By Wayne Yi, CFA
“What we do has consequences, intended or unintended. The decisions we make, the actions we bring – have weight.” - Charles Rhoades, Jr.
We have been enjoying what will likely be the longest period of economic expansion ever for the country. Corporate earnings have been resilient, consumer and bank leverage has been contained, and labor productivity has been high while inflation kept low. This has been in no small part due to the Fed putting significant muscle behind the economy to move it forward from the 2008 financial crisis, slashing interest rates from over 5% down to zero and buying Treasuries and mortgage backed securities to provide market liquidity and support. Furthermore, the Trump administration’s more recent deregulation and tax reforms had turbocharged an already strong economy. Thus, the U.S. has been a standout performer versus other developed and emerging economies.
The End of Quantitative Tightening
While initially warranted, the consequence of the Fed’s decision to backstop the economy for such an extended period, has been a market that is now heavily reliant on low-rates and easy access to capital in order to maintain its current growth trajectory. This has made it very difficult for the government to extricate itself from the market without risking another recession. This past December’s volatility shock exemplifies this, as Chairman Powell’s comments regarding the balance sheet de-levering program remaining on autopilot amidst the China trade uncertainty, and holiday trading illiquidity exacerbated the year-end market rout. Investors are relying on both floaties and swim fins, provided by the Fed, to keep the economy afloat. And much like my own sheltered children, market participants would rather get out of the water and leave the party than learn to swim on their own.
Source: Yardeni Research
Chair Powell quickly backed off his comments within the first few days of the new year, signaling no further rate hikes in 2019 and plans to pause the balance sheet reduction program. Equity markets rallied strongly as investors interpreted this as the signal to jump back into the pool. Looking forward, the Fed is on pause and analysts are now calling for the next action to be a cut rather than a hike. At about $3.5 trillion, the Fed balance sheet will still be four-times its pre-2008 size. With still relatively low rates and a full balance sheet, the Fed is in a precarious position with limited options if the economy were to slow.
Share Repurchases as a Form of Corporate QE
I attended a volatility conference in March, and an interesting observation and inference was made that last year’s volatility and year-end sell-off could have been much worse had it not been for corporate share repurchases, which provided much needed market support. At about $1 trillion in announced buybacks in 2018, doubling the prior year’s levels, companies provided liquidity to sellers in December. Furthermore, by taking shares out of circulation, corporate earnings-per-share growth has accelerated, making their stocks more attractive.
Source: JPMorgan Asset Management
Quantitative easing has provided companies access to cheap capital, which in part was used to fund share repurchases, amongst other activities. With low rates and a benign default environment, borrowers have been able to lever up as the cost to maintain debt has been low. Today, we are at post-crisis highs for leverage and lows for coverage, as we are already at or approaching the peak of the cycle.
Large leveraged loan issuers (EBITDA >$50mm) in the primary market
Source: Goldman Sachs Global Investment Research
Staying Domestic is the Best Defense
So then what would that portend if the Fed is out of monetary policy ammunition, corporate earnings falter, and buybacks stalled? Luckily for us, a panel of experts at that same conference unanimously agreed that volatility will be lower this year than last, save for a few bouts of intermittent spikes. We are not holding our breath on that outcome, but we do recognize that earnings are still slowly growing, the economy is stable, and the budget deficit currently manageable. The U.S. remains the safe haven of the world while the Chinese economy has been slowing, weighed by trade impacts and its own over-extended balance sheet. European growth has been muted as Brexit has taken over the headlines, Italy continues to remain a mess, and bulwark countries such as Germany are seeing softness as well, forcing the ECB to maintain a dovish stance for the foreseeable future.
Global GDP Growth Rates and Forecast Source: Bloomberg
Final Thought: The Market Will be Higher…The Question is When
If one were to have bought the S&P 500 at last year’s September peak, and sold at the December trough, that individual would have recognized a near 20% loss in slightly over three months, versus the 4% loss on the S&P for the full year of 2018. Alternatively, if one were to buy in the depths of that correction and held on until the end of March, that person would be up the same amount. That up and down gyration is gut-wrenching, but for the long-term investor, the past six months were a non-event.
