The fourth quarter of 2018 was disappointing for investors as, seemingly overnight, economic and political risks increased resulting in a sharp correction of virtually all asset classes. On September 30th, US investors were enjoying the fruits of strong economic growth, modest inflation and a robust earnings outlook. All was good and was expected to remain that way. Yet, worrisome clouds were on the horizon, notably an accelerating trade riff between China and the US, continued weak economic performance in Europe and Asia and a midterm election resulting in a new political landscape in Washington. Since 2015, the Fed had been gradually tightening monetary policy and a continued normalization of interest rates was expected by most investors. Additionally, due to the Federal Reserve tightenings, a meaningful flattening of the US Treasury yield curve had occurred, and investors began to fear an economic slowdown, and just like that, the US equity market began its sell off. Ugly.
We too were surprised by the severity of the fourth quarter sell off in what we perceived as an overall constructive economic environment. Corrections are inevitable and tend to be worse than investors expect. Yet, this quarter was very difficult in the extreme for most market participants culminating an extremely difficult performance year across all investment styles. Excepting cash and money markets, all major market asset classes posted negative returns in 2018. Quite remarkable and unusual.
High frequency trading, exchange traded funds and other technical factors possibly exacerbated the downside, yet as investors we try to see through the short term technicals and focus on economic fundamentals when attempting to evaluate risk appetite and investment opportunities. As mentioned above, we have been optimistic on the economy and its investment implications. We have long argued that economic growth is the key and that investors need to emphasize that variable over virtually all others when evaluating investment opportunities. Yet, our framework which had been full of green indicators earlier in 2018 is now more mixed with growth remaining the most optimistic variable.
2019 1Q Key Economic and Investment Drivers
Investor perceptions of interest rates and the bond market have been very manic over the course of 2018. During the spring and summer months, many worried that 10-year interest rates were moving too high too quickly and rising rates were a risk to the equity market. Longer term interest rates then began to fall and concerns turned to a flattening yield curve, possibly signaling recession.
Our viewpoints on 2019 Federal Reserve policy, rates and the yield curve are much more muted as we look to inflation and ultimately real rates as keys. To the extent that inflationary pressures are not a problem, the Fed is unlikely to become overly restrictive. Today the real Fed Funds rate is approximately zero. The average real funds rate prior to the last 8 recessions was approximately 460 basis points with the lowest reading being 190 basis points. So, we do believe the Fed is a long way from inducing a meaningful economic slowdown and that the market concerns regarding an overly restrictive Fed and a yield curve flattening are overdone.
However, as risk variables go, however, the sharp increase in credit spreads is a meaningful worrisome trend.
Whether driven by record high levels of corporate debt, declining oil prices impacting leveraged energy players or a general risk off appetite correlated to equities, a credit squeeze in the bond market is an economic indicator that needs to be monitored closely. Despite the adverse market conditions in the fourth quarter, we have yet to see a meaningful tightening of broader levels of financial conditions.
Trade negotiations with China probably represent the most meaningful market risk today. Recall that a big part of the equity selloff that began in October resulted from reduced earnings expectations from management teams concerned over supply chain disruptions and other trade-related issues. Over the past two years, investors have benefited from constructive fiscal policy out of Washington DC. Yet tax and regulatory tailwinds have been dwarfed by concerns over trade policy. The growing list of tariffs and the inevitable ebb and flow of negotiations between the US and China have clearly spooked investors. The President adds fuel to the fire with tweets such as this:
Between the two nations, China has the most to lose in a prolonged trade war. Its economy is more fragile and more reliant on exports and, without the United States as a trading partner, would experience greater economic uncertainty. Indeed, prior to November 2018 for the year-to-date period, the Chinese stock market had underperformed the US’s sharply. And so, not surprisingly, Chinese authorities began taking a more conciliatory stance on tariffs, and Chinese stocks have (surprise, surprise) performed better over the past few months, outperforming the US by nearly 7% since November.
As always is the case, equity investing comes down to earnings and investors have benefited greatly from an extremely robust earnings environment. Per FactSet, the S&P 500 set multiple records in earnings in 2018, including the following:
- 5.4% Increase in Q118 Bottom-Up EPS Estimate: Highest increase in (quarterly) bottom-up EPS estimate during a quarter since FactSet began tracking this metric in Q2 2002
- 53% S&P 500 Cos. Issuing Positive EPS Guidance for Q118: Highest number of S&P 500 companies issuing positive EPS guidance for a quarter since FactSet began tracking this metric in Q1 2006
- 80% Earnings Beat % in Q218: Highest percentage of S&P 500 companies reporting actual EPS above estimated EPS for a quarter since FactSet began tracking this metric in Q3 2008
- 77% Revenue Beat % in Q118: Tied (with Q417) for highest percentage of S&P 500 companies reporting actual revenues above estimated revenues for a quarter since FactSet began tracking this metric in Q3 2008
- 7.5% Earnings Surprise % in Q118: Highest aggregate difference between actual earnings and estimated earnings for a quarter since Q4 2010
- 26.0% Earnings Growth in Q318: Highest quarterly (year-over-year) earnings growth reported by S&P 500 since Q3 2010
- 10.5% Revenue Growth in Q218: Highest quarterly (year-over-year) revenue growth reported by S&P 500 since Q3 2011.
- 12.0% Net Profit Margin in Q318: Highest quarterly net profit margin reported by S&P 500 since FactSet began tracking this metric in Q3 2008
- 20.3% Earnings Growth in CY18 (projected): Would be highest annual earnings growth reported by S&P 500 since CY 2010.
- 8.9% Revenue Growth in CY18 (projected): Would be highest annual revenue growth reported by S&P 500 since CY 2011
Yet, after five straight quarters of double digit earnings growth, both forward revenues and earnings did in fact begin a modest decline early in 4Q, as we indicated earlier, which raised investor fears and adding pressure on already fragile markets. While earnings expectations have indeed come in, they are still indicating growth for 2019 and, most importantly, equity prices have appeared to factor this in as the sell-off in equities has resulted in very attractive valuations for stocks. Ultimately, we believe this will draw attention back to stocks.
We have taken a balanced viewpoint on market opportunities going into the new year. We do believe there are many interesting opportunities from a valuation standpoint, but fundamental risks do remain and need to be resolved. A recession is unlikely but continued uncertainty from policy-makers would likely cause further volatility. But we believe resolution of these policy risks is at hand and are still constructive on US equities. Fed policy is likely not to surprise investors in 2019 and a trade deal with China is likely. With these policy risks resolved, we expect credit spreads to improve as well.
For our Portfolio Solution mandates, we have full allocations to equities with overweights to the US and Emerging Markets, believing that the growth potential and valuation are most compelling in those markets. We have additionally maintained full allocations to alternatives believing those investments to be better diversification tools than fixed income.
ABOUT THE AUTHOR
David Cleary, CFA is a Partner 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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