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INVESTMENT ENVIRONMENT1
Source: Orion Advisor Services, AlphaGlider
Last quarter, and calendar 2018, were the worst quarter and year for global equity markets since the Great Recession a decade ago. The MSCI All-Country World Index (ACWI) Investable Market Index,^d which AlphaGlider uses for the equity portion of its benchmarks, was down over 13% during the quarter, and down over 10% for the year. US equity markets were down more than foreign equity markets in Q4, but down less over the full year. Investors fleeing to quality and safety drove up bond markets during Q4, helping US bonds to just barely break into the black for 2018, as measured by the Bloomberg Barclays Aggregate Index.e
The US economy continues to grow strongly, stimulated by lower corporate tax rates, deregulation, and higher government spending. Real GDP expanded 3.4% in Q3 over the prior year period, and is expected to grow approximately 2.5% during Q4. Unemployment remained extremely low at 3.9%, and average hourly private sector earnings grew 3.2%, the latter’s highest rate since 2007. Unsurprisingly, US holiday retail sales were buoyant and consumer confidence levels remained high.
While the US economy looks healthy in the rear view mirror, the view out the windshield is less sanguine. The Trump administration’s tax and spending plans added $2 trillion (over $6,100 per American) to the national debt (now approaching $22 trillion) during a strong economy. A decade into an economic upturn, the US should arguably be paying down its debt so that it better restores its ability to stimulate the economy during future downturns.
Source: Bloomberg, J.P. Morgan, AlphaGlider
The corporate sector also loaded up on debt this cycle, going from less than 1.5x earnings before interest, tax, depreciation, and amortization (EBITDA, a measure of the cash available to pay off the company’s debt’s interest and principal), to 2.3x. Much of this corporate borrowing went into stock buybacks.
While manageable when interest rates are low and income is strong, these higher debt levels become more difficult to sustain as rates increase and growth inevitably decelerates once the sugar high from lower corporate tax rates, deregulation, and higher government spending wears off. But unlike the federal government and companies, the US households (with the exception of recent college grads) de-levered their balance sheets nicely during this economic cycle.
With the sustained expansion in the US economy, the Federal Reserve (Fed) raised its benchmark rate by a quarter point for its fourth time in 2018 and its ninth time since late 2015 — to a range of 2.25-2.5%. However, the Fed pulled back its future guidance of expected rate increases in 2019 from three (3) quarter point increases to only two (2). It should be noted that the bond market believes that deteriorating fundamentals will force to the Fed hold steady at 2.25-2.5% for the entirety of 2019. Fed Chair Jerome Powell indicated on January 4 that the Fed may back off its path of rate increases and winding down its balance sheet if economic data and stock market movements justify doing so.
As I discussed in my recent CIO Commentaries, the bond market is warning of the growing likelihood of recession over the coming year or two — via the flattening of the yield curve. The delta between the 2-year and 10-year Treasuries compacted further during the quarter to only 19 basis points (bps; 0.19% points), down from 23bps at the end of Q3 and 30bps at the end of Q2.
Chief financial officers (CFOs), the employees most familiar with their companies’ numbers, are also pessimistic about the global economy according to a recent Duke University survey. Nearly half of the 226 US CFOs surveyed believe that the US will enter into recession by the end of 2019, and 82% of them believe that a recession will have begun by the end of 2020. CFOs from other countries are similarly pessimistic about their companies’ local economies, with 86% of Canadian, 67% of European, 54% of Asian, 42% of Latin American, and 97% of African CFOs expecting recession by end of 2019.
Source: Steve Sack/Star Tribune
Democrats gained control of the House of Representatives in the November midterm elections, while Republicans made a net gain of two seats in the Senate, securing a 53-47 majority. With split control of the House and Senate, the prospect a meaningful legislative action over the next two years is unlikely. However, the gridlock kicked off even before the House officially changed hands on January 3, with the partial shutdown of the federal government on December 21. Trump maintains he won’t sign a government funding bill that doesn’t include $5.7 billion for his Mexican border wall, while Democrats in the House and Senate have offered up only $1.3 billion for border fencing and approximately $300 million more for other technology-based boarder security items. Trump warned on January 4 that the partial shutdown could last for “months or even years” if he doesn’t get his wall funding. Even though both sides appear dug into their positions, we suspect that the pain and hardship created by the shutdown will force a compromise within days or weeks.
