Have Investors accurately digested all the cross winds in the global and financial markets?

While we join the chorus of investment managers and strategists that suggest the markets in Q4 overreacted to changes in the economic and financial fundamentals, there are plenty of issues to work through before we see an end to the high volatility across most of the capital markets. Waiting for complete clarity on all the issues is an invitation to miss futures rallies, but a quick walk through the fundamentals indicates to us the road ahead is not a straight one for asset prices. We continue to believe equity markets will be positive over the course of the year, but gains might be hard-earned as volatility remains high and the relative performance of stocks in the near term might look more like that seen in the last quarter of 2018 rather than that of the first half of the year.

What are the main issues we are closely following?

This year’s “wall of worry” is fairly tall with less clarity than is typical in assessing the outcomes. On the U.S. economic front, there was a fairly steep and swift decline from the real GDP growth of 4.2% in Q2 of 2018 to a broad consensus estimate of sub-2% for the second half of 2019. That alone was the reason for some performance give-backs in risk markets in late 2018. However, with recession indicators becoming more noticeable, particularly as domestic and international politics create uncertainty, attention to business sentiment, corporate earnings guidance and Federal Reserve intentions become more timely indicators for potential portfolio action.

Another concern is with the overall Federal Reserve policy, which appears to be belatedly evolving with the data but whose impact is large, late and thus difficult to assess. While the Fed appears to have backed down from the most hawkish policy rate statements from early October of 2018, there still appears to be a gap between the market’s expectations that rate increases are over for 2019 versus the Fed’s dot plots and their reading of the of the contemporaneous data. With few guideposts, the Fed’s Quantitative Tightening (or “QT” — the central bank’s withdrawal of liquidity from the economic system through the selling of its securities portfolio) has few historical parallels to approximate its economic or financial impact. Furthermore, QT still seems like a priority for the U.S. Federal Reserve, at least judging from Fed Chairman Powell’s last statements. Whether the Fed interprets flexibility around rate increases and balance sheet adjustments the same way as the markets leaves potentially a wide margin for investors to be disappointed. With wages still rising and import prices beginning to percolate, look for the Fed to not always sound perfectly accommodating to markets, which may create volatility along the way. Ultimately, it is our view that the Fed will be less model driven and err on the side of being slightly accommodating in a clearly slowing economy. In any event, raising rates in an environment with high corporate debt–much of which is at the borderline of investment grade–requires close watching.

 

Another consideration is the U.S. consumer, who is the largest economic driver in the world and for whom the numbers are encouraging. More people are working with higher wages and with recent lower energy costs (which typically account for 5–10% of household expenditures). This gives us reasons to believe that the outlook remains solid. Albeit not great, Christmas season results were good all things considered, and that likely sets the tone for consumer spending unless the situation changes materially from here. While overall consumer confidence is high, some indicators like the sense of timeliness for home purchases raises red flags beneath the surface of relatively healthy finances.

Outside the U.S., the Chinese economy continues on a slowing path and policy maneuvers designed to stabilize growth have not gained much traction yet. While we have high conviction Chinese policy makers will stem the tide, the timing of the turn in growth is less certain. Looking to not make the same mistake as in 2015-2016, when overstimulation resulted in a frothy real estate market and other dislocations, policy levers are likely to be pulled more cautiously and their global economic impact to be less certain.

The macro and geopolitical scenes have so many sharp edges that not expecting some drama in the next few quarters would probably be naïve. We believe that the China-U.S. trade war will morph into a cold war where the battle is focused less on tariffs and more on strategic rifle shots (e.g., the exclusion of Huawei from the global 5G build-out) which may incite a change in global supply chains away from China. We do expect an agreement where both countries meet in the middle, with each side of course claiming victory and knowing how to manipulate the stated terms. If the initial 90-day deadline gets extended, however, markets may be roiled. But with both China and the U.S. in economic slowing mode, the costliness in terms of economic growth from a trade slug fest argues for the trade issue to be handled more delicately once victory is declared.

The U.S. and European domestic political scenes may also churn up some volatility. That, together with economic uncertainty and the lack of fiscal or policy relief, we would expect results in neither the U.S. nor Europe leading in relative equity performance early in the year. Rather, we believe that they would take a back seat to the emerging markets (EM) which have had deeper corrections in 2018, are slightly more attractive from a valuation point of view and have the uncertain timing but conviction of more Chinese stimulus is ahead.

