PHOTO CREDIT: NASA Earth Observatory image by Joshua Stevens, using MODIS data from NASA EOSDIS/LANCE and GIBS/Worldview
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Source: Orion Advisor Services, AlphaGlider
INVESTMENT ENVIRONMENT1
Global equity markets finished the decade on a strong note. The MSCI All-Country World Equity Index IMI,^d a good proxy for global equity markets, was up 9.1% for the fourth quarter on a total return basis, and 26.4% for the year. Emerging markets (MSCI Emerging Marketsc) led the way with an increase of 11.8%. However, it was the US market (S&P 500a) that dominated global equity markets over calendar 2019 and the decade as a whole, up 31.5% and 257% (13.6% annualized), respectively.
Fixed income markets took a breather in the fourth quarter, +0.2% for the Bloomberg Barclays US Aggregate Bond Index,e after a buoyant first nine months of the year.
The first portfolio manager I worked for when I started my investment career in the 90s used to always say that “earnings drive returns,” but that wasn’t the case for equity markets in 2019. For example, the US equity market’s strong performance last year (S&P 500: +31.5%) stands in stark contrast to its earnings growth. Entering 2019, sell-side analysts forecasted 8% growth in S&P 500 earnings for the year but they will likely end up being flat as shown below.
Source: FactSet, Axios Visuals, AlphaGlider
International companies also experienced a 2019 earnings growth drought accompanied by large share price increases. Changes in earnings per share for developed (MSCI EAFEc) and emerging (MSCI Emerging Markets) market equity indexes over 2019, per I/B/E/S estimates, were -2% and +1%, respectively. Their total returns for the year were +22.0% and +18.4%, respectively.
Mind you, markets are forward-looking machines, reacting today to expectations of the future. With such large price moves across global equities markets in 2019, investors appear extremely optimistic about corporate earnings over the next couple of years. The two primary developments for investor optimism over the last year, in our opinion, were: 1) renewed stimulus from central banks around the world, and 2) a relaxation in US-China trade tensions.
First, and most importantly — central bank stimulus. In response to a slowing manufacturing sector, the Federal Reserve (Fed) made three (3) 25 basis point (0.25%) cuts to their benchmark overnight rate, which exited the year at 1.5-1.75%. But perhaps more impactful to the economy and the markets, but less reported by the press, was the Fed’s sudden reversal from selling down about $35 billion worth of government securities per month from its balance sheet, to aggressively adding around $100 billion per month (quantitative easing).
Source: Board of Governors, St. Louis Fed, AlphaGlider
The Fed wasn’t the only central bank stimulating the global economy — over half of the central banks in the world were also easing as of the third quarter, a rate not seen since the last decade’s global financial crisis. The European, Chinese, Indian, and Australian central banks were among the larger players to join the Fed in cutting rates last year. Most of these central banks are signaling they will continue their dovish policies in order to keep the next recession at bay.
Source: UBS, Financial Times Research
The second reason for optimism in 2020 — the apparent relaxation in US-China trade tensions. Although the President Trump and China President Xi Jinping appeared to reach a tentative truce in their trade war over dinner in Buenos Aires in late 2018, the two countries couldn’t agree on the details of the deal in the following months. Frustrated by the delay, Trump ratcheted up tariffs against China twice more in 2019, and threatened to do so a third and fourth time during the fourth quarter. However, the two countries reached a new agreement late in the year that has much in common with the tentative deal to which Trump and Xi agreed in Buenos Aires. In this agreement, which is being dubbed the “phase one” deal, the US is agreeing to a modest reduction in its current high tariff levels, while China is agreeing to make large purchases of American agriculture and energy commodities and to address some of the Americans’ concerns about intellectual property. The deal may be signed as soon as this week.
Source: Peterson Institute for International Economics, AlphaGlider
Just before Christmas, the House impeachment inquiry found that Trump solicited foreign interference in the 2020 US presidential election from Ukraine to help his re-election bid (abuse of power), and then obstructed the inquiry itself (obstruction of Congress). The Senate’s impeachment trial will begin soon now that House Speaker Nancy Pelosi sent the impeachment articles to the Senate this week. Only two previous US presidents have been impeached (Andrew Jackson and Bill Clinton), and neither of them were convicted during their Senate trials. Gauging by the lack of market reaction to the impeachment proceedings, it would appear that investors expect with high certainty that Trump will become the third president to be acquitted by the Senate in his impeachment trial.
Besides impeaching the President, the House also voted overwhelmingly to approve the USMCA trade deal between the US, Canada, and Mexico after the White House made concessions to the Democrats to eliminate some patent protections for pharmaceutical companies and to boost enforcement of labor and environmental standards. The deal, which will supersede NAFTA, moves to the Senate where it is expected to be easily ratified in the current quarter.
