historic averages and are at their lowest level of the last five years. Whether or not stocks are pricing in a coming, economic slowdown is something we will touch on in the outlook. To quickly summarize, our view is that growth will decelerate, but a recession is not imminent.
On the second point regarding areas of underperformance, in many client meetings and past commentary we have noted the attractive valuations within international developed markets. At the end of 2017, growth was starting to pick up within Europe and Japan, and it seemed as though developed market economies were turning the corner. However, growth abroad has faltered during the year as uncertainty regarding Brexit and political discord in mainland Europe took center stage. As a result, we have shifted some of our developed international exposure to feature a more defensive investment that screens for companies with high quality fundamental characteristics and positive earnings momentum, which has helped mitigate some of the downside risk experienced and should provide for better returns in the future.
We also have highlighted in past commentaries and meetings the energy pipeline sector (MLPs), which possessed high yields and discounted prices. Our experience with this particular asset class has been an exercise in frustration. We focus on fundamentals and for the most part those have indicated future success. High dividend payout, a structure to encourage an increasing stream of income and, in the past, they have generally been insulated from the sharp swings of commodity prices. Yet while oil prices rose significantly earlier in the year and U.S. commodity production boomed, the MLP sector continued to underperform, prices became more discounted, and many companies cut dividends. Perhaps MLPs will perform well at some point in the future, but when the environment is ripe for strong company performance, as it was in 2018, and it fails to materialize in the share price, there is something that is not clearly understood about the business environment and we chose to exit the asset class.
As we reflect on the last year and take stock of where markets lie heading into 2019, we believe that markets have started to price in a recession occurring in the short-term, even though the economic and corporate data has not begun to reflect that possibility. Though markets are often forward looking and can often move before the data does, of the last 20 bear markets, just 11 were associated with a recession. The stock market is not a consistent predictor of economic distress. There are overreactions to both the downside and upside in stock prices. From our perspective, we have not seen flashing warning signs that a recession is imminent but are cognizant of a few conditions that might push us in that direction, whether it stems from continued trade hostility, or the Fed moving rates aggressively higher. These two actions were the driving force behind volatility over the last quarter, but there is reason to believe they may dissipate, and markets can recoup some of the ground that was lost as we start the new year.
Global Equity Markets
After the December sell-off, U.S. and global stock markets are trading below their historical average valuations. Whereas U.S. stocks were slightly expensive relative to their historic averages earlier in 2018, and international equities were below average, nearly all major markets are trading at a discount now.
Though valuations are cheap, it is always a reality that markets can get cheaper. Stocks don’t trade at average valuations for prolonged periods of time. They often overshoot to the upside, as they did in the late 90’s, for longer than investors anticipate. They can also overshoot to the downside, as they did in 2008 and 2011. In is our view that valuations may stabilize for a few reasons, the foremost of which is that they have fallen too far too fast, and the economy, though it is poised to grow at a slower rate, is unlikely to move into a recession. Our view on this would be different were valuations coming from significant highs back to average levels with substantial room to fall further.
It is possible there is more pain to come in the short-term, it is important to take stock of how much damage has occurred and what has happened in the past when markets have been this oversold. As of the last week of December, just 6 stocks (1.2% of the index) in the S&P 500 were above their average price over the last 50 days.
When stocks experienced this degree of selling and have seen their prices fall so far below recent levels, near-term returns over the next 6 months have been mixed but returns twelve months later have been positive 100% of the time. On average, the S&P 500 has been 23% higher after the type of selling pressure we saw in December occurs.
Regarding overseas markets, we noted in the introduction that we recently shifted some of our developed international exposure into a factor-based strategy that screens for companies with low valuation, quality balance sheets, and strong momentum. Our belief is that this strategy will help generate upside returns abroad while protecting against downside risks that are present due to political volatility and slow growth.
On emerging markets, fears of a China slowdown and the negative effect of tariffs sent equity prices lower in the first three quarters of the year. Of note is the outperformance in emerging markets during the fourth quarter of last year, where the MSCI EM index fell 7.6% compared to a 13.5% decline in the S&P 500, a spread of nearly 6 percentage points. In the current expansion, downdrafts in U.S. stocks were usually met with even larger declines in emerging market stocks, so it is encouraging to see emerging markets show some greater resiliency during this period. Part of the reason for that is due to weakness in the U.S. dollar, as the Fed reduced its guidance for rate hikes. If the Fed continues to move to a neutral policy stance and holds back on hiking rates, this could be supportive of emerging market currencies and assets. Another reason for recent EM outperformance is stimulus in China, which is likely to kick in as a response to the trade related slowdown. Tax cuts have been proposed to stimulate consumer spending, which totals around 80% of Chinese GDP. The Chinese central bank has also cut reserve requirements for banks, which should support credit lending and inject over $100 billion into the economy.