Trump’s tariff war against its largest trading partners began to take its toll on the US companies and consumers which pay the tariffs on their imported purchases, and on US companies and farmers which are losing export sales and pricing due to retaliatory tariffs. The magnitude of these impacts increased dramatically in late September with Trump’s application of a 10% tariff on an incremental $200 billion of Chinese imports, and China’s retaliatory tariffs on $60bn of US exports to China. Trump had threatened to increase the tariff on Chinese goods from 10% to 25% on January 1, 2019 if China did not give into his demands for fairer trade practices. However, Trump pushed back his deadline to March 2, 2019 after a post-G20 summit dinner meeting with Chinese President Xi Jinping in Buenos Aires during which Xi pledged more purchases of US agriculture, energy, and industrial products. Mid-level negotiations between the two countries began in Beijing this week.
Chinese manufacturing activity slipped into contraction in December, for the first time in 19 months. While US tariffs were a headwind for Chinese manufacturers, it was the steep fall in domestic demand that surprised many market participants. Several US companies have also blamed weakening Chinese consumer demand recently, including Apple, Starbucks, FedEx, Tiffany, and Ford.
Slowing growth has not been confined to China. Japan (the 3rd largest economy in the world behind the US and China) and Germany (4th) both had negative quarter on quarter GDP growth in Q3, albeit with the aid of some 1-off negative factors. On a year-on-year basis, their respective GDP Q3 growth rates were an anemic 0.0% and 1.1%, respectively.
Politicians within the United Kingdom (UK) seem no closer to agreeing to Brexit terms than the day after the fateful June 2016 Brexit vote which put the divorce in motion. UK Prime Minister Theresa May’s deal for a “soft” Brexit is unpopular with politicians from both pro- and anti-Brexit camps, and currently does not have the votes to clear Parliament. Upon stalling for time to attract more support for her deal, May was challenged with a vote of no confidence in December — which she survived. The situation is extremely fluid as we approach the March 29, 2019 negotiating deadline, but it appears that the probability of the UK either crashing out of the European Union (EU) without a trade deal, or deciding to hold another Brexit referendum, have increased recently. The outcomes forced by the March deadlines for US-China trade and UK- EU Brexit negotiations will surely be important topics in my 1Q19 CIO Commentary.
Source: J.P. Morgan Asset Management
Global commodity markets are also flashing warning signs about the economy going forward. The price of WTI crude oil collapsed 38% during Q4, while copper is off 20% from its summer highs. Although rising supply is an important factor in setting prices of these commodities, so too is falling demand.
PERFORMANCE DISCUSSION
I devoted much of this section in last quarter’s CIO Commentary to the “barbell” nature of global investment markets during the first nine months 2018. The majority of equity and fixed income segments across the globe had produced negative returns, but a small and high profile band of US companies in the technology, health care, and consumer discretionary sectors had done extremely well. In Q4, the trend fell apart in dramatic fashion.
Equities were down across the board in Q4, but the best relative performers during the first nine months of the year were among the worst performers in Q4 — US technology was down 17% and consumer discretionary down 16%. The worst relative performer during the first nine months of the year, emerging market equities, was down “only” 7.5%, 580bps better than the equities portion of our benchmarks, MSCI ACWI IMI. Reversion to the mean was the name of the game, and thus was challenging for market participants who had deliberately overweighted past winners (momentum players), or those who had unconsciously overweighted past winners (those on autopilot and failed to rebalance).
All AlphaGlider strategies were down in absolute terms during Q4, but all but our most conservative strategy (AG-C) outperformed their respective benchmarks. The biggest driver of our relative outperformance during the quarter was our underweight position in equities. The mix of regions within our equity positions also helped our relative performance — being underweight US equities (S&P 500 was down 13.5%) and overweight emerging market (SPEM, SPDR Portfolio Emerging Markets)2 and Singaporean (EWS, iShares MSCI Singapore) equities which were down “only” 5.8% and 7.0%, respectively.
Our Q4 performance was held back somewhat by the short duration of our fixed income investments relative to the index. The 10-year Treasury yield fell 37bps to 2.69% during the quarter which benefitted longer duration bonds more than the shorter bonds we predominately held.
