Bainco celebrated its 31st Anniversary on April 1st while Boston prepared for the 122nd running of the Boston Marathon right outside our front door. Similar to marathon training, investing often incites emotions ranging from excitement and triumph to frustration and defeat. There are no shortcuts in investing; maintaining focus, discipline, and determination is the surest way to reach long-term objectives. At times the road will get bumpy requiring proper preparation and execution to manage through the volatility and reach the end goal. At the close of 2017, investors stood victorious at the finish line of a year characterized by strong returns in everything from stocks to real estate and commodities.
“There are no short cuts in investing; maintaining focus, discipline, and determination is the surest way to reach long term objectives.”
Robust economic growth across the globe and a new tax code in the US drove expectations of improving discretionary and capital spending. Anticipation surrounding lower corporate taxes and the repatriation of capital back to the US set a strong backdrop for 2018 corporate earnings growth. In January we saw 2018 S&P 500 earnings growth estimates quickly rise from 9% to 25% as analysts incorporated these factors into their models. Perhaps the most significant market concern, the threat of an unstable North Korea, seemed to diminish when they sent a delegation to the Olympics and signaled an openness to direct discussions with the US about disbanding their nuclear program.
Fast forward three months and we now face concerns about an escalating trade war with China, early signs of inflation, and new risks related to technology and market darlings; notably Facebook, Amazon, and Tesla. As a result, the volatility we have anticipated has emerged and the investing climate has changed, but the underlying positive factors from January remain.
The market lulled some participants into a complacent state over the past 18-months as it moved steadily higher. Some investment managers became overly confident the trend would continue and implemented significant leverage and aggressive strategies intended to profit from the low volatility. On February 5th the trend changed leading to an unwinding of the aforementioned strategies in spectacular fashion. The volatility index spiked 116% causing several funds and products to close and exit all of their positions, leading to a significant dislocation in the equity market. The Dow Jones Industrial Average fell 1,175 points, the largest single-day decline in the history of the Dow, although not the largest in percentage terms. The drop was driven in part by a report of January average hourly earnings increasing by 2.9% leading to concerns that inflation might be back after a 10+ year absence. Recent readings have been more subdued but inflation is a key risk that we are watching.
February 5th also happened to be Jerome Powell’s first day as Chairman of the Federal Reserve possibly signaling the start of a more hawkish Fed. Powell delivered on that expectation by increasing the Fed Funds rate to 1.75% at the Fed’s March meeting. The commentary surrounding the decision implied a steeper path of rate hikes and stated that the economy is no longer fragile. This is a change from Powell’s predecessor, Janet Yellen, who consistently referred to the ‘fragile state of the economy’ and adjusted the timing of interest rate increases to stabilize markets when presented with volatility in the equity and bond markets. It appears Powell may implement a more consistent approach of increasing rates with less concern for market action. We expect the markets to test him on this point and would not be surprised to see additional volatility surrounding future interest rate increases. We have been carrying a level of Put protection on the portfolio for some time as a partial hedge against the uncertainty surrounding the change in interest rates. While they are applied to only a portion of client portfolios, they rose nicely in value, as expected, and dampened some of the volatility.
Over the last few years, we have capitalized on this investment climate, letting our winning stocks run, which drove outperformance as trends persisted for long periods of time. As a result, we generated low turnover, adding to the positive returns on the portfolio. However, we did make some portfolio adjustments. Last year, in anticipation of an increase in volatility and to improve our portfolio we trimmed Facebook, sold General Electric and bought XPO Logistics and Raytheon.
As active investment managers, we believe that volatility creates opportunity. As such, we are rotating into investments that enhance portfolio diversification and provide exposure to strong growth trends. An example of this is our initiating new positions in JPMorgan, Boston Scientific, Boeing, Nvidia, American Tower, and Constellation Brands. We are optimistic that over the coming months we will see additional opportunities to reposition client portfolios while remaining focused on delivering long-term after-tax results. We trimmed Alphabet (Google) and UnitedHealth Group, both long-term holdings that had appreciated into large positions and had considerable gains. We are maintaining a position in each name as we continue to believe in their underlying long-term stories but opportunistically shifted weight into names which add diversification and new growth drivers to the portfolio.
Trade War or Posturing?