Looking forward, emerging market growth is still projected to significantly outpace developed market growth. Much of this is driven by younger demographics abroad, which leads to a greater working age population and increasing incomes. Emerging markets are likely to remain volatile but represent one of the better long-term investment options in a diversified portfolio.
The U.S. Economy
As the initial positive effects of tax reform wear off, there is poised to be more modest growth in the economy throughout 2019. 2018 saw the U.S. grow at a rate of around 3.0%, well above its average annual growth rate of 1.95% since 2008. Business optimism and low taxes are likely to help maintain growth this year, but higher interest rates and continued uncertainty regarding tariffs and trade are likely to keep a lid on the pace of growth going forward. The Institute of Supply Management surveys various manufacturing companies on a monthly basis to get their pulse of the economy. While this survey still shows the economy to be expanding, the difference in sentiment from the beginning of 2018 (fresh off tax reform) and 2019 (in the throes of a trade war) is stark:
At the end of 2017, global sales were on the rise and activity was robust. At the end of 2018, tariffs are consistently mentioned as an issue which is causing confusion over orders and sourcing, in addition to inflationary pressure. Apple recently cut earnings guidance with the primary factor being Chinese demand and “rising trade tensions with the U.S.” Multinational corporations are starting to feel the pinch of tariffs and we may see reductions in guidance going forward, though it is not all doom and gloom. On Paychex most recent earnings call, in the midst of the December sell-off, they noted that “If you look at the vectors in our business, they’re pointing up; not down. They’re not pointing neutral; they’re pointing up. When we look at the wealth of data we have on everything from clients who go out of business to sales to new clients, it looks positive to us.” Cintas, the uniform maker, responding to a question of slowing growth said “We have seen a pretty good economic environment and are not hearing signs of a slowdown…our guidance is pretty strong and reflects confidence going forward.” Trade concerns are certainly showing up in earnings reports and there is a high likelihood that it may dominate earnings calls this season. However, it is important to keep in mind that not all companies have reported disruptions from trade and there are still signs of optimism in companies closely tied to broad economic growth.
On the consumer, two areas we are closely watching are that of earnings and employment levels. The unemployment rate in the U.S. currently stands at 3.7%, significantly below its historical average and a sign that the jobs market is in very good shape. Typically, when recessions start, we see the jobs market begin to deteriorate, but it is important to note this has not happened. Hourly pay has also increased at a nice rate over the last year, with the Atlanta Federal Reserve’s wage growth tracker showing pay growth at 3.9%, its highest level of the current expansion.
Where the major risk lies for the economy and consumer rests in the two prongs of trade and Federal Reserve policy. If trade wars continue to hit business sentiment and slow expansion plans, it will start to push through to hiring plans and the jobs market. Regarding how long the impasse will last, it is impossible to know what President Trump’s next move with China is. Based on actions taken after the G-20 meeting in December, it looks that both parties are ready to make a deal and put the trade spat behind them. This is evidenced by Beijing’s move to suspend tariffs on U.S. autos, purchase U.S. soybeans, and pledge to revamp industrial policies that hurt foreign competition. On the U.S. side, Trump has initiated calls with Xi and is sending a team of officials to China in early January to push for formal proposals.
Secondarily, if the Federal Reserve insists on raising rates further from current levels, this will make debt more expensive and filter through to the housing market along with consumer and corporate balance sheets. We believe the Fed will pause its current rate hike campaign and signal to the markets that it is on hold until volatility dissipates, and inflation remains tame.
Central Bank Policy
The second major risk for the economy and markets revolves around future Federal Reserve policy. The Fed’s two official mandates are to maximize employment and stabilize prices. On employment, it is clear that their policy has been loose enough to help economic growth, with unemployment rates at multi-decade lows. Regarding price stabilization, a key goal for the Fed is to keep inflation in check. Over the last few years, inflation has ranged from zero percent in 2015 to 2.2% as of the most recent reading in November. Perhaps more importantly, inflation has simply failed to materialize and as a result, it begs the question over why the Fed should raise rates further if prices are generally in check and the labor market is healthy?
It seems this question has been in discussion amongst Fed officials, with the Dallas Fed President Robert Kaplan saying “it’s critical” that the Fed pay close attention to what the markets are saying with respect to interest rates starting to effect more cyclically sensitive parts of the economy and encouraging the Fed to not hike rates in the first half of the year. New York Fed President John Williams also said the Fed is “open to rethinking” rate hikes this year, indicating that recent volatility in the markets and some deceleration in economic growth would put the Fed on pause.