Select actions taken by the Chinese government in 2018 to stimulate the economy

• Cut the required reserve ratio 3 times in 2018, taking it from 17.0% in January to 14.5% in December
• Measures to protect funding for infrastructure projects underway, accelerate new projects and mobilize private   capital for infrastructure.
• CBIRC asked financial institutions to give more support to infrastructure investment, importers and exporters, and creditworthy companies experiencing temporary problems.
• Raised upper limit of annual taxable corp. income for preference to 1 million yuan
• Middle-class centered personal income tax cut equivalent to ~0.6% of GDP
• Widened income tax exemption on re-invested profits for foreign firms
• Raised export tax rebate for 1172 items

On a final note, it is rare for a stock market decline of the magnitude of that seen in Q4 to be followed by a “V” shaped straight up recovery. As in the past, there is likely to be a partial test of last year’s asset price levels as nervous investors use the post-crises bounce to reduce risk and evaluate whether the fundamentals are materially different from expectations six months ago. It is very possible that, like in 2018, January produces the bulk of the upside of equity prices unless the macro picture becomes more benign and investors have enough confidence to increase PE multiples even as earnings look to rise a more modest 5–6% from 2018 levels.

Current Portfolio Positioning: Balancing a long-term perspective versus preparing for immediate risks

As long-term investors, we have constructed strategic allocations that are meant to create a balance between long term return generating assets and asset preservation allocations. The highest return endowments use high allocations to illiquid assets and high tracking error managers (that together equate to very high-risk budgets/tolerance) to generate their returns. We have more risk preservation assets in our portfolios in order to deal with difficult periods like the last three months, but are also more tactical in order to deploy some of our portfolio liquidity when an appropriate upside-to-downside ration seems advantageous.

Allocations to core fixed income, elevated macro hedge funds allocations (for those clients that execute with partnership vehicles) and gold clearly showed their risk mitigation characteristics during the Q4 meltdown. Additional tactical moves have been made to reduce the impact of the above potential economic and policy developments, starting in 2017 when we began reducing high yield credit. We currently have basically no economically sensitive commodity exposures outside of equities, and our allocation to lower-than-benchmark duration fixed income is materially higher than the strategic allocation in order to take advantage of risk-off episodes. We have also swapped our short yen positioning to a long position since we see the Japanese currency as a risk-off haven and the beneficiary of a the rebound of Japanese securities by foreign investors which is underway.

What is our current overall investment profile?

With our base case being a pause in the trade war with China, the Federal Reserve backing off from its most hawkish proclamations, earnings expected to rise about 5% in the U.S. and a little more elsewhere (especially in the emerging markets), our portfolios are slightly overweight equity risk and other risk assets such as infrastructure (MLPs) and REITs. Our most notable overweight versus the benchmark remains emerging market equity. Right on cue with U.S. markets at their widest level of outperformance in 2018 the chorus of “sell EM” and “buy more U.S.” proved perfectly wrong as EM outperformed the S&P 500 by ~6% in Q4. Interestingly enough, the favored U.S. sector of large-cap technology underperformed the EM index by approximately 9% in the same time frame. On a three-year trailing basis, moreover, EM is only marginally below the S&P 500 in terms of total returns, even as China and likely other parts of the emerging markets stimulate their economies while the period of stimulation in the U.S. is over with little more than the debt build-up to show for it.

With valuations coming down and the blemishes of large-cap technology on the table (data privacy, demand shortfalls, increasing competition, etc.), we are building up our U.S. technology exposure but are waiting for another air pocket to add more. As expressed earlier, we favor Japan in our EAFE (Europe, Japan and the Far East) bucket as the equity market is inexpensive (10–11x 2019 EPS projection), it is under-owned by global portfolio managers with rising dividends and buybacks as part of a new but nascent push toward better governance on the part of Japanese corporates. We will continue to hold our energy exposure as we believe the reversals of OPEC with regards to supply cuts and the Trump administration as it relates to the Iran sanctions are behind us, even as demand has held up reasonably well. Both MLPs and U.S. exploration and production companies have had a strong start to 2019.

Lastly, we expect better performance out of active management as the key central bank policy changes, trade war narratives and extremely narrow sectoral/stock focus of investors in the 2018 environment gives way to performance driven by fundamentals and valuations. Tactical changes will continue to be a core part of our investment process as long as volatility presents opportunities and risks outside the scope of normal fundamental values.