Many investors may be excited to put 2018 in the rearview mirror, as its contrast from 2017 was stark in many ways. However, a deeper look at 2018 may reveal that the challenges of the year, while real, were different than many have understood them to be.
Further, the outlook for 2019 may also be different than consensus views, as the conditions of capital markets, the economy, and the tension points that exist for investors entering the new year are better unpacked.
As is our tradition each new year, we want to review the year behind us, evaluate our own forecasts from a year ago, and establish the perspective that is driving decision-making and portfolio-positioning into the new year. We commemorated the 10th anniversary of the financial crisis in the fall of 2018, and for many investors, the practice of investing right now feels like “waiting around for the next inevitable crisis.” Many investors (or would-be investors) have been doing such for years. The fact of the matter is that there is some great history to learn from as we enter 2019, but it is hardly isolated to the history of 2008.
The financial crisis, and particularly certain policy steps taken after the financial crisis are certainly pertinent to the landscape in which we find ourselves. But as you will see, 1998 and 2016 perhaps offer greater assistance to our understanding of 2019 than 2008 does. And even then, no history provides a blueprint for the future, just some illumination that still requires interpretation and application.
Properly interpreting and applying the lessons of history is challenging but vital. And properly interpreting and applying the realities of the present are equally challenging yet equally vital. In this white paper we strive to do both – to understand the immediate past, and in some cases, the not-so-immediate past – and to look into the year ahead with an application that is suitable, timely, and opportunistic for those whose capital we are responsible to steward.
It is to that end that we work.
2019 Perspective Video
2019 Perspective Podcast
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2018 In Review
Performance Summary across Markets
The U.S. equity markets suffered a 6.2% decline in 2018 measured by the S&P 500, and a 5.6% decline measured by the Dow Jones Industrial Average. Both equity indices entered the final month of the year up roughly 3% but declined ~9% in December alone. The entire fourth quarter saw the market drop 13.5%, surely the worst quarter in ten years.
The top-performing sector for the S&P 500 ended up being Health Care, delivering a +6.5% return on the year. Utilities were the only other positive-performing sector on the year, ironic given their dreadful first quarter performance. Technology went from a significant leader of the pack (+19% through Q3) to a negative performer on the year, giving up nearly 20% in the fourth quarter alone.
Beyond broad sectors, the sub-sector returns tell an important story. The major bank stocks were hit hard, with many (but not all) financial stocks down 15-30%. Asset manager stocks were down from 20-50% almost across the board (only Blackstone seemed to escape with a barely positive total return). Automobile stocks saw significant deterioration, as did the homebuilding sector. The message was quite clear: Rate-sensitive companies did not respond well to the tightening conditions of the Federal Reserve.
Small-cap stocks as measured by the Russell 2000 index ended the year down 11%, declining 20% in the fourth quarter, moving from leading asset class on the year to among the worst performing asset classes (more on this in our evaluation of 2018 forecasts).
Globally, equity performances only got worse, as China’s market declined 33%, Mexico declined 16%, and Japan declined 12%. Across the pond, the European numbers were a huge frustration to many asset allocators, as the oft-repeated silliness that “it is Europe’s turn to narrow the gap with U.S. equity performance” was exposed. Germany declined 21%, France 11%, and Spain 15%. The UK declined 12%, almost all of that coming in the fourth quarter behind continued Brexit volatility.
While the emerging markets index declined 15% on the year, it performed ably in the wild ride of Q4. The reversal of emerging markets’ relative underperformance to developed markets was noticeable (more on this in our evaluation of 2019 perspectives).
The bond market worked very hard to deliver a barely positive return for 2018, despite spending about 50 of the year’s 52 weeks in negative territory. Treasury yields dropped enough in December as risk assets sold off to create a positive return on the year (+0.1%). The good fortunes in the late-year Treasury bond market did not apply to any bond category with credit exposure, though, as Preferreds dropped nearly 5%, High Yield bonds dropped 2%, Investment Grade Corporate Bonds dropped 3.8%, and Floating Rate Bank Loans dropped 0.3%. In all such credit bond exposures, the entire decline for the year came from the fourth quarter.
Gold declined 2% on the year, and the broad commodity index declined 11.6%. Real Estate Investment Trusts were down 6%.
It is impossible to ignore the challenge of finding positive returns in 2018 for the broadly diversified asset allocator. From domestic to international markets, bonds to stocks, commodities to real estate, there were few sources of positive return in 2018, with most asset classes just competing over the magnitude of downside (most of which was actually quite muted on a full-year basis).
Consider this: Of the major broad investment asset classes, the top-performing asset class in 2017 was up 38% (Emerging Markets), and the worst-performing asset class was up 1.7% (Commodities). In 2018, the top performing asset class was up 0.1% (Bonds), and the worst performing asset class was down 14% (with everything in between negative).
The S&P 500’s negative return represented its first negative total return since the financial crisis year of 2008, though 2011 and 2015 were both negative on a price basis, but with dividend yield managed a barely positive total return. Had the year ended on December 1, it would have been another positive return for markets, but that is not the way a 12-month calendar works. The run of positive years from 2009-2017 ties the nine straight years of positive S&P 500 years we saw from 1991-1999, though the cumulative return then was a stunning 442%, whereas this nine-year run ended at 255%, a 15% annual return (vs. the 21% of the 1990s).
