Altair Insight: Fundamentally Firm (4Q18) – Quarterly Market Review
After a year that upended almost every asset class, it would be understandable if some investors entered 2019 with trepidation. The fourth-quarter sell-off that negated solid gains in U.S. stocks over the first three quarters deflated confidence going into a new year that, like many, seems fraught with risk.
Amid all the doubt posed by the U.S.-China trade war, slowing global growth, Federal Reserve tightening and a decelerating U.S. economy, we still see a year that shapes up to be significantly better than 2018 and a landmark for this economic expansion. We expect the bull market to surpass the 10-year mark in March and the expansion to become the longest in U.S. history in July.
This hardly means we view the economy or the markets through rose-colored glasses or that we are dismissive of the substantial risks. A number of wild cards are in play that will shape political outcomes for the better or the worse and could resurrect market turbulence.
However, beneath the trend of slowing growth that dominated headlines and cast a gloom over markets through the fall and early winter lies a still-solid foundation. We believe the plunge in risk assets was overdone in light of this firm economic footing, and even with a January rebound the outlook remains positive.
A slowdown does not mean a global recession is around the corner or that the U.S. economy is headed for trouble this year. Both the domestic and world economies are still expanding and can remain healthy assuming the trade stand-off eases and the Federal Reserve backs up its recent statements with a pause in interest-rate hikes, both of which we believe to be likely.
While we are not recommending taking on more risk in portfolios, we do think the market shake-up presents some opportunities to increase allocations in a couple of particularly beaten-down asset classes that now offer attractive valuations. Therefore, we are advising clients to increase allocations to U.S. small caps and emerging-market stocks, shifting assets from a global stock fund. In addition to this tactical trade, the market turmoil also has pushed some portfolios to be out of balance from their targets and now need to be rebalanced.
On the whole, we believe conditions remain sufficiently promising for clients to remain fully invested at their asset allocation targets across the higher-, medium- and lower-risk categories.
As we stay the course, we want to take this opportunity to pay tribute to the late John C. “Jack” Bogle, who helped make that one of the investing world’s mantras. The Vanguard Group founder, rightly regarded as the conscience of the financial services industry, left behind an enduring legacy with his passing on January 16th.
We share many of the investing beliefs that he so passionately advocated. Among them: Avoid a high-cost, high-turnover approach. And avoid emotional or impulsive moves – “Have rational expectations for future returns and avoid changing those expectations in response to the ephemeral noise coming from Wall Street.”
Hear, hear. Rest in peace, Mr. Bogle.
Our quarterly review of the markets through the lens of five select topics looks at the causes behind 2018 volatility, prospects for the rest of 2019 and some opportunities.
1. The markets and the economy became atypically disconnected in 2018.
“You must remember this …
The fundamental things apply
As time goes by.” – Song lyrics from “As Time Goes By,” by Herman Hupfeld
Imagine for a moment that you made a New Year’s resolution a year ago to forswear all news in 2018, perhaps holing up in the International Space Station or a Tibetan monastery to avoid Twitter. Upon your return in 2019 you are told only a few select facts about what happened during your time offline:
- The U.S. economy had its first year of at least 3 percent growth since 2005.
- Global GDP, while slowing, expanded at an above-trend pace.
- U.S. unemployment fell to a 49-year low of 3.7 percent and ended the year at 3.9 percent.
- Employers added the most jobs since 2015.
- Corporate earnings rose by about 24 percent, the most since 2010.
- Core inflation held steady at around 2 percent.
Then you open your year-end statement and find it was a year when almost every asset class went backward. What dire event, or events, could have prompted this disparity?
U.S. stocks had their worst year in a decade and the Standard & Poor’s 500 logged only its second calendar-year loss (-4.6 percent) since 2002. International stocks fared even worse, their decline worsened by the rising dollar. Taxable bonds as measured by the benchmark widely known as the Agg (Bloomberg Barclays U.S. Aggregate Bond Index) had their fourth-worst year in the past half-century, with a rare full-year decline. Commodities (especially oil), REITs and hedged/opportunistic strategies all lost money. Only municipal bonds and cash had gains.
