Investment Commentary: Fourth Quarter 2018

  • January 10, 2019

Looking Back: Market Review

U.S. and global stocks dropped sharply in the last quarter, capping a year marked by turbulence and losses across most asset classes. Among investors’ worries are signs of a global economic slowdown, exacerbated by ongoing Federal Reserve monetary tightening, U.S.-China trade tensions, and political uncertainties in Europe and the United States.

After tumbling 7% in October and then stabilizing in November, U.S. stocks fell again in December as investors reacted negatively to the Fed’s language surrounding its 25-basis-point rate hike. While the Fed’s updated forecast implied one fewer rate hike in 2019 than previously communicated (two instead of three), Fed chair Jerome Powell gave no indication it would ease up on its balance sheet reduction program (rolling off hundreds of billions of maturing assets purchased during quantitative easing), nor that a pause in rate hikes was imminent (although he didn’t rule it out). As one commentator summed it up: “This was a more dovish Fed, but not dovish enough for the markets.”

Large-cap U.S. stocks dropped 9% in December and fell 13.5% for the quarter (its worst quarter in seven years). For the year, U.S. stocks were down a more modest 4.4% (total return). The negative year broke the S&P 500’s remarkable nine-year run of positive returns. Smaller-cap U.S. stocks fell more sharply, losing 20% in the fourth quarter and 11% for the year. Foreign stocks struggled as well, with developed international markets and emerging markets both down for the year 13.3% and 14.5% respectively. However, their underperformance versus U.S. stocks came earlier in the year. In the fourth quarter, emerging-market (EM) stocks beat U.S. stocks by seven percentage points, while developed international stocks outperformed the U.S. market’s return by 1%

Core bonds, which typically perform well when stocks do poorly, had losses through November. But a strong rally in Treasury bonds in December resulted in a slight positive for the year.

What stands out about 2018 is the breadth of negative returns across almost every type of asset class and financial market, whether government bonds, corporate credit, equities, or commodities. (And don’t forget cryptocurrencies: Bitcoin plunged 72% for the year.) A study done by Deutsche Bank in mid-November noted that 90% of the 70 different asset classes they track were posting negative returns for the year. This was the highest percentage of losers in the study’s 100-year history.

Simply put, it was extremely difficult to make money in the financial markets last year.

The contrast with 2017’s strong market results is also striking—and serves as a useful reminder of the unpredictability of markets. It may feel like ancient history, but it was only a year ago that we were reporting 25% to 30%-plus returns for international and EM stocks. U.S. stocks were tallying 20%-plus gains, market volatility was at a historical low, daily market price swings were exceptionally muted, and losses were few.

It also reinforces the importance of maintaining a balanced perspective: when an outlook becomes the overwhelming consensus view, you should assume it is already reflected to a strong degree in current financial market prices. Extremely high (or extremely low) asset prices and valuations are already discounting extremely optimistic (or extremely pessimistic) outcomes. Those circumstances can create opportunities for fundamental, valuation-driven, long-term investors such as ourselves and many of the active managers with whom we invest.

Looking Back: Key Drivers of Our 2018 Portfolio Performance

While we’d never predict what the stock market will do in any given year, U.S. stocks’ poor performance in 2018 wasn’t a complete surprise. Overall our portfolios have been reducing exposure to  U.S. stocks. This is based on our “medium-term” (five- to 10-year) forward-looking analysis of valuations, normalized earnings growth, and dividend yield, across a range of scenarios we view as reasonably likely or plausible.

In our balanced portfolios, the proceeds from our underweight positions in U.S. stocks have been tactically allocated to international markets and mid-stream infrastructure, where our analysis strongly suggests there is higher return potential over the medium term. We also have meaningful allocations to low duration and flexible bond funds, as well as dollar denominated emerging market bonds, to complement our core intermediate investment-grade bond holdings.

In 2018, the results of these portfolio allocations were mixed. As noted above, in absolute terms, most investments were negative for the year. However, several of our actively managed core and flexible-oriented bond funds posted positive returns.

But overall, it was a very challenging year for our globally diversified active portfolios, driven by sharp declines in international and emerging stock markets and underperformance from most of our active international equity managers. Although, our internally managed U.S. Core and Dividend equity strategies were a small bright spot of relative performance.