Perhaps the biggest surprise to investors in 2018 is that the market experienced a modest decline despite unprecedented earnings growth. Top-line revenue growth (+10.7%), operating margins (+12.1%), and earnings growth (+26.1%) all exceeded the expectations of even bullish prognosticators. And yet markets dropped anyways as the “E” of the famed “P/E ratio” advanced, but the multiplier itself declined. The P/E ratio declined a lot more than the market itself did, as positive organic earnings themselves offset the valuation decline.
The question that surely looms is whether or not the magnitude of the drop experienced in equity markets in December marks a turning point in this present bull market or merely another notch in the nearly 25 incidents that markets have meaningfully moved since 2009 before adjusting to the upside. It has been the most meaningful of the various market drawdowns we have had since 2011, and as I type has already recovered 33% of the recent decline. Nevertheless, the catalysts to the market downturn (Federal Reserve policy, a trade war with China, and concerns over global growth conditions) remain unresolved heading into 2019.
As our 2019 Perspectives will make clear, we actually see more comparisons in the recent market decline to early 2016, and even 1998, than we do the rest. Nevertheless, it will take time to have clarity as to whether or not the late 2018 drop was merely a mid-life crisis or the actual aging of this bull market.
Bonds: Can’t live with em’, Can’t live without em’
The significant flattening of the yield curve in 2018 generated all sorts of media attention, and certainly had a big impact on how bond investors did on the year. Short-dated bond yields much higher as the Fed raised their Fed Funds rate four times at 0.25% apiece last year. The Fed Funds rate going from 1.5% to 2.5% brought the short end of the curve higher, but it did not bring the long-end higher in the same proportion.
The 10-year Treasury yield did not move in tandem because the Fed left the short-rate at 0% for so long. The 10-year bond yield will historically equal the short-term rate on top of its projected path. Investors no longer believe the Fed will move the short term rate much higher, so the 10-year and 30-year stayed anchored lower. The investment implication is very frustrating because investors (and policymakers) want to believe growth expectations are such that a higher long-term bond yield is justified, but policy credibility and market skepticism tells a different story. It makes bond maturity positioning very hard to optimize, as what interest rates are “supposed to do” and what they “actually do” diverge greatly (and often for extended periods of time).
If one knew that interest rates across all maturities were going to be going in a straight line higher, it would be a lot easier to avoid the bond market. No one knows any such thing, of course. Bonds spent a good portion of 2018 in negative territory, but saw yields collapse in the last month of the year – and why? Because stock markets were dropping, largely behind the fear of – higher interest rates! The irony is thick.
The entire composition of Treasury bond ownership appears to be changing, as “household” ownership of Treasuries is skyrocketing higher while the largest owner of Treasuries (the Federal Reserve) is reducing their ownership. Foreign owners (primarily China and Japan) appear to be “flatlining” in their ownership, neither decreasing nor increasing at any noticeable pace.
Bonds did two things for investors that must be appreciated:
- They made the case for an important downtick in performance expectations for the future, as investors experienced the pricing reality of what happens to bond portfolios in the midst of a rising rate environment (and equally potent, the lack of perpetual price increases when interest rates are not consistently going lower).
And yet,
- They made the case for not abandoning ownership of the asset class entirely, as they proved a valuable desensitizer of equity market volatility when needed most.
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Our 2018 Forecasts (re-visited)
#1: “Risk” of a melt-up is real
Perhaps the fact that the market in 2016-17 went up fifteen months in a row (the most in history), and was up for those two years beginning February 2016 in 22 of 23 months, was itself the “melt-up.” January of 2018 caused this forecast to be even truer than I expected, but it ended just there – in January of 2018. The stock market moved a stunning +7% in three weeks last January, delivering this forecast immediately, but then hitting a February reversal and second quarter pause that lasted into the summertime.
#2: The days of no volatility are going away
This may be a pretty easy one to take credit for getting right, and yet in fairness, it was a no-brainer coming out of 2017.
The market was up or down more than 1% in a single day just eight times in all of 2017. It was up or down more than 1% nine times in 2018 – December of 2018, that is. For full-year 2018, it was up or down more than 1% a stunning 64 times in 2018. The market had five days where it swung more than 1,000 points in a single day this year (it had only had three in history before this year).
The VIX began the year at roughly 11 and closed the year at ~25, a +130% increase on the year. However, it did spend much of the year (from April through October) at well less than 20, with its real elevation just picking up and bouncing around as the market decline of the fourth quarter commenced.
So yes, the historical anomaly of low volatility that existed in 2017 was indeed replaced by more normalized, and even slightly elevated, volatility in 2018.
#3: Growth-to-Value: The FANG days are numbered
This theme ended up being vindicated in the final quarter of the year, no doubt, but in much of 2018, the trouncing of value stocks by high-priced growth stocks, notably the famed “FANG” names of Facebook, Amazon, Netflix, and Google, continued. (Nvidia was considered part of this club as well, though it turns out providing chip units for the crypto-currency world was not as promising of a business as had been thought before crypto’s 85% fall from grace). The so-called “new tech” category led the market much of the year until the market experienced its Q4 distress, in which case those stocks with the highest disconnect from historical P/E (price-to-earnings) ratios suffered the greatest.