Even factoring in worries about the trade war and tighter monetary policy, we do not believe the steep fourth-quarter sell-off that produced those returns was justified by economic fundamentals.
Markets of course are forward-looking and take the global big picture into account, so more than just robust 2018 U.S. data shaped last year’s returns. The world’s largest economy remains the driving force behind global economic growth and continues to power a nearly 10-year-old bull market, however, and we think it likely those trends will continue for at least the first half.
The economy’s momentum is likely to slow this year, but not to the point of contraction. We continue to track multiple key indicators, and even with some recent softening the majority are solidly positive and not flashing a recession warning.
Recently there has been some lackluster data in consumer confidence, the housing market and capital spending by businesses. We are closely watching these vulnerabilities to see if they worsen and spread to other areas. Yet overall the economy continues to be in good shape, led by solid consumer spending which accounts for about 70 percent of GDP.
An important canary in the coal mine for recession-watchers is the Conference Board’s U.S. Leading Economic Index (LEI), which combines 10 forward-looking economic indicators including building permits, three measures of factory orders, new unemployment claims, consumer expectations, hours worked in manufacturing, stock prices, a credit market snapshot and the interest rate spread. No U.S. recession has ever begun without the LEI falling first for months on end, and it currently is high and rising – up in 18 of the past 20 months.
Internationally, the outlook is clouded by several potential economic or political flashpoints (see topic #3 below). Yet even amid the persistent concerns about waning growth that hang over markets, the World Bank has deemed the global economy healthy despite the reduced momentum.
Volatility is likely to continue at a high level in at least the first part of this year. But we do not see a recession on the horizon and feel there is still time left in this expansion. That belief keeps us committed to full allocations to both U.S. and international stocks.
2. We expect the framework for a trade war deal to be established within months but not without bouts of market volatility in the interim.
Trying to predict the end of a political dispute is tricky. Unlike with corporate earnings, GDP and even Federal Reserve rate increases, there is a limited trail of relevant economic data on which to base a forecast. The lack of clues means markets lurch up and down in response to every related rumor and tweet.
The increasing incentives for both Presidents Trump and Xi to ratchet down the U.S.-China stand-off lead us to believe at least a partial agreement will be reached in the months ahead. However, no overall quick fix is likely to resolve complicated differences over trade, cybersecurity and intellectual property theft. With a final resolution likely to require lengthy negotiations, market volatility tied to the trade war will probably continue past the 90-day truce period that ends March 1st.
The dispute has weighed heavily on the global growth story that propelled markets in 2017 and much of 2018. The residual effects of the trade war include softening in the Chinese economy, a stronger dollar, weakness in emerging markets, waning demand for oil and commodities, falling consumer confidence and a drag on U.S. business spending. Global trade volumes have declined, contributing to the growth slowdown.
The direct impact from trade tensions has not been material on the U.S. economy so far, however. The total effect on U.S. GDP growth from tariffs was estimated by the International Monetary Fund recently at a modest 0.3 percentage-point drag over two years, even if the Trump administration proceeds with threatened tariffs on all Chinese imports.
The additional threat that another $200 billion in tariffs taking effect in March will pose to China’s economy should prompt President Xi Jinping to negotiate more urgently toward a settlement. Tariffs already have been levied on roughly half the country’s annual exports to the United States, and its manufacturing, consumer spending and stock market all have slumped. While Beijing can use stimulus measures to try to offset the impact, the trade war remains the biggest risk to China’s near-term growth.
President Trump, too, also has compelling reasons to wind down the stalemate. As next year’s election draws nearer, he needs to avoid the damage to the stock market and economy that a more protracted trade war could inflict. He already has taken steps to lessen trade tensions with the European Union and with NAFTA 2.0 in North America, although neither front is fully resolved.
