Focus is on the Fed.
Entering 2019 the key driver of financial market performance appears to be how the US Federal Reserve and other Central Banks continue on their path to remove the stimulus put into the market to get us out of the 2008-2009 Recession. Since the conclusion of the Recession there has been a feeling of urgency to put the “Genie back in the bottle” and get back to “normalized” levels of interest rates and balance sheet assets, just in case there is another crash that requires Central Banks to use those tools again. That mentality persists but the level of assets on Central Bank balance sheets increased to levels beyond anyone’s expectations, and only the US has actually begun to wind down its policies. Due to the scale of the task and delicacy of the process we predicted there would be bumps along the way, and market volatility would spike, potentially in a dramatic fashion, which played out in the market correction we just witnessed in the 4th quarter. In 1987 and 1962, sharp, fast bear markets occurred but were quickly reversed avoiding recessions due to appropriate Fed response; we hope that is the case for 2019.
“Growth may slow… but a deep recession or bear market does not seem imminent.”
So how did we go from strong market returns and investor optimism through most of 2018 to the 15-20% market correction from all-time highs in the fourth quarter? As we entered 2018 we remarked on the unusually quiet and strong market which saw no significant dip and added 22% in 2017 to the 12% return in 2016. 2018 began with hope for coordinated global growth and an extension of the US bull market due to the dramatic tax cuts. Strong economic growth ensued in the US with real GDP growth reaching 4.2% and major US indices reaching new record levels in the 3rd quarter. Beneath a strong US market, cracks started to emerge in international markets, led by currency and debt crises in countries such as Brazil, Argentina, and Turkey, followed by weak economic data from China and Europe. As the year progressed, inflation started to materialize as crude oil prices climbed. This emboldened the US Federal Reserve to continue on its path to reach more “normalized” levels with a series of four interest rate hikes. As the fourth quarter began, investors experienced spiking oil prices, concerns about a yield curve inversion, which could signal a recession, and some bellwether companies issuing disappointing guidance. The market began to slide, reaching its bottom on Christmas Eve after a poorly received Federal Reserve press conference announcing a raise in short term interest rates to 2.5%, coupled with an upcoming Federal Government shutdown and limited progress in Chinese trade talks.
We expect markets will continue to be volatile as we enter 2019, however we believe they will stabilize over the course of the year. It looks increasingly likely that President Trump and China’s President Xi will come to a trade agreement which at a minimum would remove a psychological headwind on the markets. Analysts and economists remain optimistic for growth to stay in positive territory and a recession to be avoided. Valuations in the stock market are notably more attractive than they were in the past several years. This gives us confidence to say that even if things don’t go perfectly and economic growth is in fact weaker than expected, markets are unlikely to fall dramatically below the levels seen in December.
Are we entering a Recession?
Let’s address the elephant in the room; are we entering a prolonged bear market and recession? The current situation does not lead us to that conclusion. The most significant bear markets which led to or coincided with recessions have included at least two of three of the following common factors:
- extreme valuations
- a spike in commodity prices
- a restrictive Federal Reserve
The first two we have already crossed off the list; the big question remains the Fed. Currently the Fed could be categorized as being restrictive based on the number of successive rate hikes (8) coupled with unwinding their balance sheet. The combination of these three factors is key as they identify a bubble as well as what is usually present when the bubble bursts. We don’t see bubble-like conditions in the equity or commodity markets. Growth may slow and we may not see double digit equity returns for the next few years, but a deep recession or bear market does not seem imminent.
Our view is that it is possible that Central Banks around the world can effect a soft landing removing the stimulus implemented in reaction to the 2008 financial crisis. Though we have said consistently, it won’t be easy and market volatility will likely occur. The US is not alone in trying to remove their stimulative policies as the US Quantitative Easing (QE) strategy was mimicked internationally and taken to additional levels in Japan, China, and Europe with the purchase of corporate debt. As a reminder, Quantitative Easing is the process of central banks going into the public market and buying bonds to lower rates. Typically they just buy government securities off of which other securities are priced, which does not impact the liquidity in the corporate debt market. That represents the additional risk in Europe and Japan.
Due to the strength of the US economy, the US Fed began to raise rates and remove stimulus at the end of 2015, while Europe and Japan have maintained their accommodative policies. Fed Chairman Powell commented that the US balance sheet reduction program was on “autopilot” and that comment was attributed to sending the market to its lows in December. We agree with the markets that “autopilot” is unacceptable. Our economy is more global than ever and operating in a silo will not work. Central Banks must work together to coordinate their actions for this to end well.
So what now?
While we are not expecting a deep bear market or a forthcoming US recession, we believe volatility will continue to be elevated and equity returns are unlikely to be exceptional over the next 12 months. Bonds are not overly attractive with low yields and the potential for further interest rate increases. As such we have sold some equities and increased cash levels, which finally pays a decent yield at 2.5%, and took advantage of writing covered calls on several equity positions. We have maintained 75% of our put protection after selling 25% in late December at a significant gain capitalizing on the extreme spike in volatility and recognizing the dramatic reset in market valuation. We remain, however, primarily invested in quality growth companies that we expect to perform well over the long-term.
In early 2018 we considered adding exposure to international markets but were concerned about weak levels of growth especially relative to the US. We decided not to increase our position beyond our 12% allocation, and benefited by strong outperformance over the course of the year with the S&P 500 falling 4.4% versus the MSCI All Country Ex US -13.8%. The valuation gap has continued to widen and although partially supported by growth differentials, we are continuing to review our allocation. If we see particularly attractive opportunities we may increase our international exposure tactically.
Selecting good quality companies with strong underlying businesses should continue to drive strong risk adjusted returns in the stock market and that remains our focus. We see opportunities to capitalize on the recent increase in volatility to use options to protect positions while increasing their returns if markets do not appreciate in a straight line. As a reminder, since 1926, bull markets have lasted an average of 5 years and bear markets have averaged 2 years. Preserving capital and staying invested as the markets fluctuate, continues to be the best course of action.
We wish you all a very Happy New Year and look forward to our conversations and interactions with each of you over the year.
MARKET COMMENTARY DISCLAIMERS
This commentary contains the current opinions of the authors as of the date of publication. All opinions are subject to change at any time. This commentary has been distributed for informational purposes only and is not meant to convey a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell securities or investment services. The opinions and statements set forth do not consider the investment objectives or financial situation of any particular individual or group of individuals. Individuals will need to consider their own circumstances before making an investment decision.
Information contained herein, including market forecasts and forward-looking statements, are derived from proprietary and nonproprietary sources Bainco deems to be reliable; Bainco does not, however, warrant the completeness or accuracy of the information obtained from these sources.
Past performance is not a guarantee of future results.