Still, 2018 did not necessarily represent the full-blown reversal of growth’s outperformance over value. One can see from the chart below that value did reverse the trend meaningfully in the very final months of the year, but for the first 70% of the year, the trend had continued. What we see in the chart below is that since the financial crisis, the real hey-day of Value over Growth was 2016. Ultimately, the arguments that led to this forecast last year are more applicable now than ever – can valuations are too stretched in many growth names and sectors, and that defensively, investors tend to find safety in the stability of Value during times of market skepticism. The post-crisis reign of growth-over-value has hardly come with a poor absolute performance from Value. But relatively speaking, we continue to believe this tide has turned, and for good reason.
#4: Small-cap in light of tax reform
Our view coming into the year was that small-cap’s under-performance in 2017 relative to large-cap, and the under-appreciated impact tax reform would have on profitable small-cap companies, would pave the way for a significant year in profitable small-capitalization companies. And indeed, through the first eight months of 2018, small-cap (as an index) was up a stunning 12.5% (an all-time high), benefitting on a relative basis (vs. the S&P 500) from the impact of the rising dollar (which tends to hurt multi-national companies much more, largely absent from the small-cap universe). In other words, for the first eight months of the year, we were more right than we anticipated being, for all the reasons we forecasted.
The reversal, though, was stunning. Not only did small cap lose its relative edge to the S&P 500 in the final months of the year, but lost its entire absolute performance as well, closing the year down 12.2%. Fears of higher interest rates (plenty of balance sheet leverage exists in the small-cap universe) and greater discussion of recession worries (which heavily impacts small cap) caused multiples in the space to collapse. High beta was the huge winner in the first 2/3rd’s of 2018 and was the great loser in the last 1/3rd.
Our chosen exposure to the space dramatically outperformed the index because of a greater focus on cash flow visibility and an outlook for productivity. Much of the absolute performance was lost late in the year, but the relative outperformance was maintained. Should a recession prove to be “not imminent” in 2019 it is entirely possible that small cap will see another resurgence this year. However, if one is looking for ways to “de-risk” the equity exposure they do have, a neutral or underweight small-cap position is a great way to do it.
#5: Political reckoning for big tech
It would be disingenuous to discuss the 2018 journey of “new tech” without discussing the political climate that so deeply infested those waters. Gone are the days where Silicon Valley is untouchable in Washington D.C. The pendulum appears to have swung the other way, hard and fast. Congressional hearings, newspaper op-eds, and regulatory scrutiny, are the “new normal” for this sector after a couple decades of feeling mostly untouchable. This has a profound impact on valuation, and when the valuation is forced lower it has a profound impact on the ability of these companies to use their highly-valued stock to fund inorganic growth. The negative feedback loop is significant and is likely in early stages. This does not necessarily mean a further collapse of stock prices in this sector, but it does seemingly indicate a headwind to growth that needs to be understood when calculating future expected returns.
#6: Inflation conversation
It intrigues me to read what I wrote a year ago on this subject, and how “hedged” the language may have appeared at the time, but how prescient it proved to be. The warning was specific to a narrative of inflation as the Fed’s efforts to counter disinflation were repealed. That happened in spades in 2018, and yet, also as forecasted, actual measurable inflation did not!
Antiquated advocates of the Phillips Curve continued to express concern that wage growth was opening the door to inflation, and yet oil prices declined precipitously, housing prices slowed substantially (and flat-out reversed course in many areas), and consumer prices moved in the Fed’s target of +2.1%.
The inflation vs. deflation debate is not settled, either in the halls of the Federal Reserve or in the capital markets that are trying to price in such expectations about the future. Inflation chatter got more airtime in 2018 than any year since the financial crisis, though, and yet such inflation chatter was accompanied by Oil declining 25%, Gold declining 2%, and broad Commodities declining 11.6%. Go figure.
#7: Buy bonds that act like bonds
This theme was certain to play out right if for no other reason than the context in which it was uttered, for it was not a market call whatsoever, but a risk management determination. The emphasis was not on stating that Treasuries would outperform Credit, or that Municipals would perform a certain way, etc. Rather, it was a realization that entering 2018, the economy and risk assets had enough built-up risk in this stage of the cycle (healthy and compensated risks, but risks nonetheless), and that ticking down credit risk made sense after years of “cheating” extra return via credit markets (i.e. debt instruments in the corporate and mortgage sector vs. sovereign or municipal debt obligations).
The truth is that until December some exposure to High Yield, Bank Loans, and Securitized Credit added to fixed income returns, even as higher rates in the “bonds that act like bonds” category (Treasuries, investment grade corporates, etc.) hurt their price return. But come September, when the very risk an asset allocator is worried about diversifying actually surfaced, the “bonds that act like bonds” theme worked very well, helping to offset stock market drawdowns as bond prices escalated in response to declining yields.
Conditions in the credit markets will be addressed more extensively in our 2019 Perspectives section, but the fact of the matter is that what was prudent for 2018 remains prudent for 2019: Credit-sensitive sectors of the bond market may very well perform extremely well in 2019 if all risk assets rally, but if it is diversification and risk mitigation a bond investor is after, a slightly underweight total bond allocation which is more allocated to traditional bond sectors is a more prudent way to diversify a portfolio.
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2019 Perspectives
- Theme #1: It’s all about the Fed. But it’s really all about corporate credit!
- Theme #2: Capex determines how many innings there are to go
- Theme #3: The case for emerging markets in 2019
- Theme #4: The case for alternative investments in 2019
- Theme #5: Negative housing chatter will accelerate, resulting in a crash needed garden-variety correction
- Theme #6: Patience in the Energy story
- Theme #7: Déjà vu all over again
Theme #1: It’s all about the Fed, sure. But it’s really all about corporate credit!
To appreciate how significant an issue this is, one has to appreciate the history that has gotten us to this point. The financial crisis created a slew of challenges for policymakers, not the least of which was the threat of insolvency for the nation’s entire financial system under the weight of mortgage defaults and grossly inadequate collateral. They addressed that issue by injecting taxpayer capital in the banks directly and putting the largest mortgage providers in the country under government conservatorship (Fannie/Freddie). However, the collateral damage that had spread throughout the economy was deeper than anything the country had seen since the Great Depression and wider than any policymaker could be expected to resolve. To the extent the solvency crisis was thought to be resolved via TARP and other governmental measures, the liquidity crisis became the next urgent priority for monetary policymakers.
As I addressed through much of my series on the financial crisis at its 10-year anniversary last fall, liquidity crises are different than solvency crises. A “kitchen sink” approach became the Fed’s mandate, and in addition to a slew of emergency lending facilities, the normative policy tools to provide liquidity to a de-leveraging economy became ZIRP (zero interest rate policy) and QE 1-3 (quantitative easing, three rounds). These policy tools remained in effect for essentially eight years, an awfully long time to drive re-leveraging in the economy.
You notice in the above chart that, in a complete reversal of pre-crisis conditions, it is not the mortgage and household sector where the most leverage has built up this time. The U.S. corporate economy has re-leveraged, as companies of all shapes and sizes took advantage of extremely favorable borrowing conditions to refinance debt, to take on new debt, and to drive growth via credit expansion. It is worth noting though, as this does represent a key nuance in this cycle, that rising corporate debt has been primarily in the Investment Grade space of borrowers this time around relative to other highly leveraged borrowers. Leverage ratios have increased (debt-to-assets), and coverage ratios have decreased (earnings-to-interest expense). These levels have not reached epidemic proportions by any means, but they reflect conditions that are far more vulnerable to monetary tightening than prior years.
The point of this history lesson is not to state that prior policy was in error – just that they were never going to be without consequence. The outcomes that came out of prior policy were highly intentional. Corporate America followed the mandate that policy was dictating for it – profits expanded, investment picked up, and the desire to use the instrument of monetary policy to re-provoke economic activity succeeded. And yet, those very policy determinations post-crisis are the reason Fed policy is so consequential as we enter 2019. The doctor gave the patient a lot of medicine; the market’s fear now is that maybe, just maybe, the patient is being weaned off the medicine too quickly.
Financial conditions have tightened immensely, and that is before the Fed finishes its stated intentions of further tightening (meaning, there have been 2-3 more rate hikes projected for 2019, and over $1 trillion left to reduce from the Fed’s balance sheet – we no longer believe in these Fed projections, and neither does the market). To properly forecast 2019, we have to not only assess what proper policy ought to look like, but what policy will most likely be(the latter being far more important than our views on the former since we are not on the Federal Open Market Committee). The Fed had previously projected three rate hikes in 2019 and recently decreased that expectation to two (while maintaining a verbal flexibility to do three if conditions warrant). However, the market is saying that they do not believe the Fed will increase rates at all in 2019.
Present futures market activity is only putting a 5% chance that there will even be one rate hike in 2019, and there is actually a 23% probability that they will cut rates one time. The market is pricing in just a 0.1% chance that there would even be two rate hikes (let alone three). And there is presently a 70% probability of no rate hikes all year.
The primary issue that matters to equity markets in 2019 is not what the Fed sets the short term interest rate at (though that effects what is the primary issue). Rather, it is the response of credit markets to whatever monetary environment is presented. In other words, the ability for corporate America to favorably access credit markets (tighter as they may be) will be a huge determinant in how equity markets perform in 2019.
High yield credit spreads tell us a lot about the access companies have to needed credit and liquidity. Current spreads suggest tightening credit, but nowhere near “shut off” credit. Spreads have not widened nearly as much as they did in early-2016 or mid-2011. Wider spreads will mean more than just losses in high yield bond investments; they will mean a constriction of credit that is sure to have a wide impact throughout the economy and the stock market. The high yield market is hardly the only measurement of credit conditions, but it is one that we will be watching carefully.
Levered bank loans are another one. If I marked this 2018 chart as “S&P 500” instead of “Bank Loan ETF” you would not be able to tell the difference (look back at the earlier S&P chart shape if you do not believe me).
The correlation between a credit instrument like levered bank loans and the S&P 500 is as high as it has ever been precisely because of what I am describing … It is investor concern that the Fed will starve off access to liquidity in the credit markets that is behind this market distress, and therefore seemingly different asset classes like bank loans and equities respond in kind.
And this essentially brings us to the highly connected issue of dollar liquidity …
Three things are impacting global liquidity: (1) The Federal Reserve’s tightening monetary policies; (2) A gigantic U.S. budget deficit that drains money from the private sector to be replaced by less productive purposes; and (3) Europe’s preparation for ending their monetary bazooka.
2019’s performance in risk assets will largely come down to whether or not the Federal Reserve effects a soft landing in the corporate economy as they navigate their monetary path. Our forecast is that they will be on the brakes for all of 2019, allowing time for credit conditions to absorb this new post-post-crisis paradigm and that sectors most negatively impacted by the Fed tightening of 2018 will be the areas most likely to benefit from this pause in 2019.
Theme #2: Capex determines how many innings there are to go
I would not be defensive if someone wanted to accuse me of already beating this horse to death throughout 2018, but because the ultimate outcome for the horse is still very unknown, and on this horse so much of the economic expansion and stock market furtherance will ride, it is incumbent upon me to drive this point home further still (and yes, I am aware of how badly I just mixed metaphors). The tax reform bill signed in late 2017 and enacted in 2018 was much more than a tax reduction bill across corporate America. Indeed, the benefits from a lower corporate tax rate to the after-tax profits of the S&P 500 were largely priced into markets by very early 2018. It is in the peripheral aspects of tax reform that I believe there exists a plausible catalyst for growth yet to be priced in: The full expensing of capital expenditures, and the repatriation of foreign profits.
On those two aspects of the tax reform legislation, a plausible case existed/exists for a renaissance of capital expenditures (capex) that has been sorely lacking for a decade in the American economy. Investing these new-found cash flows into productive projects drives growth and holds inflationary pressures at bay. I do not believe this outcome is assured, and yet I certainly do not believe this outcome has been priced into markets. We know of the instant benefits to shareholders that the tax legislation created – benefits that did and do matter (stock repurchases, increased dividends, debt reduction, and M&A). But it is this other category called Capex that will be the largest wildcard to organic economic growth and productivity in 2019.
Our thesis became after the Q3 GDP print which revealed a sudden collapse of business investment (after 3 consecutive quarters of substantial growth in this silo) that it was the trade war weighing down corporate appetite for substantial capital spending. This remains our thesis, though we also believe other peripheral headwinds potentially exist besides the main gorilla of suppressed global trade. With the windshield into these matters now severely spotted by the open-endedness of the China trade negotiations, it will be very difficult to project the capex outcomes until the windshield is cleared of the China/trade/tariff distraction.
Theme #3: The Case for Emerging Markets in 2019
A more exhaustive treatment of this theme will be the subject of an early year Market Epicurean piece, no doubt. But the +37% returns of 2017 (and really ~+55% if one includes the last eleven months of 2016) were damaged by the 14-15% drawdown in 2018. In hindsight, the headwinds that hit Emerging Markets last year are easy to decipher: (1) A rallying U.S. dollar, (2) The impact of the trade war, and (3) Fears of a global slowdown.
Yet even in the disappointment of 2018 one can see the principles of our emerging markets investing worldview at play. The Chinese stock market declined by over 30%, and yet Brazil’s stock market was almost breakeven. Is Brazil’s economy in a stronger place than China’s? Not at all. Is there political leadership more stable and encouraging? Of course not. Rather, individual company performance and the reality of dispersion accounts for the difference. In 2019, an improved macro landscape combined with the value of present fundamentals will create a different outcome for the emerging markets space.
Any reversion to the mean in historical valuation levels, let alone broadly improving fundamentals themselves, is likely to bode very well for the space in 2019. The thesis does not require a lot of surprise “good things” to happen (though it would help to avoid surprise “bad things”).
We continue to believe in the demographic driver (one billion people entering the middle class from emerging countries in the next seven years). While currency fluctuations, sentiment, and particulars of financial management around debt are impossible to time or invest around, that demographic shift represents a prime opportunity for profit-seeking companies in these domiciles to monetize. It creates consumer and infrastructure and banking needs in the emerging markets that far transcend their historical role as materials and commodity exporters to the developed world. We cannot find a way to invest in emerging markets without the currency and geopolitical strain that surfaces from time to time, but strong productivity growth to the U.S. at a lower valuation makes this a growth investment opportunity we see as a prominent theme in 2019.
From Turkey to China to Russia to Malaysia there exists no shortage of geopolitical heat and dysfunction that can weigh on total valuation, or even add to the asset class risk premium. Our view is not, and never will be, a non-discerning broad acceptance of geopolitical chaos as somehow a positive thing for investors. Rather, the selection of companies used to monetize this theme must be bottom-up, fundamental, sensible, and keenly aware of top-down concerns that may mitigate the company-specific opportunity.
It is interesting to note that as the U.S. began a migration from growth-to-value in light of the combustion of the FANG stocks in Q4, such a distinction is not so prevalent in the emerging markets. Secular trends towards higher dividend payments and a more sophisticated financial apparatus for dealing with dollar-denominated debt and foreign exchange realities of local profits serve as future catalysts in the space as well.