The United States and China account for 40 percent of global trade, so the stakes are high for the world economy in this dispute. Now the stakes are rising sharply for the two leaders, which should hasten a meaningful truce of some kind.
We expect the framework of an agreement easing trade tensions to be reached as 2019 moves along, even if the absence of a swift final resolution means uncertainty lingers for markets.
3. Global growth hinges on more than settling the trade war.
While the United States remains on firm footing, the outlook for the world’s other leading economies is less certain.
Slowing growth in key regions is complicated by other threats, including geopolitical tensions, rising populism, the prospect of global monetary tightening and high sovereign debt levels.
We are keeping close tabs on these issues and the darkening skies abroad, to use the World Bank’s term, as they can alter the pace of the global economy for better or worse. Many of the risks, however, already are reflected in depressed market valuations that seem based on highly pessimistic assumptions. As long-term investors, we are intent on balancing the risks with the potential rewards, which are likely to come eventually with an improved outlook.
The risks appeared to heighten recently when two primary engines for growth in Europe and Asia contracted in the third quarter. Germany had its worst year since 2013 with growth estimated at 1.5 percent, slowed by the trade war, falling car sales and other issues as it nears an important political transition with Angela Merkel leaving the chancellorship. Japan, too, faces a stiffening test in 2019 after its fragile recovery stumbled and persistently low inflation fell below 1 percent.
Staunch monetary support from central banks remains in place in both regions, however – an important linchpin of our continuing faith in the category. The European Central Bank, while having ended quantitative easing in December, has pledged to keep interest rates at record lows until at least this fall and said it will resume easing if needed. Japan, too, has signaled its readiness to ramp up stimulus.
Another top-five economy, the United Kingdom, has been so hard-hit by Brexit pressures that it is expected to tumble from fifth to seventh in the world rankings, behind India and France. Even if the country manages to delay or avoid crashing out of the European Union in a “hard Brexit,” it will be difficult to reverse all the economic damage already done.
China, while officially designated an emerging economy, will have a huge impact on how the developed category fares by virtue of its demand and trade capacity. Its own slowdown precedes the trade war and will not be fully reversed by an economic peace treaty. What provides hope in the short term is Beijing’s stepped-up spending on infrastructure to spur demand, along with its interest-rate cuts.
Despite these significant risks, the considerable upside potential at these valuation levels keeps us committed to our target allocation to developed international stocks.
We are optimistic about the potential for this asset class and expect it to be a net beneficiary of a trade war resolution and possibly a falling dollar. We especially like the diversification benefits of non-U.S. stocks, which held up much better than their peers during the December downturn. And we see especially promising prospects for emerging-market stocks – more on that in #5 below.
4. The Fed must act prudently to keep this business cycle going and we believe that it will.
Fed Chairman Jerome Powell stubbed his toe in December and investors felt sharp pain. As a result, we expect Powell and the Fed to be especially careful about increasing interest rates this year.
The stubbing, while figurative, comes from Powell’s own metaphor. He had suggested that raising rates is like moving in a dark room full of furniture: You proceed extra cautiously to avoid bumping into anything. Soon afterward, the Fed raised rates, projected two more increases in 2019 when none were expected and signaled via Powell that the plan to aggressively shrink its $4 trillion balance sheet was on autopilot.
Ouch. The additional blow to already-reeling markets helped seal the worst quarter in a decade. Four interest-rate hikes in 2018 plus a $420 billion reduction in the balance sheet contributed to last year’s turbulence. Signaling a more flexible approach, as the Fed did in late January by projecting no 2019 rate hikes, can go a long way toward keeping markets stable this year if it sticks to its apparent decision to put its normalization push on hold.