The three and one-half year saga that is Brexit appears to be moving into its final phases. After failing to get his Brexit deal through Parliament last fall, UK prime minister Boris Johnson called a December general election in hopes that the electorate would deliver him a strong mandate to get his deal done. Johnson, and his Conservative party, won in a landslide. Assuming the European Parliament gives a green light to the exit agreement, which they are expected to do, the UK will officially withdrawal from the European Union (EU) on January 31. However, there will be a transition period during which the old rules will apply (i.e. UK still being in the EU) to allow the UK and the EU to hammer out the a trade deal before the transition period ends at the end of 2020.
At this point, it would appear that we will see a “soft” Brexit that will allow for relatively easy movement of citizens between the two blocs and no customs border between the Republic of Ireland (part of the EU) and N. Ireland (a part of the UK). UK and European businesses should gain final clarity on trading terms by the end of the year, four and one-half years after the UK population narrowly voted to leave the EU.
We have written much about the tensions between the US and Iran ever since Trump pulled out of the nuclear deal known as the Joint Comprehensive Plan of Action (JCPOA) in May 2018. The subsequent sanctions that Trump applied against Iranian oil and gas exports have been effective in crippling its economy and currency, the rial. Iran struck back against the US and its regional allies throughout 2019 by attacking oil tankers in the Persian Gulf, downing a US drone, and temporarily disabling one-half of Saudi Arabia’s oil processing capacity. In the final weeks of 2019, Iran more directly targeted Americans by using its Shiite proxies in Iraq to launch rockets into US-manned bases, killing an American contractor.
Source: Bloomberg
Trump refused to retaliate militarily against Iran throughout most of 2019, but his patience with Iran’s attacks expired in the year’s final days. On December 29, the US hit targets in Iraq and Syria controlled by Kataib Hezbollah, an Iranian-backed paramilitary group, killing 25. Two days later, pro-Iranian protesters stormed the grounds of the US embassy in Baghdad but did not harm any embassy staff who hid in a safe bunker until US marines dispatched from Kuwait were able to disperse the protesters with tear gas.
On January 2, Trump broke the tit-for-tat dynamics between the two countries by authorizing airstrikes on two of Iran’s highest ranking military leaders. One of those attacks was successful, killing Maj. Gen. Qassim Suleimani soon after he disembarked from a commercial flight at Baghdad’s airport. The killing of Suleimani, Iran’s de facto number two in command, set off large protests in the streets of Iranian and Iraqi cities, condemnation and threats of retaliation from Tehran, and a request by Iraq for the US to remove its troops from their country. A few days later, Iran launched 16 missiles into two Iraqi bases housing US troops, but only caused minimal damage and no loss of life.
The situation is fluid as I write this, but it appears that both Washington and Tehran are deescalating the conflict. However, this cessation in hostilities will likely be temporary as Iran continues to suffer heavily from US economic sanctions and Trump has promised to prevent Iran from developing nuclear weapons — a goal that Iran is likely pursuing aggressively now that the US pulled out of the JCPOA and killed Suleimani. Investment markets, including the energy markets, have remained remarkably steady (or perhaps complacent) throughout this period of rising conflict between the US and Iran.
PERFORMANCE DISCUSSION
Despite their conservative footing, AlphaGlider strategies held their own during a very strong fourth quarter for global equity markets. Our most conservative strategy, AG-C, slightly beat out its benchmark, but our remaining strategies slightly trailed their respective benchmarks.
For the quarter, our strategies benefitted from their overweight positions in emerging markets (SPDR Portfolio Emerging Markets, SPEM; +11.0%). Our strategies were also helped by the short duration in their fixed income funds as rates rose in quarter. Our strategies were most held back by their overall underweight positions in equities, and by the mix of regions and industries in our equity exposure. For example, our US consumer staples (Fidelity MSCI Consumer Staples, FSTA), US high quality (Vanguard Dividend Appreciation, VIG), and Singapore (iShares MSCI Singapore, EWS) funds all fell short of the global equity market’s (MSCI ACWI IMI) +9.1% showing, ‘only’ putting up +3.6%, +4.8%, and +7.0% returns during Q4.
AlphaGlider strategies’ relative underperformance was slightly worse over the fully year of 2019 than for the fourth quarter — they returned between 70% and 80% of their respective benchmarks. We were underweight the most expensive parts of the market and overweight the cheapest, but 2019 was a year in which the most expensive assets appreciated the most. Our underweight positions in equities, particularly US equities, and the short duration in our fixed income exposure during a year of collapsing rates were the primary reasons for our relative underperformance.
Despite their slightly higher fund expense ratios, our ESG strategies marginally outperformed (8-18bps) their core AlphaGlider strategy counterparts over the six months of their activity. We’re still new at this, and this data is too short to be statistically significant, but we believe our ESG strategies will track closely with our core strategies given the small difference in their fees and the similar macro exposure relative to their benchmarks.
OUTLOOK & STRATEGY POSITIONING
This section usually focuses on the investments bought and sold by AlphaGlider strategies, with a particular focus on pre-tax expected returns. However, it’s after-tax returns that really matter to us all as investors — after all, it’s after-tax returns that we ultimately spend. In the waning days of 2019, Congress and the President altered the rules governing the ways many of our retirement accounts are taxed when they signed into law the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Although the name of the Act suggests that your after-tax returns will be going up, they very well may be going down as a result of the Act which went into effect on January 1. In the following section, I discuss the most important parts of the SECURE Act that affect many of our clients and readers, particularly those who are still of working age.
