By Wayne Yi, CFA
Those of you who are avid fans of Netflix’s hit series “Stranger Things” will appreciate the characterization of the fourth quarter as the Upside Down for global markets. For those who are unfamiliar with the show, the Upside Down is an eerie alternate realm to the one you and I are living in, where sinister creatures dwell and occasionally break through to ours. Certain individuals were lost to the Upside Down, but the courageous were able to fight through and survive. But they needed a plan, and investors today require one even more so.
Let’s put the fourth quarter and the full year of 2018 into perspective. We entered the year coming off a strong stock market run in 2017, led by the FAANGs, which was enjoyed by many. Both value and growth styles, along with domestic and international equities, enjoyed strong macro fundamentals with a benign inflationary environment that allowed for Fed balance sheet reductions and rate hikes to be comfortably absorbed by the market. Volatility was low with occasional spikes, driven by tensions with North Korea, quickly dissipating. Brexit, while a concern, had a long fuse for Parliament to arrive at a solution. Chinese economic growth drove returns for emerging markets. To end the year, the passage of a new tax reform bill was expected to provide further momentum to propel stocks, specifically in the US, higher.
As we entered 2018, equities rallied with vigor in January, however we began to see a wider distribution of returns across markets. The first salvo of a trade war with China was made in February and catalyzed domestic and international equity dispersion, further fueled by a strengthening dollar as investors rightfully viewed the US’ domestic growth, rising rates, and now protectionist measures, as an attractive market to be allocating capital to. We would note that “growth” stocks performed well but the continued rise in rates weighed on slower growing “value” stocks, as they were viewed to be more rate sensitive and subject to inflation. Brexit rose in prominence, to the detriment of European markets, and geopolitical concerns from Russia, Turkey, and Saudi Arabia continued to drag on emerging markets. The administration’s trade disputes and threats of tariffs against Europe, our NAFTA counterparts, and China further segregated performance of the US from the rest of the world. Through all this, investors leaning into domestic high-multiple growth equities and away from more defensive fixed income assets looked like heroes through most of 2018.
The Upside Down
Source: MQS Research
We entered the Upside Down in late September, and the correction accelerated past Christmas as we saw volatility rise and equity markets swoon. The concerns in the back of investors’ minds throughout the year, about fully valued stock multiples, an inverting Treasury yield curve, continued trade tensions, and European political uncertainty, all wrapped in a slower growing economy finally came to front and center when Chairman Powell pointed to continued rate hikes and balance sheet de-leveraging regardless of these economic yellow flags. Almost all markets and asset classes ended down by the end of the year.
Higher quality assets began to regain ground during these final months as value-oriented companies, particularly in domestic large caps, outperformed on a relative basis. While both value and growth styles generated negative returns, defensive, lower-beta industries such as Healthcare and Utilities were actually positive on the year. “Quality” businesses, as defined by strong recurring revenues and margins, with clean balance sheets performed best, even if valuations were higher than the broader market.
This inflection was more pronounced in fixed income assets where investment grade bonds regained all their losses from the first nine months of the year to end barely positive, while high yield bonds and loans correlated with equities and gave back all their gains, if not more, in the final quarter.
Source: Barclays Capital, MQS Research
In this advanced technological age of satellites and cell phones, any one of us can be dropped in the middle of nowhere and find our way home, as long as we have a signal and access to power outlets. Finding one’s way, at least geographically, is no longer a skill. It was thus a curiosity for me to hear of something called “orienteering”, which Google describes as a sport where participants have to find their way to various checkpoints across natural terrain with only a compass and a map. To know where we want to go (long-term high quality investment returns), we must first establish where we are. We are deep into an expansionary cycle, arguably artificially extended from low rates and tax incentives. While economic forecasts point to slower growth, what we should appreciate is that the trajectory is still positive, with relatively contained inflation and low unemployment. The government shut-down will likely leave a mark on GDP, but all signs point to further expansion in 2019. Corporate earnings thus far continue to point to solid top- and bottom-line growth. While stock performance seems to be driven by even the smallest change in guidance, the overall direction of earnings has been positive. Sentiment around trade talks with China shift like an autumn leaf in the wind but leave room for economic upside if any semblance of a deal is reached. Furthermore, stocks are cheaper today than they were over the past several years, although we recognize that volatility is also higher.