Normalization of monetary policy – increasing short-term interest rates to more normal levels after years of being held artificially low to stimulate the economy and shrinking the balance sheet – is a worthy goal that we generally support. It fits with the Fed’s mandate to pursue maximum employment, stable prices and moderate long-term interest rates.
Even with a solid economy, however, the Fed cannot be tone-deaf in plowing ahead with a preset course. As New York Fed President John Williams said recently, the motto of “data dependence” is more relevant than ever.
The stock market, as a leading indicator, provides some of the key data the Fed must consider. Inflation that continues to be tepid at around 2 percent, too, suggests little need for the central bank to rush ahead with a 10th rate hike since 2015. If it does, it risks inverting the fast-shrinking yield curve between the two-year and 10-year Treasury yields – an event that historically has preceded recessions by pinching bank lending margins and contracting loan activity.
Importantly for investors, Powell took a more conciliatory public stance in early January and the Fed doubled down on it at its January 29-30 meeting, removing references in its statement to gradual hikes and suggesting it could even reduce them if needed. The central bank’s assurance that it will remain patient on any future rate moves gives us confidence that overtightening is unlikely in 2019. Slowing the pace of its balance sheet reduction, which the Fed said is under consideration, would be another plus for the economy and for markets.
Based on current data, there is arguably no need for further increases any time soon; the economy is not over-heating. A Fed pause in its rate-hike cycle will help keep this expansion going and markets stable.
5. We believe markets overreacted in the recent downturn and we are making moves to capitalize on some opportunities that emerged as a result.
Rahm Emanuel, Chicago’s outgoing mayor, once famously said “You never want a serious crisis to go to waste.” And just as opportunities can emerge from a political crisis, they also can present themselves after market sell-offs. With this thinking in mind, we are overweighting a couple of now-promising equity categories after they were battered in 2018.
U.S. small-cap stocks‘ drop into a bear market left them oversold, growing faster than large caps and forecast to report another year of double-digit earnings. While larger companies are under more direct pressure from the U.S.-China trade dispute and a broader overseas growth pullback, we expect smaller, domestically focused companies to outpace the performance of multinationals.
The decline in the benchmark Russell 2000’s price-earnings ratio has been dramatic – back to 2013 levels – after investors became concerned about the impact of higher interest rates on smaller companies, which usually utilize higher levels of leverage. After a 30 percent peak-to-trough slide last fall – including 12 percent in December, the index’s worst month ever – it would take a significant deterioration in macroeconomic conditions to realistically justify a further decline.
U.S. small caps should flourish under a steady economy once the trade war dissipates, as we anticipate.
Emerging-market stocks, a historically volatile asset class, could face more upheaval before the current period of market swings is over. But their valuations are attractive, and we find the asset class compelling despite the risks.
The iShares MSCI Emerging Markets ETF has a price-to-earnings ratio for the trailing 12 months of 11.2, well below the 13.1 median of the past five years. The discount is even greater when compared to developed international and U.S. stocks, which both are above their 10-year averages.
We believe emerging markets will benefit from both the Fed’s likely pause in raising interest rates and a halt to the dollar’s steep ascent. Higher rates and a stronger dollar contributed heavily to last year’s 15.3 percent fall in the emerging markets benchmark, with crisis-ridden Argentina and Turkey among those experiencing particularly steep declines. Once fears of both those trends fade, investors should return to these stocks in great numbers – especially if there is at least a partial resolution of the trade war.
Cheaper valuations generally result in better long-term results. We are willing to increase our allocations to these two categories at today’s depressed prices despite the risks given our intention of holding these positions for an extended period.
We recommend staying fully invested to your risk allocation targets. Despite slowing growth, the U.S. economy is solid, driven by a strong consumer backdrop; the global economy remains healthy, and valuations are more attractive after the late 2018 sell-off.
The most attractive asset classes are U.S. small caps and emerging-market stocks, which were hit disproportionately by the sell-off. Where appropriate, we plan to overweight these two categories.
