Photo credit: Katherine Frey/The Washington Post
Source: Orion Advisor Services, AlphaGlider
INVESTMENT ENVIRONMENT1
After putting up a nearly 20% gain in the second quarter, global equity markets continued their bullish ways in the third quarter with an 8% gain. Year-to-date, global equity markets (as measured by the MSCI ACWI index)^d squeaked back into positive territory, a miraculous outcome given their 22.4% deficit at the end of the first quarter. Emerging markets were the best performing region during the third quarter while the US was the strongest year-to-date.
Domestic fixed income securities (as measured by the Bloomberg Barclays US Aggregate Bond index)e notched a modest increase in the third quarter. However its +6.8% year-to-date performance still exceeded that of US equities.
The COVID-19 pandemic continued to wreak havoc on human health and the global economy, a condition that will likely continue for several more quarters given the onset of the northern hemisphere flu season and the long lead time to develop and widely distribute a vaccine. The US continues to be among the worst affected countries exiting the quarter, on both an absolute basis and a per capita basis, with more than seven million confirmed cases and 200,000 deaths.
Source: OurWorldInData.org
As the quarter ended, President Trump contracted the virus — joining UK Prime Minister Boris Johnson and Brazil President Jair Bolsonaro as leaders of major countries who downplayed the seriousness of the virus, mishandled their respective country’s response to it, and also became infected by it.
Europe was hit hard during the early stages of the pandemic, but government-mandated restrictions were effective in arresting the spread of the virus over the late months of spring and early months of summer. With most of those restrictions lifted over the summer, a worrying second wave of infections is ramping across the European continent (see graph below; note that the EU’s population is over one-third larger than the US’s). Some local jurisdictions in Europe are reimposing restrictions that were effective against the virus, but damaging to their economy in the short term.
Source: GZERO, Johns Hopkins University
Source: The Wall Street Journal
Key aspects of the US economy continued to improve in Q3, including unemployment, retail sales, consumer confidence, manufacturing activity, service activity, imports, or exports. Economists and politicians debated whether the aggressive US fiscal and monetary responses would result in a V-shaped (rapid) or a U-shaped (slow) economic recovery. So far it looks like both are happening, with highly educated and well-off people doing just fine while less educated, less well-off, minorities, women, and small service business owners struggling. In other words, we are having a K-shaped recovery. Generally speaking, the former group has held onto their jobs because they could be moved online, whereas many in the latter group have lost their jobs or have been forced out of employment to take care of children affected by school closures.
Source: BCA Research
Unemployment benefits and the CARES Act initially helped both categories of Americans, but the payouts have begun to taper off. Given the rebound in the US stock market and the distractions from the upcoming election, fresh COVID-19 infections within its ranks, and a surprise Supreme Court confirmation process, the odds of Congress approving another COVID-19 spending package before the election to support those hardest hit are fading. But even without additional aid spending, the US government response to the pandemic has been much more aggressive than by the rest of the world. Although the US makes up just over 15% of global GDP, its fiscal spending to combat the economic effects of the pandemic has nearly matched that of the rest of the world combined, (see chart to right). While US companies and individuals have benefitted from this stimulus this year, they are on the hook for the bill in the form of higher government debt. This debt will have to be paid back eventually by a combination of raising taxes, cutting government spending/benefits, and currency debasement/inflation. In just over a decade the 2007-8 financial crisis, Trump tax cuts, and COVID-19 stimulus have more than doubled the US federal debt as a percent of gross domestic product (GDP), as shown in chart below.
The Federal Reserve (Fed) announced a major shift in its price stability (i.e. inflation) policy. The Fed is not changing its target to achieve a 2% inflation rate, but it is changing how it measures it. In the past, the 2% target was an instantaneous measurement. Going forward, the target will be measured over an undetermined period of time in what the Fed calls a “flexible form of average inflation targeting.” As inflation has been running below the Fed’s 2% target for much of the last decade, the Fed will now use its monetary policy to attempt to drive US inflation above 2%, the amount and duration yet to be determined. In accordance to this new policy, the majority of Fed members expect their benchmark rate to be pegged at its current 0-0.25% level through 2023, as shown below.