We have no theme this year simpler than this one: The emerging markets took their medicine in 2018, and we believe it will be a very profitable snapback in 2019.
Theme #4: The Case for Alternative Investments in 2019
“Alternatives” are a difficult asset class to have an outlook on, since they are not really an asset class at all. As the great Alexander Ineichen taught me at UBS nearly twenty years ago, “Alternatives” are an asset manager, not an asset class (meaning, they represent the idiosyncratic approach of given asset managers, de-correlated from traditional stock and bond investing). To have an outlook on “alternatives” is to inevitably have an outlook on a particular alternative asset manager or approach.
And yet, certain paradigms to suggest a more fertile environment for alternative managers than others. A period of excessive monetary accommodation increases the likelihood that the tide will lift all boats, and makes it more difficult for a hedge fund to stand out. But we find ourselves in a period of monetary uncertainty, of legitimate headwinds vs. tailwinds, and of dramatic dislocations in capital markets. Our theme here is partially driven by our confidence and conviction in our own process around manager selection and due diligence, but it also speaks to the environment in which we find ourselves in: Beta may be a harder source of return than it has been the last ten years.
Our advocacy of alternative investments is by no means a bearish call on equities (if anything, it is a bearish call on bonds). But it is a recognition that many questions exist in the clouds of the stock market, and that few investors (ourselves included) are looking to solve those uncertainties by taking on greater volatility than has already been baked in. Rather, recognizing the risks embedded in manager execution, we see approaches with very reduced correlations to stocks and bond markets as a way to invite the pursuit of positive absolute returns without increasing expected equity market volatility.
This was a standout area at The Bahnsen Group in 2018 and we believe represents a prime thematic approach in 2019.
Theme #5: Negative housing chatter will accelerate, resulting in a crash needed garden-variety correction
2018 created some of this chatter, to be sure. But poorly contextualized data points around demand moderation and a slowdown in new construction did not form a comprehensively negative narrative.
2019 will go all the way in this process, and the narrative will not be pretty. However, the PTSD of 2008 will lead to a colossal misunderstanding of housing, as the mere existence of a negative narrative will distort the distinction between a market-based rationalization towards affordability and a full-blown “crash.” To be sure, the notion that residential real estate had ever de-coupled from short-term interest rates was a dangerously naïve belief. The “price” of money effects assets which are purchased with borrowed money, period. This should not be hard to understand.
It is impossible to provide granular commentary on housing to a national audience. The fact of the matter is that housing is both national and local and that how housing prices will behave in 2019 will be quite different in certain neighborhoods versus others. The neighborhoods most vulnerable to correction are areas in which prices have most exceeded rational levels of affordability. In certain high-priced locales like Manhattan and coastal Orange County, for example, a heavy reliance on foreign purchases has caught up with the marketplace, and is likely to impact both median price levels and “time on the market.”
Other markets are susceptible to the impact of rising rates, as buyers essentially “buy a monthly payment,” not a home’s sticker price. Our concern from an investment standpoint is not on the nature of one’s primary residence adjusting to natural market forces, but rather whether or not it is true that permanently rising housing prices are positive for an economy. That is certainly the consensus narrative, yet it is perhaps the most widely held fallacious belief we can think of.
Any correction to more reasonable price levels is a positive for the economy in that it is counter-inflationary, and it provides additional capital for other production and consumption.
Theme #6: Patience in the Energy Story
The acceleration of U.S. production of oil and gas is no longer a “new story” as it has exceeded even the most optimistic of outcomes in terms of the United States role as the global marginal producer. The relevance of American production capacity has been recognized in the upstream marketplace, though commodity price instability weighs on that highly leveraged sector of the energy complex.
But limited infrastructure capacity remains an unappreciated story in capital markets, which is both a positive and negative for investors. On one hand, the positive is that there exists a seemingly huge opportunity, and on the other hand, investors have understandably lost patience, many wondering what they must be missing as markets continue to be underwhelmed by the story. Our thesis remains that even the negative is really a positive, as this is above all else a yield play, and so while the market pricing may frustrate or confuse investors, the cash flow that investors receive remains highly attractive, with the future discounting of this cash flow into the stock price a simple “cherry on top.”
To be sure, some midstream pipeline companies have benefitted in a transitory way from the limited transport capacity out of this production surge. Companies with excess capacity have been able to meet a market demand where pricing differentials existed and captured an attractive boost to EBITDA in the process. This is positive in either of the ways this scenario could play out: The transitory inefficiency continues, and high-quality players capture this market opportunity for longer; or, the bottleneck is alleviated as more pipelines come online, namely, the pipelines of these very companies seeking to provide more transportation volume to the U.S. energy sector.
Predicting when the market will price the stocks of the major pipeline companies in line with their discounted cash flows has become a fool’s errand. Focusing on high-quality companies in the space who properly managed the great disruption of 2014-15 and who have made structural and capital allocation changes to their businesses have not. With current yields in the 7-9% range, and the same secular tailwinds in play – a favorable administration in the executive branch of government, large expected increases in export volume of oil and (especially) natural gas, and inadequate pipeline infrastructure to safely and adequately meet U.S. transportation needs as production has reached all-time highs – 2019 seems set to offer investors a very high level of portfolio income, with the possibility of long-awaited capital gains.
