Investment Commentaries: First Quarter 2018
| Index Returns | 1st Quarter | Trailing 12 Months |
| S&P 500 US Large Cap Index | -0.8% | 14% |
| MSCI All Country World Stock Index | -0.8% | 15.4% |
| Barclays Capital Aggregate Bond Index | -1.5% | 1.2% |
| US Core Consumer Price Index - (Inflation) | 0.8% | 1.9% |
The most notable characteristics of the first quarter of 2018 were the return of stock market volatility and the continuing rise in bond yields. Higher and more persistent volatility indicates that investors have begun to incorporate higher levels of uncertainty into stock prices. Rising bond yields indicate that bond investors are waking up to the reality of a longer-term rising interest rate environment. As we discuss the market environment here at Pendleton Street, our discussion revolves around three main questions:
1) What changed between the beginning of the year and the end of the first quarter?
2) Have the fundamentals changed enough to warrant the downturn in stock prices, and increase in market volatility?
3) Do our answers to the first two questions change our intermediate or long-term views, which would in turn influence our views on asset allocation and security selection?
We summarize the events of the quarter, and our thoughts on the above questions, in the following pages.
Current Environment: After a year-long run of uncharacteristically low stock market volatility, by February 8th the S&P 500 index of US large- cap stocks had declined -10.2% from its late-January high, marking the first decline of such magnitude since February, 2016. By the end of the quarter, the index remained -8% below its most recent high.
Major bond indexes also declined during the quarter, as the impact of increasing interest rates over-powered the tendency for investors to turn to bonds for safety during periods of heightened stock-market volatility.
Bottom Line: It looks as though the honeymoon is over. The persistence of higher volatility in equities markets since the correction began in late January suggests that the seemingly relentless investor-optimism that began shortly after the election of President Trump has given way to what we expect from any substantive relationship - a series of ups and downs.
What remains to be seen is whether the couple in question is willing to put the work in to maintain a fundamentally healthy relationship over the next three years. The key word is fundamental, as we believe that economic, market, and company fundamentals are what ultimately drive long-term portfolio returns. From that fundamental perspective, we tackle the first question...
1) What has changed between the beginning of the year and the en of the first quarter?
In the weeks prior to the market’s peak on January 26th, investors began to show signs of over-optimism and a disregard for known risks in pursuit of short-term gains. Over-optimism served as the kindling that a few key sparks (outlined below) turned into a mild flame as stock prices began to fall:
Inflation: Inflation is a measure of how much consumer prices increase over time. One of the Federal Reserve’s mandates is to promote stable prices (i.e. keep inflation consistently low), and one way they try to do that is by raising interest rates to reduce borrowing and slow spending. Wage growth is thought to cause higher inflation, and an early February jobs report indicated that wages had grown at an annualized rate of 2.9% - the highest growth since 2009. A subsequent report from the Labor Department reported wages had increased at an annualized rate of 2.6% - the highest growth in that particular figure since 2015. Indicators of higher inflation sparked concern that the Fed might raise interest rates more swiftly than they had previously indicated, which in turn would raise the required rate of return for most other asset classes sooner than was expected, potentially causing valuations to decline (see below for a more in-depth discussion of how this can impact valuations).
Rising interest rates and a new Fed Chair: Jerome Powell replaced Janet Yellen as the new Chair of the Board of Governors of the Federal Reserve System (or “Fed Chair” for short) on February 6th. While Chairman Powell’s approach to monetary policy is believed to be very similar to Janet Yellen’s, he is thought to view government regulation much more negatively than his predecessor. Most visible signs point to Powell being as - if not more - accommodating to markets than Janet Yellen, but the uncertainty caused by that change only added to the uncertainty caused by indications of higher inflation.
Threat of trade war with China: The tariffs on Chinese imports proposed by the President, and the subsequent retaliation by the government of China by threatening tariffs on US imports is nothing to ignore, but the amount of direct damage it could do to either economy is surprisingly low given the media hype. Markets are more concerned with the potential for indirect effects, both with China and other important trade partners. Additionally, investors are concerned that this approach with China signals the beginning of more protectionist actions that could be disruptive to US and global economic momentum. It is not the tariffs that are causing the volatility, as much as it is the uncertainty around the impact they and other potential actions in the future could have on global trade.
All three of the paragraphs above primarily describe changes in the way investors THINK about investing; not changes to the underlying investments. Which is why we ask the second question...
2) Have the fundamentals changed enough to warrant the downturn in stock prices, and increase in market volatility?
S&P 500 Operating Earnings, which shed light on corporate profitability across the wider economy, grew by 17% in 2017 and are expected to increase by another 25% in 2018 and 10% in 2019. All three years of growth are significantly higher than long-term historical average growth in Operating Earnings of 6-7% annually. How can markets decline when the underlying companies are expected to perform so well?
Stock prices are a function of two primary expectations and two requirements:
Expectations: Investors form expectations of 1) future economic benefit (i.e. cash flow) generated by an investment, and 2) growth of that cash flow over time. As expectations increase, so should prices.
Requirements: Investors require a rate of return 1) higher than a low risk-alternative such as US Treasury bonds, and 2) with an additional premium for taking on the risk that the investments in question will not perform as expected. Falling Treasury bond yields and increasing confidence causes prices to move higher. Conversely, a period of rising bond yields and increasing uncertainty causes prices to move lower.
In fact, we can see how all of the expectations and requirements combine to form a Price-to-Earnings multiple, as shown in the visual to the right.
Currently, expectations (in the form of high earnings growth estimates) are pushing prices up, while requirements (influenced by both rising yields and increasing uncertainty) are pulling prices down. The net result has been a shift in market valuation back towards its long-term average when compared to underlying profitability (see the chart to the right).
It is important to remember that this tug-of-war between risk and opportunity that results in market volatility and periods of declining stock prices is normal. The extended calm and upward march of stocks in 2017 was extra-ordinary. Most importantly for our team is what all of this means for how we manage client portfolios...
3) Do our answers to the first two questions change our intermediate or long-term views, which would in turn influence our views on asset allocation and security selection?
We have been discussing our concern that markets were overly-optimistic and potentially over-valued with clients for the last few quarters and have already made changes to portfolios to reflect those concerns. While this pullback has brought high-level market valuation back towards a more reasonable level, stocks in aggregate are not undervalued – we believe they are fairly-valued. When an investment is fairly-valued, it is priced to provide a fair return, which is actually a good place to be.
One significant change we made to diversified portfolios during the quarter was to selectively reduce interest-rate sensitive stock positions, using the proceeds to increase portfolios’ existing positions in precious metals such as gold, silver, and platinum, via an ETF that physically owns the underlying metals. We see acceleration of inflation as an increasingly likely trend, and modestly increasing positions in precious metals is currently the most efficient way to protect portfolios from erosion of purchasing power.
As we have seen over the last three months, conditions can change quickly, and we strive as a team to be ready and able to make changes as quickly as necessary. That said, our primary concern now is that we adhere to our investment process that relies on systematic rebalancing of portfolios to keep allocations in-line; diligent research and analysis to evaluate and adjust positions when necessary, and frequent communication with you, our clients, to make sure we understand and stay updated on your objectives. We do not take lightly the trust you place in us as advisors and look forward to speaking with you soon.
Matt A. Morley, CVA, CEPA
Chief Investment Officer