As we wrote last quarter: economic health does not guarantee market health, and vice versa, at least in the short run. The fourth quarter of 2018 saw the mood of the stock market overshoot the relatively healthy economic data to the downside. Conversely, the first quarter of 2019 saw the markets rebound and perform extremely well despite economic data weakening all around us.
It is a “moody” market often exacerbated by sensationalized media coverage and access to quick-strike ETFs that make it ever easier for mood changes to quickly enter the market and blur fundamental valuation. For Q1, the mood was happy and client portfolios saw very strong equity performance as well as positive returns from fixed income.
The words “so far” feel increasingly necessary to attach to a lot of commentary. The consumer is holding up reasonably well...so far. The US debt and deficit burdens are being tolerated by the global bond market...so far. Earnings have softened but not enough to scare investors out of the market...so far. Part of this caveating of things is just instinct as the years of economic expansion and market rally have persisted for such a long time in this cycle. And, the other part of this caution is that the synchronized global growth that gave investors the “all clear” signal is now behind us. At best, global growth is mixed and out of synch; at worst, we are muddling through a synchronized global slowdown where central bankers are closer to easing than tightening.
On the positive side, the relatively healthy consumer drives a majority of the US GDP picture, and remains a positive offset to the negatives facing global markets and economies. Simplistically, if a consumer has a job, a lower tax bill, an appreciating 401k and equity in his/her home, then confidence and spending tend to sustain themselves. The housing market has not been stellar but is certainly more fundamentally healthy than the shaky underpinnings that led to the subprime crisis. As for the job market, it remains robust although monthly numbers have been volatile recently.
Considering the mixed outlook, we remain market weight and neutral to our benchmarks. We continue to lean on smart security selection, much like in 2018. It is rarely fun or prudent to be a market timer, and that is particularly true in this environment. We are fortunate to be able to look through the cycle on behalf of our clients to long term, patient compounding of assets.
Our portfolios are in a relatively neutral position, both in terms of dollars allocated but also in terms of sector and factor risk underlying. We are holding stocks that we think are quality, long-term investments but also with the ability to add exposure as opportunities open up. We seek stocks that we are comfortable holding through volatility should the worst of geopolitics and economics materialize while also capturing price appreciation and compounding value during good times.
The collective market mood has grown accustomed to downward earnings revisions and a less robust outlook. However, for the most part, there has not been a tipping point to outright fear and selling in the stock market so far. In fact, the “managing down” of expectations could allow for some upside surprises against a lowered bar. In any case, this year’s earnings will have harder comparisons to beat after the big bump they received in last year’s numbers from the tax changes. Q1 earnings season kicks off next week and will start to add clarity to the picture.
The global proliferation of technology has justified a relatively persistent overweight to technology in our portfolios. In many cases, the risks for many tech companies are more geopolitical and anti-trust in nature than customer, cost or profit margin related. We have been trimming and taking profits along the way, but have nonetheless remained materially invested in the sector. Positioning varies by strategy, but we also have small over weights in healthcare and consumer sectors.
The nature of growth and growth investing is evolving. The lifeline of abundant capital is sustaining growth companies to the detriment of the value investor waiting for cooler heads to prevail and eventually reward the out of favor value stocks as the growth stocks come back to reality. To the extent that growth (and growth in the absence of any near-term profitability) can be funded and sustained with a cheap cost of capital, the “moats” and customer bases that these growth/tech companies are able to create ultimately push value stocks further into a corner in terms of their ultimate viability and competitive positioning the longer this cycle stretches on.
During Q1, we moved our international equities recommendation up to neutral from underweight. The underweight served client portfolios well, but we felt that relative valuations made it the right time to add back to positions. However, within international, we remain skeptical of Europe and therefore have tilted our buying more to emerging markets and Asia. Our cross sectional view of Europe at this point leans to it being “cheap for a reason” as opposed to a great bargain.
While not the primary impetus for our adding to international, we do expect a China trade deal to help end the stagnation in international trade which should benefit international markets, especially multinationals, exporters and emerging markets.
In fixed income, our maneuvers have been similar to equities in that we spent much of 2018 retrenching back into our core, ballast holdings. For taxable clients, this is muni bonds and for tax-exempt clients, this is Treasury and Agency debt. In early December, we moved back to neutral fixed income by rotating our cash overweight into fixed income. We believe there will be fewer rate hikes in 2019 than the market was originally forecasting; bond yields are reasonable again and, if global growth does soften, bonds are an attractive holding.
Both the stock and bond markets are nervous about a potential “policy error” by the US Federal Reserve if it tightens monetary policy too far, too fast. Some argue that according to the inverted and distorted shape of the US yield curve that the error has actually already been committed and needs to be reversed via an immediate rate cut.
In our opinion, it is not a foregone conclusion that the Federal Reserve is done raising rates for this year or for this cycle. The same data dependent flexibility that they invoked to soothe the market from December onward could be reversed by a string of data pointing to a revival in growth or an increase in inflation. As much as the Fed has become a dovish bunch over the past decade, they are still central bankers at heart and should inflation actually return, it remains to be seen if they will have the gumption to resist more hawkish maneuvers, or at least more hawkish rhetoric, rather than deliberately allowing inflation to overshoot. In other words, it is easier to talk about letting inflation run above target now, when it is comfortably below target, than it will be to stay dovish when/if things actually break above target.
In the midst of the interest rate debate, there could be another round of political brinksmanship on the debt ceiling, government shutdown, deficit spending and fiscal cliff later this year.
Our positioning in opportunistic fixed income remains modest. We have a small exposure to dollar-denominated emerging market debt and high yield bank loans. We trimmed our high grade corporate bond overweight throughout 2018.
Ironically, “triple Bs” (BBBs), the lowest rated investment grade bonds appear more risky than bonds in the high yield (below investment grade) market. There is a large cohort of BBB-rated debt that would overwhelm the high yield market should it ultimately be downgraded and need to find a new investor base. Rating agencies have thus far allowed these BBB-rated companies a grace period of sorts to pay down some debt and deleverage. However, earnings could easily shrink faster than debt can be retired and result in a series of downgrades that would dislocate prices. herefore, we would look to a more pronounced spread widening in investment grade credit before adding any exposure there. We have room to add on weakness if valuations get sufficiently attractive.
We are considering positions in gold or other safe haven assets, but are comfortable with basic cash as an offset to more volatile exposures elsewhere in portfolios for now.
The recovery from the late December market lows was a welcome relief to portfolios. However, the decisiveness of the recovery seemingly pulled forward some of the best return scenarios for 2019 and argue for caution, or at least more modest expectations, for the remainder of the year.
While no one roots for the downside of a business or economic cycle, there is such a phobia in the media and politicized central banks of ever allowing anything bad to happen that it risks compromising rational, orthodox policy and distorting meritorious access to capital. Asset bubbles will inevitably be created if the goal is to never allow any sort of recession or market correction. It is folly to be trying to banish downturns forever, particularly if debt dynamics get out of control in the process—this approach could make the ultimate reckoning more painful—yet this is seemingly the risky corner that central bankers, politicians and media have painted us all into. These reactionary policies and hypersensitive markets are likely to result in continued market volatility and suggest a cautious approach in the months ahead.