All AlphaGlider strategies outperformed their benchmarks during 2018, yet still finished in the red in absolute terms. As in Q4, our underweight position in equities was the primary driver to our relative outperformance for the full year. During 2018, MSCI ACWI IMI was down 10%, while the fixed income portion of our benchmarks, Bloomberg Barclays US Aggregate Bond index, was flat.
Although the short duration of our fixed income allocation hurt us in Q4, it benefitted us for the full year (the 10-year Treasury yield rose 28bps). Our various short duration bond positions posted small positive returns.
We were relatively successful with some of our more narrowly focused US sector funds, specifically our health care (FHLC, Fidelity MSCI Health Care, +5.5%), technology (FTEC, Fidelity MSCI Information Technology, -0.4%), and communication services (FCOM, Fidelity MSCI Communication Services, -0.9% vs -10.1% for the S&P 500 over our 6-month holding period).
The main drag to our strategies’ performance during 2018 was our overweight position in emerging markets (SPEM, -13.2%), our equal weight position in developed foreign markets (SPDW, SPDR Portfolio Developed World ex-US, -14.2%; EWS iShares MSCI Singapore, -11.3%), and in our two value oriented US equity funds, (SPYV, SPDR Portfolio S&P 500 Value, -9.0%; VDC, Vanguard Consumer Staples, -7.8%).
OUTLOOK & STRATEGY POSITIONING
AlphaGlider entered 2018 with a significant underweight position in US equities based on valuation grounds. Fast forward to today and the valuation on US equities has improved — i.e. they have become cheaper.
Exiting 2017, US equities (as represented by the S&P 500) were trading on 24x trailing earnings (i.e. trailing P/E), 18x forward earnings, and sported a trailing dividend yield of 1.8%. With the aid of significant operating margin expansion, corporate tax cuts, and a 6.2% price drop during 2018, the S&P 500 enters this year trading on a trailing P/E of 18x, a forward P/E of 14.4x, and a 2.0% trailing dividend yield. US equities are definitely more attractive now than they were a year ago, but we found that foreign equities became even more attractive.
The chart below shows a couple interesting things about the S&P 500 and foreign equities. First, the chart shows that the S&P 500 and foreign equities (ACWI ex-US) historically generated similar long-term returns — that was until 2012 when the S&P 500 left the rest of the world in its dust. The chart only goes back to 1997, but I can confirm that the returns of the S&P 500 and developed foreign equities (MSCI EAFE, developed foreign equities) between 1970 and 1996 were relatively similar, 12.8% and 12.5% annualized, respectively. Data for ACWI ex-US doesn’t exist for this time period, but I expect it would be similar to EAFE as any emerging market component of ACWI ex-US would have been relatively small prior to 1997.
Source: J.P. Morgan Asset Management
We think that higher interest rates and elevated leverage (see net debt/EBITDA chart in Investment Environment section above) should soon begin to dent the rate of US share buybacks.
We think that the S&P 500’s 12%+ operating margins, which are running approximately 50% higher than than their average over the last 20 years, are more vulnerable than foreign company margins which haven’t expanded much above their long-term averages (see chart below). The bottom line is that higher margins attract more competitors and encourage workers to more aggressively demand their “fair share” of company profits.
Source: Yardeni Research, AlphaGlider
We think that the $1 trillion federal budget deficits are unsustainable and will eventually need to be reduced, in part, through higher corporate tax rates.
Another interesting observation from the MSCI ACWI ex-US and S&P 500 Indices chart is the current valuation premium of the S&P 500 relative to the rest of the world. The S&P 500’s forward earnings multiple is 25% higher than the rest of the world’s (14.4x vs 11.5x), and its dividend multiple (inverse of its dividend yield) is 65% higher. This implies that the market believes that the S&P 500 will grow earnings, cash flows, and dividends more quickly than foreign companies going forward. This seems somewhat improbable in our mind as historically the S&P 500 has grown earnings at a similar rate as foreign companies (that’s why returns between 1970 and 2012 are so similar). And with potential EPS growth headwinds for the S&P 500 in the form of deleveraging/slower buybacks, operating margin pressure, and higher tax rates, we actually think that its EPS growth will lag that of foreign companies over the coming decade. As such, we believe that the S&P 500 should actually trade at discount, not a premium, on current earnings and dividend valuations.