Distribution coverage relative to cash flow and debt levels remains paramount, and underlying credit market conditions will impact market sentiment. Our bias is always to the higher quality side of this investment story.
Theme #7: Déjà vu all over again
We know that all economic recessions have involved a bear market in stocks, but we also know that not all stock market corrections have involved economic recessions. Transitory corrections in stocks that are not accompanied by recessions tend to be short-lived and of a lower magnitude in decline. 1947, 1962, 1966, 1978, 1987, 1998, 2011, and 2016 all serve as historical precedents.
We want to focus on 1998 and 2016 as a theme for 2019, and I will explain why.
In 1998, the stock market dropped over 20% quickly and violently in August – and volatility persisted for a month or two – despite robust GDP growth, increasing corporate profits, and structurally low unemployment (sound familiar?). The Federal Reserve responded to the mixed signals between the economy and the stock market by, well, by siding with the stock market. The Russia ruble devaluation and failure of Long-Term Capital Management left the market in sudden disarray, and the Fed had telegraphed pulling back from monetary stimulus as the technology boom and bull market had led to a perfectly healthy economy. By October, the Fed was dramatically cutting rates (on multiple occasions) in a low-unemployment, growing economy, reflecting the philosophy that has defined every Fed Chair since: Liquidity must be provided to prime the pump for risk assets whenever such feels threatened.
In 2016, the comparisons are even more stark (and recent!). We entered the year with the Fed telegraphing four or five rate hikes in the need to normalize monetary policy. Unemployment was continuing to drop, and though GDP growth was not hot, it was stable. As 2015 ended, oil prices had collapsed, and China’s economic vulnerability was the talk of the town (sound familiar?). After experiencing the worst January in the history of the stock market, the Fed completely reversed course in February and harmonized their capitulation with central banks around the globe. They would not raise rates throughout the year, and China would navigate to a much softer landing than feared. Granted, no trade war threat was complicating that element, but a synchronized policy response was implemented to assist both the U.S. and China. Oil prices bottomed in February and staved off the deflationary threats many felt were at play.
History does not repeat itself, and one could easily accuse me of self-selecting 1998 and 2016 as parallels to the present paradigm out of hope rather than analysis. But it is in the analysis that I find the most compelling reason for this conclusion: The Fed’s data dependence becomes a self-fulfilling prophecy towards dovishness when risk assets punish their hawkishness. We see that playing out right now, in real time. I have no doubt that a real recession will come in due time, and I further have no doubt that a real and sustained bear market will accompany that recession, in due time. But the nature of capital markets, the political realities underlying present circumstances, the pressures embedded in credit markets, and the lessons oil producers learned in recent years, all point to a 2019 that has an eery similarity to 1998 and 2016. We will change our mind on a dime if facts dictate such, but this theme is a prominent one in our thinking for 2019.
The Fed, China, oil – none to be taken lightly, yet déjà vu all over again …
Conclusion
While these seven “themes” speak to our overall worldview entering 2019, it is now necessary to succinctly summarize our practical viewpoints as we exit the challenges of asset-allocating in 2018, and seek the optimal positioning for our clients in this new year.
The trailing multiple on the S&P 500 is now 15.6x earnings, slightly below its historical average, and more importantly, the forward multiple on 2019’s earnings expectations is barely above 14x, definitely below its historical average. Unlike the beginning of 2018, we are not entering the new year with equities clearly at a full or even slightly excessive historical valuation. Companies making more money than a year ago are trading at a lower valuation than they were a year ago – this is a good thing for patient, long-term equity investors.
This is certainly different than claiming equities are trading at extreme buying conditions. Valuation metrics are at or slightly below historical averages – they are not “screaming bargains” (such as after the washout of Q1 2009). And some strain on valuation is reasonably warranted, given ongoing uncertainty around the trade war, the global response to Chinese economic conditions, the Fed’s path of monetary stewardship, the health of credit markets, and the likelihood of a declining rate of growth in earnings. In other words, valuations reflect the reality of the present equity landscape.
What is interesting about that list of potential headwinds, or complicating factors to economic growth and a bull market for stocks in 2019, is that each one could quite easily turn into a tailwind as well. A comprehensive trade agreement with China may not just relieve a stressor from capital markets, but even improve global economic health. The Fed may settle on a path that, at least for 2019, enhances economic confidence and lubricates corporate credit conditions (granted, it is hard to believe they could do that without inviting some future distress, but this is a 2019 treatise, not a 2020 or 2023 one). And ultimately, S&P earnings have every chance to surprise in 2019, particularly if the business confidence that drove capital expenditures higher in 2017 and early 2018 re-surface, leading to a productivity renaissance which always drives profits higher.
It is not for us to “bet the house” on which outcome will play out which way and when amongst these different tension points. Rather, it is our duty to allocate client capital around the reality of these tension points, accepting the potential outcomes, likelihoods, and risk-reward tradeoffs embedded therein. The process of allocating capital around a particular viewpoint in a particular time is called “tactically tilting,” and it is done from a baseline level known as a “strategic allocation” (a sort of neutral, default position given one’s timeline, goals, and risk parameters).