Now the market must wrestle with whether interest rate policy is too restrictive or whether the pause in rate hikes will encourage investors to dip their toe back into the stock market given recently discounted valuations. From a historical perspective, the idea that interest rates of 2.50% are “too tight” is laughable, especially considering that Paul Volcker hiked rates to 20% in 1981.
Though rates are not elevated from a historical basis, the markets are clearly focusing on whether or not their current levels are restrictive in the near term. After years of holding rates at zero, in a leveraged economy, there are going to be hiccups with increasing interest rates to any level. At present, the market is acknowledging that higher rates have led to a decline in mortgage issuance and refinancing and weakness in housing related sectors.
From our view, rates at their current levels are not too tight on lending or credit creation, though their elevated (relative to recent history) levels will take time to work through the economy and market and portend for slower growth than 2018. Again, this is not a recessionary issue but rather a deceleration that has been priced into stocks. Liquidity being created by central banks, through the form of low rates or quantitative easing has been a significant positive tailwind for stock markets since 2008. Liquidity being taken out of the market, through higher rates or quantitative tightening is a headwind that is presently being felt in stock markets. A more neutral stance or a pause in tightening programs by the Fed and other central banks can provide some alleviation and remains one of the factors that we are closely watching.
Global Bond Markets
Bonds did not provide their usual degree of protection during the market downturn, primarily due to the fact that bond yields were moving higher and prices were moving lower for most of the calendar year. Unlike many other periods of rising rates the coupons of many issues were too low to overcome the price decline. This is a result of 10 years of near-zero rates. The Fed’s rate hiking path put pressure on fixed income markets, which hurt bond investors, but has also worked to make future return prospects more attractive.
At the start of the year (2018), cash was yielding 1.52% and is now yielding 2.44%, an increase of almost 1 percentage point. Short-term corporate bonds have also seen a nice boost in income, with yields moving from 2.46% to 3.70%. The longer end of the maturity spectrum has not fared as well, with the 10 Year Treasury yield increasing from just 2.44% to only 2.65%. At one point during the year, the 10 Year Yield hit 3.2% but moved substantially lower during the month of December as traders flocked to safe haven assets. Floating rate bonds, an area we emphasized in the beginning of the year, were one of the best performing fixed income assets as they displayed little interest rate sensitivity and generated greater coupon returns for investors as the year moved on. On average, floating rate bonds are yielding 6.39%, and are compensating investors well for their spread above cash.
As we look towards the rest of the year, we believe it makes sense to own a mixture of short to intermediate maturity high quality bonds, whether they be corporates, agencies, or TIPS. Investors are not being adequately compensated to go further out on the maturity spectrum, particularly if the Fed is on hold with interest rate policy and longer dated yields may increase due to a confluence of factors which include rising inflation, less of a flight to safety, or other reasons. Floating rate bonds have fallen recently during the market volatility and anticipation of the Fed halting rate hikes, but we believe there is still opportunity for positive returns in excess of fixed coupon bonds. It is important to note that this is an area we continue to monitor closely given that there is greater sensitivity to risk and the economic cycle.
After a difficult year in 2018, we believe there are reasons to be optimistic in the next year. Equity valuations are attractive, both on an absolute basis and compared to fixed income yields. The economy has cooled a little bit from strong growth in 2018 but still looks poised to grow, with consumers feeling confident and the jobs market in healthy shape. Though interest costs have risen, and the impact of higher rates has reverberated in various sectors of the economy, we believe it is leading to a moderation in growth rather than a significant retrenchment.
One wildcard continues to be policy out of Washington D.C., and we are closely watching the ongoing renegotiation of trade terms with other countries, China in particular. Recent signs are encouraging and common-sense would point to a deal being made in the first quarter. However, it would have behooved both parties to reach an agreement at many points during the last year and common ground was not reachable. The ongoing tension from the trade war has begun to work its way into corporate commentary and we suspect it may continue to do so for at least the first quarter. The sooner a deal is reached the better for both U.S. and foreign markets.
As we manage your portfolios in the coming years, we continue to navigate the balance between taking advantage of long-term opportunities, as well as short-term risks. While we would love to avoid every drawdown that occurs within the equity market, we are mindful of the fact that volatility is a feature of the market, not a bug, and in order to benefit from the long-term return potential that stock markets offer, one must accept the fact that volatility is part of the journey. We appreciate the confidence you have placed in us and look forward to continuing working together.
Investment advisory services offered through Independent Financial Partners, a Registered Investment Adviser
WhartonHill Investment Advisory is not owned or controlled by Independent Financial Partners
The opinions voiced in this material are for general information only and are not intended to provide specific investment 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 via St Louis Federal Reserve, Bloomberg, Morningstar, and JP Morgan