Our clients and close followers of my writings will know that we are not fans of a simple price to earnings multiples in isolation, as they tend to be highly misleading during periods of market extremes. When we are in the depths of a recession, which cause profit margins to be low, P/Es are pushed to their peaks (because the denominator, EPS, collapses), incorrectly indicating overvaluation. And when we are in the late innings of a long economic cycle, P/Es appear deceptively low (because of the temporarily high denominator).
A decade into this economic recovery, with margins 50% above their longer-term average and share prices triple to quadruple their 2009 lows, we think that we are in one of those periods of market extremes in which P/Es are misleading. In times like these, we prefer to look at cyclically adjusted P/Es (CAPE, or also commonly referred to as a Shiller P/E), price to book (P/B), and price to sales (P/S). These valuation metrics, like nearly all valuation metrics, are pretty useless over short time periods, but they tend to do a good job at predicting long-term returns (e.g 10 years) throughout the investment cycle, including periods of market extremes.
The chart below shows a range of valuation metrics for various regional markets, all relative to that of investable equities around the world (i.e. what we use for our benchmark, MSCI ACWI IMI) as of the end of 2018. The data for the chart is from StarCapital Research as of December 31, 2018. The chart clearly shows the large valuation premium of the US market relative to equities in foreign developed markets, and especially relative to the regional equities in which AlphaGlider strategies are overweight — emerging markets and Singapore (a developed market). We do not only like these regions because they are cheap. We also like them because we believe their companies are more likely to maintain or expand their operating margins, while also growing faster, than most other regions in the world — particularly the US.
Source: StarCapital Research, AlphaGlider
World Equity Valuations: 21.1x CAPE, 14.8x trailing P/E, 9.4x P/CF, 1.9x P/B, 1.3x P/S, 35.8x P/Div (2.8% dividend yield)
Ok, by now you should know why we prefer international equities (emerging markets and Singapore specifically) to US equities. Now it’s time to discuss how we are putting these convictions to work, and how our strategies differ from our benchmarks and from typical US investors’ portfolios.
Let’s take our down-the-middle 60/40 strategy, the AlphaGlider Global Balanced Strategy (AG-B), as an example. 60/40 here refers 60% equities and 40% bonds, which is the makeup of AG-B’s benchmark. As we’ve mentioned earlier in this commentary, we use a global equity index (MSCI ACWI IMI) for the benchmark’s 60% equity portion.
Source: AlphaGlider
To the right we have a chart that breaks down current international and domestic equity allocations for AG-B, for its benchmark, and for our best guess of a “typical” American household today. You’ll notice that at 51% total equities, AG-B is underweight relative to the benchmark (60%), and to the typical household (65%—admittedly a swag) which has either been slow to rebalance 10 years into this bull market, or worse, has become overconfident and put fresh money into what was been doing well for them over the last couple of years.
Although AG-B is underweight equities, it is actually overweight international equities, 29% vs 27% for the benchmark and only 13% for the typical household (the International Monetary Fund puts the split of domestic/international equities in US household portfolios at approximately 80/20). And when it comes to US equities, AG-B is heavily underweight: 22% vs 33% for the benchmark and 52% for the typical household.
We have no idea when the next recession and/or severe market downturn will occur, or what will be the catalyst to trigger them. We admittedly have no clue how stocks will perform over the coming year, and we remain suspect of anyone who believes that they do. However, we have observed that securities which are priced for perfection rarely turn out to be perfect. And when they don’t work out and reality takes hold, losses can be quite high. Our valuation work leads us to believe that US equities may be priced for perfection right now (refer back to the chart two pages ago). Admittedly, US equities have performed well in the recent years, despite their high valuations, hurting our strategies’ absolute and relative performance. But we’re in this for the long-term while protecting our downside risk in the short-term. This path helped our strategies beat our benchmarks in Q4 as well as the full year, and we believe it will continue to work well going forward as the valuation gap between US and foreign equities converge.
During the fourth quarter we made one small adjustment to our strategies — we sold out of our relatively young position in a telecommunication services sector fund, (FCOM, Fidelity MSCI Communication Services), soon after its holdings were reshuffled due to sector classification changes. We used the proceeds to boost the size and duration of our fixed income position by buying more of our preferred US aggregate bond fund (SPAB, SPDR Portfolio Aggregate Bond).