Source: Bloomberg
Many a wise investor has warned against paying too much attention to politics, particularly presidential elections. However 2020, like 2016, may turn out be an exception to this rule. Economic policies, be they tax, trade, or regulatory related, tend to be fairly static regardless of the party of the President due to momentum and resistance from an opposing party controlling one or both houses of Congress. We saw Trump and the Republicans enact major tax cuts,scrap trade agreements, rollback environmental regulations, and hinder the Affordable Care Act (ACA) during the 2017-18 window they controlled Congress and the Presidency. These economic policy changes reshuffled the deck so to speak, creating new winners and new losers within the US, and global, investment landscape. If polls and betting markets are to be believed, we may see another seismic shift in economic policies that could affect our investments, both at home and abroad. As I write this on October 9, bettors on PredictIt.org put the odds of a Democrat sweep at ~60% (see chart below; ~68% on the Presidency, ~68% on the Senate, and ~88% on the House). Should the Democrats sweep, we would expect corporate taxes to increase for all US companies (Biden’s plan calls for a 28% corporate tax rate, up from Trump’s 21%), the return of environmental regulations erased by the Trump administration, more government involvement in the health care sector, lower tariffs, additional COVID-19 payouts, and more predictability and consistency in policy overall. Generally speaking, we expect many of the tailwinds created by the Trump and the Republicans to turn into headwinds, and vise versa with the Republican created headwinds. It’s the status quo should Republicans hold either, or both, of the Senate and the Presidency. Democrats have a strong hold over the House at the moment, so a Republican sweep as in 2016 appears unlikely.
Source: PredictIt.org
Investors have generally reacted calmly to the increasing probability of a Democrat sweep (S&P 500 +8.8% in Q3 with subdued price movements), however options and futures on the VIXf (an index that measures price volatility of the S&P 500) indicate that investors expect large price moves in US stocks around and in the weeks following the election. We believe that has to do with rising concerns of a disputed election result after repeated claims from Trump that there will be widespread voter fraud in favor of the Democrats. Trump and Vice President Mike Pence have also refused to agree that there would be an orderly transition of power should they lose to the Biden/Harris ticket.
Moving overseas, the UK-imposed October 15 deadline for post-Brexit trade talks is quickly approaching. Although the UK officially exited the EU on January 31, the two blocks agreed to operate as if the UK still remained within the EU single market and customs union, through December. This transition period was set so that they could have more time to negotiate the terms of their future relationship. UK Prime Minister Johnson has threatened to renege on a previous agreement to maintain an open border between Northern Ireland and Ireland and stated that he would be fine with a no-deal Brexit if he doesn’t get his way with fishing rights and state aid to UK companies.
PERFORMANCE DISCUSSION
During the third quarter AlphaGlider strategies realized between 80-90% of their respective benchmark’s performance. The small shortfall was primarily due to our strategies’ overweight position in foreign developed market equities (MSCI EAFE was up only 4.8% in Q3) and an underweight positioning in domestics equities markets (S&P 500 was up 8.8%). Within our underweight positioning in domestic equities, we were held back by our skew toward value (Vanguard Value, VTV,2 +5.7%; Nuveen ESG Large-Cap Value, NULV, +4.2). Our worst performing international holding was in Singaporean equities (iShares MSCI Singapore, EWS, -0.3%).
Despite a fairly subdued return for bonds during the period (our fixed income benchmark, the Bloomberg Barclays US Aggregate Bond index, was up 0.6%), we were helped by our heavy exposure to inflation-protected securities (Schwab US TIPS, SCHP, +2.9%; Vanguard Short-Term TIPS, VTIP, +1.7%). All of our strategies also benefited from their overweight position in emerging market equities (SPDR Portfolio Emerging Markets, SPEM, +9.3%; iShares ESG Aware MSCI Emerging Markets, ESGE, +11.0%). Our more aggressive strategies benefitted from the position in technology stocks (Fidelity MSCI Information Tech, FTEC, +12.0%).