U.S. stock market outperformance versus the rest of world is reaching an extreme relative to history. We don’t believe this trend is sustainable either. The last 10 years’ performance is certainly not going to repeat over the next 10 years. We don’t believe global equity investing is dead or destined to perennially underperform the U.S. market. During the market rout in the fourth quarter there were some glimmers that this cycle may be in the process of turning, with EM stocks outperforming the S&P 500 by seven percentage points.

Looking Ahead: Investment Outlook and Time Horizon

In past letters, we’ve emphasized the importance of having a long-term perspective to produce investment success. In fact, the terms “long term” and “investor” are inseparable in our mind. With a long-term perspective comes the necessity of discipline and patience.

The chart to the right is a nice representation as the time horizon lengthens, the range of reasonable expected outcomes narrows, the shorter-term cyclical spikes and dips are smoothed out, and the underlying fundamental / economic drivers of financial asset returns become apparent.

With that framework in mind, we’ll discuss our current outlook on the markets.

Short Term (12 Months)

Over the next twelve months, uncertainty is high and the range of potential equity market outcomes is wide. There are reasonably likely scenarios that would be very positive for our portfolios given our positioning. And there are scenarios where our portfolios wouldn’t do as well. However, we don’t make investment decisions based on a short-term forecast, outlook, or prediction; the uncertainty is too high, the unknowns too many, and the range of potential outcomes too wide for us to have the confidence to do so. But we do construct and manage our portfolios to ensure our clients exposures to risk are consistent with each portfolio’s defined risk objective.

As such, we will highlight two divergent short-term macro scenarios: one bullish for stocks and one bearish. Each scenario reflects the 2019 outlook of a highly respected, independent, macroeconomic investment research firm whose research we follow: BCA Research and Capital Economics. We think either of these scenarios has reasonable odds of playing out (as well as any number of variations on them). But each has very different implications for investment returns.

BCA’s Bullish Scenario

BCA sees slowing but still solid U.S. economic growth next year. They expect a reacceleration of global growth in the second half of the year, as the effects of more aggressive Chinese fiscal and monetary stimulus kick in and the drag from tight financial conditions dissipates. Given solid U.S. growth and further employment gains, they expect the Fed to continue its gradual path of interest rate hikes—several more hikes next year than the market currently price. As such, they see the U.S. dollar strengthening until the middle of the year (due to stronger U.S. growth and higher U.S. rates relative to the rest of the world), but then weakening as growth outside the U.S. reaccelerates. They believe asset markets have already discounted the deceleration of growth they expect to see in the first half of the year. In this scenario, a U.S. recession is unlikely until late 2020. If so, “this will provide enough time for a blow-off rally in stocks starting in mid-2019.”

Their broad expectations for financial assets in 2019 are as follows: Global equities will generate low double-digit returns. Cyclical/value stocks will outperform more defensive stocks, driven by a strong second half of the year. International and EM stocks (which are undervalued and have more cyclical exposure) will likely outperform U.S. stocks during this period. A declining dollar will be an additional tailwind to dollar-based investors in foreign markets. Meanwhile, core bond returns will be hurt by rising interest rates and credit-oriented bond funds will outperform.

Our portfolios should perform well in this BCA bullish scenario given our current positioning: significant exposure to foreign stocks and flexible bond funds. Portfolio performance could be directionally like 2017, if not in magnitude.

Capital Economics Bearish Scenario

Capital Economics is not forecasting a U.S. recession in 2019, but they expect the economy to slow “sharply” due to tighter monetary policy and the fading boost from the 2018 tax cuts. They estimate the Fed will hike rates two more times in early 2019 but begin cutting rates in 2020. They expect the Chinese economy to lose momentum but then stabilize by the middle of the year due to monetary and fiscal stimulus. Overall, they expect slower global growth than the consensus expects, driven by slowing global demand and tighter financial conditions. However, they don’t see a repeat of the EM crisis fears that gripped the markets in 2018. They expect the U.S. dollar to weaken as Fed rate cuts come into view while other major central banks remain on hold.

The implications for financial assets in 2019 are as follows: U.S., international, and EM stocks will all have losses next year. Despite their lower valuations, foreign markets will be dragged down by falling U.S. stocks, but U.S. stocks will experience the steepest declines. Core bonds should do okay. The dollar will remain strong for much of the year, but then weaken as the 2020 Fed rate cuts come into view.

This type of bear market scenario would likely be negative for our portfolios in the short term. But the key point is that our analysis shows the potential 12-month loss in such a scenario to be consistent with the downside risk threshold for each type of portfolio we manage and would represent normal volatility for our long term time horizon and is not the sort of volatility we believe offers any success for attempted timing.

