For over a year, we have been talking about a tougher climb for stocks. The climb resumed in the first half of 2019 but was almost entirely supported by monetary policy with very little help from earnings. In 2018, GDP grew above 3% and corporate earnings grew over 20%, marking one of the best years on record… but stocks fell. This year, economic growth has shown obvious signs of fatigue and earnings are expected to be flat, but stocks are rising. Why have stock prices and fundamentals decoupled? First, the stock market has become addicted to central bank liquidity. When the Fed began ramping up efforts to remove that liquidity, stocks struggled. Then, when the Fed changed course at the beginning of the year, stocks responded with a massive rally. Second, valuations are high relative to history, which raises the bar for further gains. Today’s prices are discounting high uninterrupted future growth and investor expectations are getting harder and harder to beat. In this environment, an earnings beat is met with less excitement and gains are more a result of aggregate investor flows than bottom up fundamentals.
The market sell-off late last year was a “growth scare” as investors began to believe the Fed was on too aggressive a path to normalization. When stocks tumbled, the Fed took notice and viewed the downward move as a recessionary signal and reason to reverse course. Talk of additional rate hikes and balance sheet reduction (quantitative tightening) have been scrapped. Today, six months into 2019, global stocks have recovered, but are still below the all-time high set in January 2018, almost 18 months ago. US technology stocks (which dominate weightings in the benchmarks) are the exception, up almost 5% above their January 2018 level. US small cap stocks (Russell 2000), however, are still 10% below their peak.
Historically, a Fed rate cut has not been something to cheer, but rather a signal that the economy is weakening, and risk of recession is high. The stock market’s immediate reaction to an initial rate cut however, has almost always been positive. This was true in January 2001 and September 2007, with both periods seeing record stock gains in reaction to an initial rate cut, but subsequently experiencing very painful bear markets over the following year. The market is currently factoring in a full 1% rate cut (down to 1.40%), most likely in 0.25% increments over the next year, starting this month. If the Fed doesn’t deliver, stocks will likely head lower.
Indeed, the past couple of years have been full of contradictions. The strongest economy and earnings in over a decade last year lead to stock market declines. Weaker growth this year coincided with a massive stock market rally. The Fed reversed course dramatically, almost overnight, without much supporting evidence from the data on which they are supposedly dependent (inflation down from 1.8% to 1.6%). Stocks have soared as a result which typically implies confidence in the economy and earnings. Bond yields have plummeted which typically implies a slowdown or recession.
Despite the confusion, our outlook remains mostly the same. We see weaker economic growth and lower earnings growth. What has changed is our outlook for interest rates. Our belief that interest rates would plateau at higher levels reflected support from both Fed normalization and massive deficit spending. By the end of last year, the real yield (adjusted for inflation) on the US 10-year treasury was 1.0%, the highest it had been in seven years, but one that was normal pre-financial crisis, and that compensated investors fairly. Today that rate is just 0.14% making investment in safe bonds very unattractive.
Despite the mixed signals and our cautious outlook, we’re not suggesting getting out of markets. In fact, we are finding compelling investment opportunities. These new opportunities have upside but will also mitigate potential downside. Within our stock portfolios, we have added more defensive energy infrastructure stocks that are undervalued and pay a high and sustainable dividend. Our bond portfolios have been actively repositioned to include higher quality sectors that are less exposed to below investment grade corporate credit where default risk is rising. Within our alternatives portfolio we have added real assets through a private real estate investment in core properties that generate stable rents and monthly cash distributions. Our focus on quality and defensive sectors capable of greater cashflow generation will help us through what appears to still be a tougher climb through the remainder of the year.
2Q 2019 Performance
- Stocks globally continued to rebound although less sharply in the second quarter, ↑3.8%. Gains were led by US Mid Cap (↑4.5% & up over 20% YTD!), US Large Cap stocks (↑4.2), International Developed (↑3.9%), US Small Cap (↑2.1%), International Small Cap (↑1.8%), and Emerging Markets (↑0.7%). The US Dollar stopped climbing relative to other currencies as US interest rates fell across the maturity spectrum, with the effect of less headwind to non-US stock returns.
- Non-US stocks continue to trade at a valuation discount to the US with a significant cash yield advantage (3.8% vs. 1.8%). However, while US earnings are struggling to show gains versus a year ago, Non-US stocks are in an even more difficult position as earnings estimates drop for next year due to disappointing GDP growth. The appointment of Christine Lagarde to head the ECB has buoyed stocks under the assumption that dovish monetary policy continues.
- Total return for Taxable bonds turned in another extremely strong quarter (↑3.1%) as interest rates continued to plummet. The yield on the US Aggregate Bond Index is down to 2.45% making future returns from high quality bonds paltry and just barely above the rate of inflation. The average bond maturity in the index continues to go higher and is not at 8 years, adding more risk if interest rates were to rise again. Municipal bonds were also strong (↑4.5%). Securitized Credit (high quality mortgages and asset-backed securities) also had a strong quarter (↑2.3%). High yield corporates (junk bonds) continued to recover from their 4Q swoon (↑2.4%). Ultra-short US Floating Rate Treasuries (↑0.53%) rose at an annualized rate of 2.14%, expectedly in line with Fed Funds, and continue to be earmarked for higher yielding credit sectors when risk/reward ratios return to more compelling levels.
- Looking forward, the yield curve has flattened dramatically with the considerable decrease in rates. The bond market is discounting a recession which is at odds with credit spreads that are near all-time lows. Higher interest rates may still be in the cards due to massive amounts of new supply entering the market, however, investors continue to show a strong appetite for bonds even at near zero inflation adjusted rates.
- The Alternatives portfolio tuned in a slightly negative return for the quarter (↓0.3%). Category performance was led by Managed Futures (↑2.8%) and Multi Strategy (↑1.8%), followed by Market Neutral (↓3.7%) and Hedged Equity (↓0.1%).
- Equity Market Neutral continues to be pressured by the underperformance of Value stocks versus Growth stocks. Our strategy, AQR Market Neutral has a strong long bias toward low P/E and short bias toward high P/E stocks which have performed in reverse of their historical trends, but most significantly in the past year. We’ve considered selling the strategy but have decided to stay invested due to our conviction that Value stocks will begin to outperform again and that this strategy will prove valuable when that transition takes place.
As always, contact us if would like to discuss these topics further.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer