No truer words have ever been spoken, “And this too shall pass”.
Just three short months ago, many investors had concluded that the party was indeed over. The constructive global economic environment that had been driving equity prices higher for the past ten years was coming to an end as a convergence of factors were pushing market volatility up and equity prices down. Investors generally believed that diminished economic growth expectations, a tightening Fed, a flat yield curve, ongoing trade battles between the US and China as well as peaking company revenues and earnings would undoubtedly continue drive equity prices lower. And then one by one many of these concerns began to diminish and equity prices recovered sharply. So, when looking at the market action of the S&P 500 over the past six months, what had begun as a major equity market correction of nearly 20%, is now a modest 4% decline from all time highs. Yes, this too has indeed passed.
Our viewpoint at Crow Point Partners, over the past several months has remained much more balanced despite the market volatility throughout the fourth quarter and into 2019. We too, were concerned by many of the fundamental factors mentioned above and particularly by the market action during the fourth quarter drawdown. Yet, we attempted to see through the anxiety and our assessment was that in spite of it all, things were just not that bad; the US economy was continuing in growth mode, the Fed has learned from the policy mistake of December and that sabre rattling over trade would diminish. This viewpoint led us to increased conviction in risk assets generally, and in cheap equities, in particular. All things considered, that viewpoint has played itself out well thus far in 2019.
Moving into the second quarter, our viewpoint on fundamental economic variables remains constructive but not entirely ebullient. Our forward-looking opinion on many of the key variables which we evaluate are stable…. inflation, rates, volatility etc.... and are likely to remain range bound and should not have a disruptive impact on either equity or debt market pricing.
We have long contended, however, that the most important variable to sustain the current bull market is pure economic growth. Although off the recent peak growth rates, we continue to believe the United States growth path remains upwardly sloped and is likely to remain so for the foreseeable future. The virtuous cycle of strong job growth, improving wages and consumer spending, increasing profits and further capital and labor investment remains firmly in place.
Many investors, however, have become very concerned by the shape of the US Treasury yield curve and its predictive implications on the US economy. Historically, an inverted yield curve has been a market indicator of a slowing economy and many times a pending recession.
As of this writing the US yield curve is modestly inverted as measured by short term rates relative to the 10-year note. In a highly globalized bond market, the question of how much are US rates influenced by overseas economic weakness and the low to negative interest rates in Europe and Japan. Many investors forget that both the German and Japanese 10-year government bonds still have negative yields and by extension the US 10-year note is a high yielder. Additionally, given the Fed’s renewed caution on further rate increases, the 10-year to Fed Funds spread may have hit its interim tights.
In as much as the yield curve can be a predictive indicator for future economic activity, one needs to remember that historically, there has been a fairly long time between when the yield curve inverts and when the equity market peaks and the economy goes into recession. Looking at the past eight curve inversions, the average time to market peak was 12 months and the average time to recession was 18 months.
So, to us, the yield curve is definitely a worrisome indicator which needs to be monitored. Yet, in isolation it is not a data point which will exclusively change our viewpoint on the US economy and equity markets, at this point in time.
As mentioned above, interest rates across Europe and Japan remain at or near cyclical lows which reflect the weakening economic situations in those nations. Despite an overall growing global economy, European and Japanese growth rates have remained stubbornly low and in fact did not meet early 2018 forecasts. Emerging Markets continue to have higher growth rates than Developed Markets yet have been negatively influenced by the ongoing trade riff between the US and China, thus putting a damper on potential growth.
So, investor concerns regarding global growth are not entirely unfounded as broad macro-economic growth measures are mixed at best and in the case of Europe and Japan, they are downright weak. As is always the case, investors broadly discount potential growth through the stock market (bond market too-see curve comments above). When growth fears were at their peak in December, valuations reached an interim nadir. At the market low in late December, the US stock market was trading at roughly a 14x forward P/E relative to a 5 year average of about 17x. Other equity markets were trading at similar historical discounts. Stocks had been cheap, and a buying opportunity was clearly on the table. Today, the market reflects both improved economic prospects, as well as the regional discrepancies of growth. The United States, trades at a justifiable premium to international markets due to greater economic dynamism as well as the ability to execute on potential growth. US companies have continued to exceed analyst earnings expectations whereas many international companies have not met the mark.
Given all of that, for our multi-asset solution mandates, we remain overweight risk assets generally and in US equities, in particular. We have modestly reduced equity targets from very high levels given the recent recovery in stocks and valuation levels which can no longer be considered cheap. In spite of the higher relative valuations, we believe the growth potential of US equities could easily be realized in an environment where many fundamental economic variables are mostly static and the fiscal policy regime continues to favor business and risk taking. Small cap companies continue to be of focus for us as growth in technology and healthcare remains compelling. Overseas, we continue to maintain overweight positions in Emerging Markets. Relative valuation, long term growth potential and the probable resolution of the US-China trade riff draw our interest to EM. Europe and Japan remain generally unattractive to us. Some sort of fiscal stimulus is required to catalyze businesses and investors to take risk. Sadly, that fiscal stimulus is unlikely to occur and the low growth, low rates, low earnings regime in Europe and Japan is likely to persist.
As an asset class, fixed income remains mostly unappealing to us. Although we are not in the camp that believes that rates must rise significantly and that fixed income will post negative returns we continue to think that equities offer more long term promise. As a risk management tool, bonds continue to have utility, yet we remain underweight traditional high grade fixed income.
In lieu of fixed income, we continue to maintain large overweights in non-traditional alternatives. Broadly speaking, we believe that our approach to alternatives will offer risk benefits relative to equities yet provide higher rates of return relative to fixed income. At Crow Point Partners, our greatest advocacy point is that a flexible, multi-asset approach is the best defense to an ever changing economic and market environment and our healthy allocation to alternatives is a critical component to that approach.
Lastly, a quick thought on Brexit. Its hard to remember but almost three years ago investors freaked out over the prospect of Britain leaving the EU and what the economic prospects would be for Britain and Europe, at large. Since then, the Brexit issue has devolved into an extremely boring, very European, bureaucratic debate resulting in meaningless Parliamentary votes and further bureaucratic processes with seemingly no conclusion. And we wonder why Europe’s economy doesn’t grow. At Crow Point Partners, we believe that if Britons choose to leave the EU, all will not be lost and that the British will have trade options, most notably with the United States and Canada. Maybe investment sage, Roger Daltrey, best summed up the Brexit issue in a recent interview with Sky News.
Yes, this too shall pass.
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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