S&P 500 Index returns from 2018 Peak to April 2019
Source: Yahoo Finance
To avoid going broke buying antacids, we continue to remain disciplined and long-term focused. While we cannot predict the market’s move tomorrow, we are “not uncertain” that thoughtful asset allocation and investing for the long-term should be a rewarding and profitable endeavor.
Source: Goldman Sachs Asset Management
Outlook and Asset Allocation
A dovish Fed has reclaimed the controls to end the balance sheet reduction program by September. Coupled with no further plans for rate hikes, stocks have rallied to kick off the new year. Growth is slowing off of the tax reform high in 2018, but an accommodative monetary policy should stave off any material concerns for a recession in the near-term. While the economy is growing, its pace has slowed. Thus, we continue to think it is prudent to be rotating into higher quality (strong margins, low financial leverage), large cap, domestically oriented businesses in this current market rally. We are underweight developed international and emerging market exposures given greater economic weakness and political uncertainty in these regions. As we are closer to the end of the business cycle than we are to the beginning, we expect more frequent bouts of volatility in equities and thus find returns to come with greater risk. We believe a Value and “Quality” tilt will be more resilient to market weakness. We recommend opportunistically taking gains from a very strong first quarter performance.
Fixed Income: Targetweight
Rates are lower today than they were last year, when the Fed was on a hiking path. While the absolute return is low, short-duration assets are still returning more than the pace of inflation. We had increased our weighting recommendation last quarter as short-duration assets were providing a modest return, and can offer negative correlation to equities if broader markets were to weaken. We have modestly extended duration, but still remain shorter relative to fixed income indices. We are constructive on municipals for tax-sensitive investors. 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.
Liquid Alternatives: Overweight
We are constructive on hedge funds in the current investment environment. 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.
Illiquid Alternatives: Overweight
We are overweight illiquid alternatives 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. Furthermore, institutionalizing operations and strategic acquisitions can improve margins and 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.
This information is for general and educational purposes only. You should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Massey Quick Simon & Co., LLC (“Massey Quick Simon”) nor should this be construed as an offer to sell or the solicitation of an offer to purchase an interest in a security or separate accounts of any type. Asset Allocation and diversifying asset classes may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Massey Quick Simon), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Massey Quick Simon is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Massey Quick Simon client, please remember to contact Massey Quick Simon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Massey Quick Simon is an SEC registered investment advisor with offices in Morristown, NJ; New York, NY; Chattanooga, TN; Denver, CO; and Los Angeles, CA. A copy of our written disclosure brochure discussing our advisory services and fees is available upon request. References to Massey Quick Simon as being "registered" does not imply a certain level of education or expertise.
This newsletter and the accompanying discussion include forward-looking statements. All statements that are not historical facts are forward-looking statements, including any statements that relate to future market conditions, results, operations, strategies or other future conditions or developments and any statements regarding objectives, opportunities, positioning or prospects. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties and contingencies. Forward-looking statements are not a promise or guaranty about future events.
Economic, index, and performance information herein has been obtained from various third party sources. While we believe the source to be accurate and reliable, Massey Quick Simon has not independently verified the accuracy of information. In addition, Massey Quick Simon makes no representations or warranties with respect to the accuracy, reliability, or utility of information obtained from third parties.
Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices or benchmark index, as comparative indices or benchmark index may be more or less volatile than your account holdings. You cannot invest directly in an index.
Indices included in this report are for purposes of comparing your returns to the returns on a broad-based index of securities most comparable to the types of securities held in your account(s). Although your account(s) invest in securities that are generally similar in type to the related indices, the particular issuers, industry segments, geographic regions, and weighting of investments in your account do not necessarily track the index. The indices assume reinvestment of dividends and do not reflect deduction of any fees or expenses.
Please note: Indices are frequently updated and the returns on any given day may differ from those presented in this document. Index data and other information contained herein is supplied from various sources and is believed to be accurate but Massey Quick Simon has not independently verified the accuracy of this information.