Medium Term (5 – 10 Years)

As we extend the time horizon closer to the length of a typical market cycle, our confidence in analyzing potential returns increases meaningfully. This creates opportunities to tactically tilt our portfolio to asset classes and strategies where we believe the investment odds are strongly in our favor. We may also underallocate to areas where the risk-return profile is very unattractive.

Presently, we have a high level of conviction that international stocks will earn significantly higher returns than U.S. stocks over the medium term. This is reflected in our portfolio allocations. Also, because we expect returns to U.S. stocks and core bonds to be quite low over this time frame, we are underallocated to those areas and are confident our positions in flexible fixed income funds will prove beneficial as well.

Our base case expectation suggests we can reasonably expect low single-digit annualized returns from U.S. stocks over the medium term. We also consider a more optimistic but less likely scenario that assumes S&P 500 sales growth and profit margins sustain near historically elevated levels. In this case, expected five-year returns would be in the high single to low double digits. We think this scenario is unlikely given the late stage of the current U.S. business cycle.

Long Term (10 – 20 Years)

The third time frame relevant for our investment outlook is the long term encompassing multiple market cycles. This is the time horizon under which we construct our strategic portfolio allocations. Over the long term, we are highly confident of the benefits from owning a globally diversified portfolio

When there are no compelling medium-term tactical opportunities, we invest according to our strategic portfolio allocations. The strategic allocations are constructed to maximize the expected long-term portfolio return for a given level of portfolio risk. We strongly believe that adhering to a globally diversified portfolio, consistent with one’s risk tolerance, temperament, and objectives through multiple market cycles offers the best odds of achieving one’s long-term investment goals. Investment discipline and patience are required as well.

In the period since the financial crisis, there has seemingly been little need to own anything other than U.S. stocks. But it should be clear that isn’t a sound long-term investment approach. The results of the past 10 years are not sustainable, and they won’t be repeated over the next 10 or 20 years.

Global equity diversification makes sense for many reasons. First, it gives investors access to a broad set of opportunities. Second, diversification across assets that do not move in tandem with each other smooths the investment experience for investors and as a result, facilitates a long-term approach. Third, a well-diversified portfolio also provides greater flexibility to make tactical shifts in pursuit of higher returns without increasing risk in a material way. So, a broadly diversified long-term portfolio with a medium-term tactical overlay should increase the odds of generating superior risk-adjusted returns.

Concluding Comments

The financial markets proved extremely challenging in 2018 across the board. A historically high percentage of markets posted losses for the year. Several stock markets and asset classes fell into official “bear market” territory, dropping more than 20% from their highs. Given our globally diversified approach, our portfolios were not immune. Having said that, considering the multitude of macro risks, coupled with unattractive U.S. stock market valuations and excessively optimistic earnings expectations, we weren’t surprised by the negative year.

No one knows what the next year will bring. We may see some continuation of recent market trends or a stabilization or reversal in some of them. The market consensus will undoubtedly be surprised again. What we are confident about is our investment approach. With its strategic portfolio foundation and tactical flexibility, we believe it will be successful across market cycles.

We know the headwinds that many markets have faced over the past five to 10 years will eventually turn to tailwinds. So we stick to our process and maintain our allocations. This may feel uncomfortable. But if we remain confident in our analysis and process, that’s exactly what’s necessary to achieve long-term success and avoid the pitfalls of performance chasing and emotionally driven investing.

Related to this, our confidence in the active fund managers with whom we invest remains high, and we are optimistic about their potential for strong performance in the years ahead as the headwinds and trends shift. That said, we continually update our due diligence on our managers and will make changes when appropriate should our conviction wane.

Our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential scenarios. Over the short term, if the current recession fears are overdone, we expect to generate strong overall returns, with outperformance from our foreign equity positions, active managers, and non-core bond funds. On the other hand, if U.S. stocks slide into a full-fledged bear market, our portfolios have dry powder in the form of lower-risk fixed-income strategies that should hold up much better than stocks. We’d then expect to put this capital to work more aggressively.

Successful investing is a process of consistently making sound, well-reasoned decisions over time, and across market and economic cycles. If we continue to execute our approach with discipline and remain patient during the inevitable periods when it is out of favor, we will continue to achieve successful and rewarding long-term results for our clients.

As always, we appreciate your confidence and trust, and we wish everyone a happy and healthy New Year.

 

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