Our strategic allocation targets for stocks, bonds, and alternatives are being tactically tilted as follows:
- Equities: Neutral; even-weight
- Bonds: Slightly under-weight
- Alternatives: Over-weight
We continue to believe this equity bull market will end at some point, as all bull markets do. But we have yet to find evidence that this bull market will end in paradigmatically different circumstances than all others as far as sentiment. The old Templeton quote about bull markets dying on euphoria remains the law of the land, as far as we are concerned, and this would be the most non-euphoric ending to a bull market we have ever seen.
We are not keen to be in the recession forecasting business, as it has been the study of my adult life to watch people with no skin in the game make wild forecasts, be wrong repeatedly, and then when the broken clock lines up with their call, take credit for the call. It is either infuriating or amusing practice depending on the mood one is in. It is not just the inaccuracy or disingenuity of recession-forecasting that concerns us, but the inherent impossibility of it. Economies are pricing in trillions of transactions and actions from billions of people, each and every day. The arrogance it would take to assume one knows exactly how these things will play out (and on what timeline) is unbecoming.
Our very humble and fallible view regarding a recession watch is the following: We see 2021 as the likely earliest time one will ensue, and we further expect the next recession, whenever it may be, to be a relatively mild one, nothing like 2008.
A dramatic policy error around trade could reverse that optimistic outlook in a second, as could a meaningful monetary policy error. By believing the economic expansion will continue for a couple more innings, we are implicitly forecasting that such policy errors will ultimately be avoided.
Of course, as one can decipher from our asset allocation positioning, we are hardly assigning excessive convictions to these outlooks. Defense and prudence remain paramount.
The short duration call that was so universally touted in 2018 became embarrassing for consensus bond investors, as rates rose on the short end of the curve, but actually came down year-end in the longer end of the curve. But for 2019, we do believe the longer-end of the curve will see rates move higher, yet not above a 3.5% level on the 10-year. This ought to modestly (very modestly) steepen the yield curve, providing some net interest margin to financial firms, but more importantly, avoiding the policy mistake of a yield curve inversion.
Ironically, the market could advance 15% in 2019 and still not make a new high from where things were in late Q3 2018. I offer no such forecast of broad equity market returns in 2019, for the simple reason that market multiples are inherently unpredictable, and our philosophy at The Bahnsen Group is so bottom-up focused, we do not believe it matters.
Rather, our focus is on individual companies with significant earnings power that are likely to benefit from a more relaxed Federal Reserve. As stated in theme #6, we have plenty of patience around our energy infrastructure outlook. We believe there is embedded value in cash-generative asset managers. Low-valuation, high free-cash-flow yield names are more sensible to us than broad equity index investing given the total milieu of headwinds and tailwinds. Companies that are highly dependent on frothy credit markets with unattractive capex liabilities and inadequate cash generation are unattractive to us at this time, at least on a risk/reward basis.
We want to buy the contrarian story that Europe is investible but just cannot do it other than in the most marginal and peripheral of ways. Yes, valuations have collapsed and sentiment is atrocious. Nevertheless, the true elephant-in-the-room plaguing Europe (an incoherent set of fiscal policies across their member countries paired to a shared monetary union that inevitably benefits some while ailing others) still remains. On one hand, the idea of an ECB-led “new bazooka” of monetary accommodation could ignite risk assets there, but betting on that recklessness is far outside our client mandate (and besides, we think new levels of fiscal stimulus are more politically likely than new levels of monetary stimulus). We remain willing to miss a potential bounce in Europe, out of a desire to avoid some of the more disproportionately damaging risks that exist in Europe structurally (zombie banks, populist tantrums, threats of defections, etc.).
Japan is a different story. I was clearly early in entering the Japanese dividend growth theme in the second half of 2017, but I do not believe the theme itself is broken. It was always intended to be a long-term story, and that has not changed. I would not suggest it is tactically attractive or unattractive in 2019, just that it is a story we believe will work out over time very favorably as Japan’s corporate economy monetizes their high cash position, transitions off of a low dividend payout ratio, and takes advantage of their low capex needs.
If there is anything I would leave you with about 2019, it is the timeless message that no one knows what the year will hold, least of all the people most boldly claiming that they do. We feel confident in our themes and positioning for 2019, precisely because we have avoided arrogance and excessive risk in how these decisions were made. The cost for being early, late, or wrong in some of these calls is minimal, as our portfolio management process is created from a lasting commitment to durability and survival. Refusal to take potentially fatal risks limits upside potential, but it does something else far more important for our clients.
The world is an uncertain place right now, and the political atmosphere in America often feels broken. The financial crisis is over ten years removed from us on the calendar, but the unwinding of post-crisis decisions is very much alive. That reality, surrounded by peripheral complexities like the trade war, make for a challenging environment. Yet out of the sell-off of December 2018 and the market realities that exist persists a ripe investing opportunity for those who exercise discipline, patience, restraint, and wisdom. We promise no respite from volatility, but we do promise alignment of financial goals with optimal portfolio construction designed to meet said goals.
To that end we work, in 2019 and beyond.