Source: Yardeni Research, Refinitiv
Internationally, defensive economies like Japan are expected to be resilient, but a hard Brexit is now a real concern, and political tensions from rising populist sentiment in Germany, France, and Italy continue to challenge economic recovery. While Europe is viewed to be earlier in its expansionary cycle, these macro issues could continue to weigh on potential growth. Negative rates can also limit the tools of the ECB if the region were to experience another slowdown.
After nine 25bp rate hikes, fixed income assets are finally offering some nominal yield. Chairman Powell raised Fed Funds to 2.5% in December, and the market is expecting none to one more hike in 2019. The yield curve is still very flat but with lower risk of tightening, duration risk has somewhat dissipated. Credit risk, notably in high yield and bank loans picked up in the final couple months of 2018, not on any notable fundamental changes, rather with rapid declines in energy prices and continued concern over what cheap financing and loose covenants might portend for the asset class.
Outlook and Asset Allocation
We are changing our prior Overweight recommendation in Equities to Marketweight. We continue to remain constructive on global growth, led by the US, as corporate earnings remain strong and economic indicators are still positive. However, we are certainly closer to the end of the cycle than we are to the beginning of the cycle. Due to the increasing volatility in equities and across all asset classes, we find the returns generated from stocks generally to come with greater risk. As equity market tailwinds have diminished and fixed income assets are now offering some return with negative correlation to stocks, the relative attractiveness of stocks has come down compared to other asset classes. To be clear, we’re not advocating a wholesale reduction to bring down equity exposures immediately, rather to consistently take opportunities like the rally we’re experiencing in January to monetize gains as we are still confident in the stability of the underlying domestic economy for this year.
We continue to favor domestic equities over international and emerging markets. Although US stocks are more expensive than their international peers, we think that the underlying businesses are higher quality and are protective in a slower-growth environment. In that regard, we prefer large cap stocks over small cap as there is greater diversification of revenues, operating levers, and balance sheet optionality than their smaller company counterparts. We’ve historically favored a value tilt over growth equities for their margin of safety. We continue to refine this view and have complemented that strategy with exposure to businesses with recurring revenues, strong margins, and low leverage, defined as “Quality” businesses. While we recognize that these companies are not low-multiple enterprises, they are more resilient in less certain markets with less cyclicality.
We are maintaining some developed international and emerging markets exposure in order to provide diversification, but expect returns to be more volatile and inconsistent in the near-term.
Fixed Income: Marketweight
We have upgraded our recommendation on Fixed Income as bonds are now offering some yield, and can provide portfolio diversification to equities. As further Fed tightening seems to be muted, duration risk is lower so we are modestly extending our allocation to high quality fixed income assets including municipal bonds for tax-sensitive clients. We continue to remain selective with credit risk and thus have limited exposure to traditional high yield bonds and loans, and instead have opted for structural and liquidity arbitrage options to enhance returns.
We have upgraded our recommendation on Alternatives to Overweight. We had previously been overweight illiquid alternatives (private equity, etc.) given their longer investment periods and ability to extract value through engagement with their portfolio companies. We recognize that valuations in private equity have also risen, but to a lesser extent in the lower middle market space, and value-add strategies can offset some of the purchase premiums. Over an investment cycle, private equity investments should generate materially stronger returns over public markets in exchange for longer holding periods.
We are more constructive on hedge funds in the current investment environment and are increasing our allocation. We remain very selective on long/short equity managers as the ability to generate persistent excess returns is very difficult. However, arbitrage, idiosyncratic credit, and un-correlated asset strategies can generate strong returns in a directionless market. Furthermore, increased market volatility can potentially expand the investment opportunity for these strategies as they have modestly longer liquidity terms versus their long-only peers.
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