The drivers of AlphaGlider’s strategies’ performance for the year-to-date period were similar to those during Q3. Our strategies were held back by their overexposure to foreign developed market equities (MSCI EAFE was down -7.1%), underexposure to domestic equities (S&P 500 was up 5.1%), and skew towards value stocks (VTV -10.8%; NULV -11.3%). They were helped by their inflation-protected securities (SCHP +9.0%; VTIP +3.5%) and tech stocks (FTEC +28.2%). But unlike in Q3, our strategies were hurt for the 9-month period by the short duration of their fixed income portfolio.
OUTLOOK & STRATEGY POSITIONING
During the third quarter we made a few changes to our strategies to adapt to the Fed’s new price stability policy as well as to the rising probability of a Democratic sweep in the upcoming US election.
The Fed’s move to average inflation targeting, in conjunction with its new expectation to hold rates at its current 0-0.25% range through at least 2023, we pulled the plug on our holdings in Invesco Treasury Collateral, CLTL, an ultra short-term Treasuries exchange-traded fund (ETF). With its management fee basically cancelling any interest received from its underlying Treasury holdings, the unlikely prospect of future capital appreciation (only possible if US rates went negative), and current and expected future inflation running at ~1.5%, our position was expected to steadily lose real purchasing power going forward. In its place we opened new positions in a physical gold ETF, SPDR Gold MiniShares, GLDM. While it has a similar interest payout as ultra short-term Treasuries (0%!), we believe that gold has the ability for reasonable capital appreciation despite its 40% spike over the last year and a half. Massive US budget deficits from Trump tax cuts and from past and future COVID-19 relief, combined with the new Fed goal to overshoot its 2% inflation target increase the probability for significant spike in inflation and devaluation of the US dollar. We also believe that this small position in gold would perform well should we get a disputed election or a less than peaceful transfer of power over the coming months.
We also liquidated our health care sector equity ETF, Fidelity MSCI Health Care, FHLC, during the past quarter. We entered this position in our more aggressive strategies a little over four years ago and it performed well, up ~13% on an annualized, total return basis. The sector grew earnings at a 9% annualized rate with the benefit of Trump’s tax cuts and a benign regulatory environment. The remaining 4% annualized return came from dividends and a slight expansion in its price-to-earnings multiple (i.e. the amount investors are willing to pay for a dollar of earnings). With the real possibility that we could get a Democratic-controlled presidency and Congress (as mentioned in the prior section, ~60% if the betting markets are to be believed), we fear that health care earnings growth may be dented by increased regulation and pricing pressure, and higher federal tax rates. In order to keep our already underweight domestic equity from shrinking further, we rolled most of the proceeds from our FHLC liquidation into the overall domestic equity market (Vanguard Total Stock Market, VTI; Vanguard ESG US Stock, ESGV) and domestic value stocks (VTV, NULV).
Well, it’s now official — Charles Schwab’s acquisition of TD Ameritrade received its final government approvals and was completed last week. For those of you who are AlphaGlider clients, hopefully you received an email from Chuck (i.e. Charles Schwab, the man) welcoming you as a new client. But if you didn’t, you can check out the Client Information Hub that has the latest updates on the acquisition and integration. Bottom line, you probably won’t see any changes for at least 18 months, and possibly as long as 36 months, the time it will take Schwab to integrate the backend systems of these two operations. So until 2022 at the earliest, there will be no changes in how you access your investment account(s) on the web, on the mobile app, and over the phone, no change in the name and branding on the top of your monthly statements, no change in services and pricing.
When the integration is complete, we are not expecting much to change in your customer experience. Yes, there will be a new apps, phone numbers, and web addresses for your accounts, and you’ll need to set up a new username and password, but we expect the services and their pricing to be similar to what you’re currently getting from TD Ameritrade Institutional (TDAI). At this time Schwab pays similar interest rates as TDAI — practically nothing! And as of a year ago, both shops charge the same amount for ETF trades — absolutely nothing.
There were two primary reasons AlphaGlider chose to custody clients at TDAI when we launched back in 2013: 1) access to sophisticated, efficient, and affordable trading software that enables AlphaGlider to practice tax sensitive asset location, tax harvesting, and rebalancing, and 2) commission-free trades on many of the Vanguard ETFs that we found to be best in class at the time. We were happy to learn that Schwab will adopt TDAI’s superior trading software. And as mentioned in the previous paragraph, all ETF trades are free at Schwab.