First, three bits of good news that may affect you:
Required minimum distributions (RMDs) from non-Roth retirement accounts are now triggered when you turn 72 instead of 70.5. If you are fortunate to have sufficient taxable funds to live on, you can now push back the start of your RMDs by one year if you were born in the second half of the year, or by two years if you were born in the first half of the year. If you turned 70.5 on or before 2019, you continue to play by the old rules. Note that actuarial life expectancy tables used for RMD calculations haven’t changed since 2002 despite the life expectancy for 65 year olds increasing by 8% since that time. Fortunately, the Internal Revenue Service (IRS) has proposed new tables reflecting longer lives (thus lower RMDs) which could go into effect for all affected individual retirement account (IRA) owners next year.
You can now contribute to a traditional IRA beyond the age of 70.5. Of course you’ll still need to have earned income in order to qualify to contribute to a traditional IRA. Note that you could always contribute to most other types of retirement accounts if you had earned income past the age of 70.5, and that hasn’t changed with the SECURE Act.
529 plans can now be used to service up to $10,000 in student loans tax-free. Say your youngest child graduated college with $10,000 remaining in their 529. And say your oldest child not only exhausted their 529, but also racked up some college debt. You can now pay off up to $10,000 of that debt by moving funds from your younger child’s 529 to your older child’s depleted 529, and then paying down the debt.
And now a few detrimental sections of the SECURE Act:
- Non-spousal inherited IRAs must now be completely emptied by the end of the 10th year following the year of inheritance. This is a biggie, and it hurts AlphaGlider’s clients and readers who are young enough to have living parents or grandparents with IRAs that will be willed to them. It used to be that inherited IRAs (including inherited Roth IRAs) had RMDs based on the single life expectancy of the inheriting person (otherwise known as a stretch IRA). For example, if I had inherited an IRA from my one of my parents last year, I would only have to distribute 1/32.3 of the IRA this year (see Table 1 in Appendix B of IRS Publication 590-B for a 52-yr old beneficiary). The denominator in the fraction would then decrease by one in each subsequent year. Assuming I live to 95, I would have had over 40 years to benefit from the beneficiary IRA’s tax sheltering properties. Now if I inherit an IRA from parents, I’ll be forced to empty it within 10 years. Not only will I miss out on 30 years of tax sheltering, I will also likely be forced to pay a much higher tax rate on my IRA distributions because they a) will be received while my household income is higher as both my wife and I expect to be working over the next decade, and b) will be larger in any given year and thus could push me into a higher tax bracket. So much for “setting me up for retirement enhancement” with this provision.
- Annuity offerings will become more common in 401(k) retirement plans. Having more investment options sounds positive, but it’s probably not the case here. Annuities have always been permissible in 401(k) plans, but they were rare (only 9% of plans had them per the Plan Sponsor Council of America). 401(k) plan administrators, who are held out as fiduciaries by the regulators, have feared being sued should their chosen annuity provider go bankrupt or be determined to have predatory sales and pricing practices. Much to the delight of annuity carriers who aggressively lobbied Congress, the SECURE Act lowered the bar for plan administrators to meet their fiduciary responsibility when it comes to vetting annuity products for their plans. Plan administrators can now eliminate their legal exposure by reviewing written representations from the annuity provider (e.g. being properly licensed, meeting state insurance requirements, passing periodic financial examinations, etc.). The Act also specifically states that the plan administrator does not have to select the lowest cost annuity provider, but rather only needs to determine that the provider’s costs are “reasonable.” The standard for annuities in 401(k) plans is now on a similar level as in the retirement plans for education and non-profit organizations, the 403(b). While annuities may be helpful for some risk-averse savers late in their career, most savers with multi-decade investment time horizons are better served by investing in portfolios heavily exposed to equities. Annuities are complex investment instruments, which makes them ripe for their creators to embed high, but hard to see, expenses. Aon Hewitt reports that over three-quarters of 403(b) assets are in annuities. On a positive note, we are starting to see more state and SEC investigations into questionable annuity provider sales practices, including those of TIAA, AIG, AXA, Voya, and MetLife.
In my opinion, these are the five most important changes brought on by the SECURE Act as it pertains to a majority of my clients and readers. Below is a good summary chart of the Act’s other changes.
Source: Michael Kitces
The enactment of the SECURE Act probably doesn’t affect the way Americans should save for retirement (continue to max them out!), but it does affect the magnitude of tax-advantaged retirement account benefits. Those expecting to inherit IRAs are the big losers here. Winners include those who are wealthy enough to postpone the start of their retirement account distributions to age 72, and those who plan to work past the age of 70.5 (lucky you). If you have any questions about how the SECURE Act impacts your particularly situation, please don’t hesitate to reach out to me. And if your 401(k) suddenly gets an annuity option and you are tempted by it, give me a call ASAP!