Despite the many advances in technology and accessibility of information, markets are incredibly hard to predict. Few, if any, predicted the market correction in the 4th quarter of 2018, and even fewer predicted the rebound in the first quarter of 2019. Human behavior remains difficult, if not impossible to model and it has a disproportionate impact on prices in the short term. In fact, the increase in analytics has given the markets more data points at a much higher frequency than ever before creating both quick over reactions as well as analysis paralysis. These short term fluctuations reinforce our view that thoughtfully considering the data and investing in quality growth companies through a disciplined investment process allows us to ‘stay the course’ and generate positive long term returns.
During the 4th quarter it appeared the Federal Reserve was going to ignore weakening markets pushing interest rates higher and further tightening monetary policy. Thankfully, the US Fed followed the European Central Bank and quickly changed their tone: stabilizing markets. In a late December speech, Fed Chair Powell stated that future interest rate increases would be data dependent, marking an abrupt pivot in policy. In January and again in the March meeting, the Fed has not only reiterated their patience but through the “dot plot”, lowered their consensus short term interest rate forecast for 2019 from 3.2% to 2.6%. Markets quickly embraced the change as supportive and have moved markedly higher in the first quarter.
The positive reaction to the Fed’s willingness to be patient evokes an old adage “Don’t Fight the Fed”. Historically a pivot in Fed policy from restrictive to accommodative or vice versa, has closely been followed by a reversal in markets. We agree that this is a good rule of thumb, but we clarify the Fed is currently paused and has not fully reversed its policy. Typically the Fed reverses course to either stabilize weak markets or slow an overheating economy. They may cut rates next year but we fear the economy would need to weaken significantly to drive that action. With the economy at full employment and inflation still north of their target level it would be very unusual for the Fed to cut rates. That being said, a pause and a slowdown of their balance sheet reduction may be enough to propel equity markets higher. Rather than look for the Fed cuts to stimulate the economy, we are hopeful the economy maintains its strength and allows the Fed to simply pause and keep their current level of interest rates.
Since 1950 an inversion in the yield curve has been one of the most consistent predictors of an upcoming recession. Specifically, when the yield on the 10-year treasury has fallen below the 2-year, a recession has followed within the next 9-24 months. This exact inversion has not occurred recently but the 10-year treasury did fall below the 3-month treasury rate causing concern among market participants and leading many to forecast a full inversion. We believe that this cycle is unique with the Fed driving short term rates up ahead of inflation resulting in an unnatural distortion of the yield curve and a likely false alarm.
The US Treasury Yield Curve: showing dramatic YOY change
Unlike in prior inversions where the market correctly predicts slowing growth and lower inflation, we believe that a series of unique events is driving long term interest rates down. First, Central Bank intervention has artificially lowered global rates. Second, the largest companies in the public market are more profitable than ever and are looking for ways to invest their cash; they are more likely investors in bonds than borrowers. Lastly, and perhaps most importantly, the Federal Reserve has traditionally raised rates to fight inflation whereas this cycle has been about returning to normalized rates regardless of the level of inflation. These factors have distorted the treasury curve and we believe have limited the inversion indicator’s usefulness. Instead, we are watching the corporate credit curve which is much less manipulated and it continues to point to a normal credit market.
The Purchasing Manager’s Index (PMI) and Institute for Supply Management (ISM) indices are a group of manufacturing and services indicators we see as insightful into the current state of the world economy. Globally these indicators have slowed, particularly in Germany and China which contributed to the 4th quarter market decline. Moreover, the indices show that the global manufacturing industry is fairly weak but the service sector is still robust. The US has a much larger percentage of the economy driven by the service sector and that is a key reason we favor the US over other developed markets. With the majority of emerging markets driven by commodity production or manufacturing, we are keeping our exposure limited to India. As a net importer vs exporter of commodities, India is a beneficiary of lower global inflation.
Beyond the dynamics of the economy, the path of equity markets from here will be shaped by a robust IPO schedule in the coming months. This year alone more than 100 unicorns, private companies with valuations of greater than $1 billion, are expected to make their debut as publicly traded companies, headlined by Uber, Pinterest, Slack, WeWork, and Airbnb. Uber has a staggering valuation expected to exceed $100 billion, far and away leading all others. The defining question is whether the public and private markets are aligned such that the IPOs will be well received or will struggle to gain acceptance?
Over the past decade, the private investment landscape has grown by leaps and bounds as pension funds, endowments, and wealthy individuals have shifted massive sums of money into the private markets. Until recently, after a certain level of financing and at elevated valuations, a company required access to the public markets to raise further capital. That paradigm however has changed, with Uber as the posterchild, having raised $24 billion in private financing. According to McKinsey & Company, $778 billion of new private equity capital was raised in 2018, increasing the total amount of available capital to a record $2.1 trillion. In contrast, last year $20 billion was raised in all US IPOs illustrating the potential challenge markets will face this year as so many try to go public. With all of the money eagerly searching for investment opportunities in the private markets, it will be important to see if companies can maintain their most recent valuations when they IPO. In addition, mutual fund companies such as Fidelity and T. Rowe Price have already invested in many of these companies privately, which leads us to question: Who is left to buy the shares if some of the largest stock market investors already own them? This is clearly a dynamic that will shape the remainder of the year.
From IPOs to global growth dynamics, 2019 is shaping up to be an eventful year for markets. We have consistently warned that the removal of unprecedented stimulus deployed by global Central Banks would be complicated. That is proving to be true as the economic picture is more complex than ever. The higher rates and removal of stimulus has weighed on the manufacturing sector and pressured the Chinese and Eurozone economies. That being said, the US service sector remains strong and we see a scenario where markets stabilize and continue to move higher. With the current environment of conflicting economic indicators, we rely on our process to build quality portfolios by diligently analyzing company fundamentals and long term secular growth trends. We believe that stock picking will be rewarded. The companies in which we are invested are growing nicely by capitalizing on long term themes and trends which we expect to continue. This gives us the confidence to stay invested. In the world of investing there is always a reason to do things differently, but time after time, process and discipline have proven to drive positive long term returns.
We are pleased to share some exciting career development news at Bainco. Emily O’Connor has been promoted to work within the Portfolio Strategy group as a Client and Portfolio Strategy Associate. Kate O’Malley has been promoted to Client and Research Associate where she will work within our Research group on investment analysis and portfolio construction. Both Emily and Kate have made invaluable contributions to the Client Service team over their past 5 years at Bainco and will continue to work on client relationships as they also take on new responsibilities at the firm.
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