The recent chatter about tariffs leaves us on edge but resolute. As equity market investors, we believe that free market capitalism is best for markets. We dislike using the threat of enacting tariffs but we acknowledge that China has been operating on an uneven playing field for some time. Trade with China is a significant growth opportunity for the US so we are hopeful that the rhetoric is merely posturing with the aim to improve trade terms and better defend US companies. In 2017, the trade deficit with China was $375B, almost 4 times the comparable figure in 2002. China has imposed significant restrictions on imports, pushing most companies to create a joint venture with a local company if they wished to sell into the country, as the tariffs were simply too onerous. For example, the Chinese levy a 25% tariff on the import of foreign automobiles compared to the US which only has a 2.5% tariff on imported cars. They also are known for allowing Chinese companies to infringe on US patents without repercussion. An improvement in any of these matters should be a long-term positive for the US economy and markets. However, markets are unlikely to respond well in the short term if there is a trade war. As we write this letter, President Xi of China made a speech indicating a willingness to step up the protection of foreign IP and a reduction of import tariffs. This indicated a willingness to work with the US, but at the same time, he also reiterated a focus on driving their “Made in China 2025” strategy and will defend those efforts to build Chinese brands and exports, leaving us uncertain as to where this will all end up.
“the Chinese levy a 25% tariff on the import of foreign automobiles compared to the US which only has a 2.5% tariff on imported cars.”
We have been building a case to shift some assets from the US to international markets for the past few quarters. The decision as to where exactly we should invest has been challenging as the dynamics in the emerging and developed markets have been rapidly evolving. The trade dispute between the US and China complicates this further. If China and the US continue their tiff, developed Europe and Asia become attractive places to invest as they would likely be relative beneficiaries from incremental Chinese imports. We continue to like our emerging market position in India and recently swapped our holding in the iShares MSCI India ETF for the Matthews India Fund. Matthews has a very similar investment philosophy to ours with a diversified portfolio of approximately 50 high-quality growth stocks which we believe will be rewarded as that market gets more volatile surrounding the next round of reforms. We think that these holdings complement our core US portfolio well, providing some additional diversification and growth opportunities.
This isn’t 1999, is it?
The first quarter saw a number of fears come to fruition for some of the most loved stocks in the market. Facebook came under fire with the revelation that users’ data had been sold by Cambridge Analytica to parties in Russia in an attempt to influence the US Presidential election. Uber and Tesla experienced fatal crashes involving their autonomous driving technology. Amazon faced scrutiny from Donald Trump about taxes and a claim they abuse the US Postal Service. During March, the growth themes of social media, e-commerce, and autonomous driving came under fire taking the wind out of the market’s sails.
Immediately one thinks of 1999 and questions if we are watching the next great tech bubble burst. This is a reasonable question given the incredible returns seen in tech over the last few years, however, we believe there are distinct differences. Perhaps leading tech stocks have gotten ahead of themselves, but the fundamental backdrop is quite different. In 1999 tech made up 29% of the S&P, similar to the 25% today, but a clear difference is valuation. Currently, the technology sector trades at 18 times forward earnings, essentially in line with the market. In contrast, 1999 technology stocks traded at >50 times forward earnings. While in 1999 many tech companies were losing money and were in some cases later found out to be outright frauds, today the leading technology companies have robust earnings and rock-solid balance sheets supported by clearly defined businesses. We believe the issues raised about these stocks are significant but that they shouldn’t derail the larger themes that are transforming the global economy and disproportionately benefiting these companies.
Our portfolios are built to have exposure to strong growth trends but also enough diversification to create staying power when those trends fall out of favor from time to time. Over the past several quarters we have been preparing for possible volatility as a result of the Fed beginning to transition to higher interest rates and unwinding their massive bond-buying program (Quantitative Easing). This is exactly what is now happening. The Fed Funds Rate has moved from 0% to 1.75% in the last two and a half years, clearly distinguishing the US as having one of the strongest economies and the most restrictive monetary policy in the developed world. As a result, long-term bond prices have suffered driving investors to our positioning in primarily short maturity fixed income. Our banking system is now the healthiest in the world and we are shifting from reinforcing the system through capital requirements and oversight, to reducing regulations and allowing banks to increase their leverage and return excess cash to shareholders. All of these factors leave us positive on the stock market but cognizant of the risks that remain. Specifically, we are watching the trade negotiations, the pace of interest rate increases, and inflation but are careful not to prematurely react until we see a clearer indication that growth will be restricted.
We continue to believe staying invested with a degree of protection by owning Puts and opportunistically rebalancing portfolios remains the prudent strategy. The market is likely to be challenging but we are excited to capitalize on the opportunities it is likely to present. As always we are focused on delivering strong long-term, after-tax returns while taking steps to preserve capital and protect portfolios from uncertainty.