We believe a recession is unlikely in 2019. The narrowing yield curve between the two-year Treasury and the 10-year Treasury – a historical precursor to recessions – has yet to invert and leading economic indexes show no economic contraction in sight.
The appearance of recessionary signs, a deepening of the trade war or an inversion of the yield curve would likely cause us to position more conservatively.
The volatility that disrupted most markets in 2018 will likely resurface periodically during the first half of this year. Geopolitical risks remain high, with current concerns involving China, global trade, Brexit, Europe’s economy and erratic oil prices.
Bonds should benefit from a more dovish Fed, with a pause to its rate-hike cycle pledged. They also retain their valuable role as buffers for portfolios in the event of more extreme volatility with stocks.
Quotes of the Quarter
“A softer economic outlook doesn’t mean we should prepare for doom and gloom.” – John Williams, New York Federal Reserve president
“If we avoid a recession, we’re going to have a really good market.” – Jeremy Siegel, Wharton School finance professor
“No one is in a position to dictate to the Chinese people what should not be done.” – Xi Jinping, Chinese president
An abrupt turnaround in the final months of 2018 spoiled what had been another good year for the U.S. market. Coming off their best quarter since 2013 from July through September, U.S. stocks tumbled nearly 20 percent from their all-time high by late December and logged their worst yearly performance in a decade. The iShares S&P 500 ETF, which had been up 9.9 percent through three quarters, finished negative 4.6 percent for the year after sinking 13.2 percent in the fourth quarter.
Investors were spooked by two issues that hung over the markets for much of the year – the U.S.-China trade war and ongoing interest-rate hikes by the Federal Reserve – and ultimately rushed to safety amid additional concerns the U.S. economy’s 2018 growth spurt will fade in 2019. Those fears accelerated after the Fed raised rates for a fifth consecutive quarter in mid-December and a dispute over border security shut down the federal government.
Health care (+6.3 percent), utilities (+4.0 percent) and consumer discretionary (+1.7 percent) were the only positive S&P 500 sectors for the year. Energy (-18.1 percent) was the big loser as a result of the 25 percent slide in oil prices. Technology’s 17.3 percent pullback in the fourth quarter left it negative for the year (-1.6 percent) as the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google parent Alphabet) that have fueled the market’s climb in recent years reversed course.
Smaller stocks fell even harder in the risk-off environment. The iShares Russell 2000 Index ETF went from double-digit gain for the year to double-digit loss after a 20 percent drop in the fourth quarter, returning negative 11.1 percent for 2018.
Growth underperformed value as an investing style at all market capitalization levels during the sell-off after a long period of lofty gains. For the year, the iShares Russell 1000 Growth ETF still was only narrowly negative with a loss of 1.7 percent compared with an 8.4 percent decline for its value counterpart.
A year after non-U.S. stocks posted their best performance since 2009 when the dollar’s value fell, the greenback reversed direction and so did returns.
Besides the dollar’s 4 percent rise against a basket of other major currencies, concerns weighing on international stocks included rising rates, economic downturns in Germany and Japan and worsening expectations for global growth as the U.S.-China trade dispute proceeded. Geopolitical flashpoints emerged throughout the year involving Brexit, Italian debt and crises in Turkey, Venezuela and Argentina, and in December the European Central Bank ended its stimulative bond-buying program.
The iShares MSCI All-Country World ex-US ETF, a dollar-denominated proxy for stocks in both developed and emerging markets, slipped 11.2 percent in the fourth quarter to finish the year with a 13.9 percent decline. Multiple overseas markets had their worst calendar year since the financial crisis: Venezuela was down 94.9 percent in dollar-denominated terms, Argentina was down 50.2 percent, Turkey was down 43.4 percent and China’s Shanghai composite was down 28.6 percent. Ukraine’s market was the top performer worldwide in 2018 with an 80.4 percent gain.
