The third quarter of 2018 proved to be a good one for investors as markets, particularly in the United States, extended this year’s bull market. Risk assets in the US, notably growth-oriented stocks, continued to outperform other asset classes as the US economy and corporate profits continued to gain momentum. At Crow Point Partners, we have long argued to focus on the growth trajectory of the US economy as that will be the primary guide to determine whether investment risk takers will be adequately compensated. Thus far in 2018 the growth trajectory has improved, well beyond early expectations, and US shareholders have benefited.
International markets, however, have not kept pace. During the third quarter of 2018, while the S&P 500 rose more than 7%, foreign equity markets only posted modestly positive returns and emerging markets posted negative results. Some of this return dispersion can be attributed to trade wrangling between the Trump Administration and some of the United States’ more meaningful trading partners like China. We would argue more of the underperformance in foreign markets has been driven by poor decision-making by policy officials in foreign economies. From Turkey to South Africa to Italy, politicians and policy makers have made poor decisions in our opinion, which have resulted in weakening currencies, investor concerns and declining investment markets.
It wasn’t just equities. Fixed income of all varieties underperformed over the quarter as investors anticipated further rate increases reflecting a faster growing economy. Overseas, emerging market debt struggled as currency devaluations and deteriorating credit conditions impacted returns.
As always, the Crow Point investment team looks to evaluate eight fundamental economic and market variables which establish the basis for our investment decisions. We try to determine if investment risks are worth taking and where those risks may be best compensated, be they stocks or bonds, US or international, large or small cap, traditional or alternative investments. Looking forward into the fourth quarter and beyond, we continue to believe that the environment for investors remains constructive, driven primarily by strong economic growth and increases in company profitability in the United States.
One of the issues causing concern for investors has been tightening Federal Reserve policy, rising interest rates and the flattening of the yield curve. We at Crow Point we have long believed that the concerns over rising rates and an inverting yield curve are excessive and in and of itself should not be a variable to cause investors meaningful worry. Rising rates, from historically low and accommodative levels, are a byproduct of the faster growing economy. Such “rate normalization” should be welcomed. Additionally, in spite of two years of tightening, the Fed is not yet restrictive as short-term real interest rates remain slightly negative and the curve, between the funds rate and the 10-year note, although flatter, still remains positively sloped. Again, not a variable which causes us undue concern.
From our vantage point, we believe the fiscal policies coming out of Washington over the past two years have been very constructive to both the overall economy and the stock market. Tax and regulatory reform have been a jolt to the economy and the results speak for themselves in terms of economic growth, employment and equity price appreciation. Therefore, the midterm elections are important and a new political regime in Washington which disrupts the current state of constructive fiscal policy would be a point of concern for us. Having said that, it appears as if the Democrats will take the House of Representatives and the Republicans the Senate, which should result in a gridlocked Washington. A steady state would continue to be constructive for economic and investment decision makers and would be viewed positively by us. Trade policy remains an open issue and could result in volatility in specific markets and industries. Thus far, changes in trade policy have had a greater impact on foreign markets and multinational companies while many US companies have shrugged off any trade concerns and continued to execute and achieve higher levels of profitability. In the emerging markets, trade negotiations have added to the growing list of concerns for investors.
So, is it time to give up on international investments and focus entirely on opportunities in the United States? We do not believe so. In the below graph we look at the growth rate and valuation of several important international markets and sectors. As you can see, some of the fastest growing companies are domiciled in the cheapest, most politically unstable markets. This tells us two things: (1) large multinational companies in these markets can compete on the global stage, particularly in an environment of overall strong growth, and (2) any political normalization could result in a meaningful bounce in those markets.
For our Portfolio Solutions mandates, our asset allocation for the fourth quarter remains fully allocated to equities with a continued overweight to dollar-based investments, particularly small cap. We have, however, reduced the allocation to smaller cap stocks in favor of select investments in foreign markets. Our largest overweight will be in alternative investments. We believe that the environment is ripe for active investment and risk management. Contrary to the environment in recent years past, correlations between asset classes, industries and securities are at very low levels which creates a ripe environment to add alpha through active management. The alternatives component of our portfolios has been strong contributor to our outperformance this year and we believe that we can continue to add value in this space. This overweight to non-traditional alternatives comes at the expense of traditional fixed income investments, which we believe will continue to post flat to negative returns. Comparatively, relatively low risk alternatives offer a much better value add opportunity.
By design our global approach is forward looking, flexible and tactical and as such we have constructed a portfolio which reflects both our fundamental outlook of the economy and markets and our probability assessment of the relative attractiveness of asset classes. We believe that this framework and portfolio construction will produce strong risk, adjusted returns for our investors.
ABOUT THE AUTHOR
David Cleary, CFA is a Principal and Portfolio Manager at Crow Point Partners
Previously he spent 23 years at Lazard Asset Management where he held a series of senior portfolio management roles over multi asset and global fixed income strategies. He additionally served as the firm’s global head of fixed income, a $26 billion platform. Prior to Lazard, Mr. Cleary worked at UBS and IBJ Schroder, mostly in fixed income asset management roles. Mr. Cleary began working in the asset management field in 1987 upon his graduation from Cornell University, with a BS in Business Management and Applied Economics. Mr. Cleary is a CFA charterholder.
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