The iShares MSCI EAFE ETF, which gauges stocks in Europe, Australasia and the Far East, sank 13.7 percent for the year, suffering almost all of the loss in the final quarter (-12.6 percent). Before returns were converted into dollar denomination, the index was down 12.2 percent for the quarter and 10.5 percent for the year in local currencies. The Stoxx Europe 600 index shed 13.2 percent, the United Kingdom’s FTSE 100 Index fell 12.5 percent and Japan’s Nikkei Stock Average declined 12.1 percent – all experiencing their biggest losses since 2008.
The iShares MSCI Emerging Markets ETF sank well into negative territory in the first half of the year and retreated 15.3 percent for the full year. It did outperform other international and U.S. stock categories during the fourth-quarter sell-off, falling 7.6 percent compared with double-digit drops for the other equity asset classes.
U.S. real estate investment trusts remained positive in the rising-rate environment for most of 2018 before the market-wide stampede from risk in December tipped the category negative for the year. The Vanguard REIT Index Fund ended down 6.0 percent after a 7.9 percent decline in the final month. It was the first full-year loss for U.S. REITs since 2008.
Higher interest rates and rising geopolitical and trade uncertainty pressured the category. REITs were underpinned for much of the year by the solid U.S. economy.
International REITs as benchmarked by the Vanguard Global ex-U.S. Real Estate ETF declined 4.2 percent in the fourth quarter to finish down 9.5 percent for the year.
Growing anxieties about the weakening global outlook and an oil supply glut helped send crude prices tumbling 41 percent from their peak and down 25 percent for the year, weakening the entire commodities complex. Record U.S. shale output and a limited supply cut by OPEC and others also contributed to the skid.
A 10.7 percent drop in the fourth quarter left the iPath Bloomberg Commodity Total Return ETN down 13.1 percent for the year. It was the index’s seventh calendar-year decline in the last 11 years, denying at least temporarily the expectation for commodities to rise late in an economic cycle.
Besides energy-related commodities, copper, coffee and sugar all saw declines of more than 20 percent for the year, affected by the global growth slowdown, the U.S.-China trade fight and related demand issues. Cocoa finished with a substantial gain while wheat, corn and cattle logged modest gains.
Coming off a solid year in 2017, hedge funds disappointed during the high volatility of 2018 – struggling to find safe havens, with virtually all asset classes declining. Managers failed to successfully navigate the market’s wide price swings, rising rates and political uncertainty, resulting in a worse year for hedge funds than for U.S. stocks.
Equity hedge funds led the losses during the late-year sell-off, with many funds paying the price for having bet on companies’ stocks to rise further. The HFRX Equity Hedge Index, which tracks both long and short equity-related strategies, slid 8.6 percent from October through December to finish with a 9.4 percent loss for 2018. The HFRX Global Index, an overall benchmark for hedge-fund strategies, ended up with a negative 6.7 percent decline for the year after falling 5.6 percent in the fourth quarter.
Taxable and tax-exempt bonds rallied in the fourth quarter to somewhat salvage what had been a down year. Interest rates plunged during the dramatic sell-off in stocks and the 10-year Treasury yield fell 0.3 percentage point in December to finish 2018 at 2.68 percent, down from its peak of 3.24 percent while still up from the 2.41 percent where it began the year. Bond prices rise as yields fall.
Municipal bonds were virtually the only asset class to come away from 2018 with gains, benefiting from a double-digit decline in issuance, governments’ strong revenue growth and fiscal discipline and the late-year dash into bonds. A blend of the Market Vectors’ short and intermediate ETFs that serves as Altair’s investable benchmark for the muni market gained 1.6 percent for the year on the strength of a 1.7 percent fourth-quarter advance.
Taxable bonds ended essentially flat thanks to the flight to safety. The Vanguard Total Bond Market Index ETF, which tracks the performance of the investment-grade U.S. taxable bond market, enjoyed its best month of the year in December with a 1.6 percent rise that left it 0.4 percent off for 2018.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.