November 8, 2018 – This past quarter marked 10 years since the 2008 global financial crisis. Back then, in the midst of a housing market collapse, bank failures, and multiple federal bailouts, the outcome appeared uncertain at best. Though it was difficult to envision a brighter tomorrow, I wrote the following in October 2008:
“With fear and uncertainty our constant companions for the past six weeks, we summon the priceless commodity of courage and restate our belief in the long-term resiliency of our economic system and financial markets.”
The global crisis precipitated a decade of unprecedented low interest rates and super abundant liquidity deemed necessary to shore up the financial system. The decade also delivered above average returns from US equities, a result that surprised countless doomsayers. In hindsight, it’s easy to see that fear and pessimism dissuaded many from seizing opportunity.
Today, the sun is setting on the past decade of financial repression. We are in a new environment of normalizing interest rates and the capital markets are again at a turning point. The pieces on the chess board are changing and naturally that raises a fair bit of angst. We at Pitcairn find ourselves in a familiar contrarian position – seeing change as a catalyst for opportunity, not negativity. This is an exciting time in the capital markets and I think the core principles so decisively reaffirmed over the past 10 years will be instrumental to success in the next 10.
US Equity Strength and Ebbing Trade Fears Headline Third Quarter Results
We believe the solidifying trend toward higher interest rates is likely to have the most significant impact on longer term investment results, but there will always be factors affecting short-term returns and such was the case over the past three months.
In our last quarterly letter, we noted that progress in global trade negotiations would likely influence near-term equity market results. In our view, trade war fears had artificially depressed second quarter equity returns. We believed that as those fears subsided, the market would respond like a compressed spring when it is finally released. In fact, third quarter US equity results were quite strong. In a quarter that saw the completion of a trade deal between the US, Canada, and Mexico, the US Russell 3000 Index returned 7.12%. Once again, US equities outperformed international developed and emerging markets.
Meanwhile, bond markets took the Federal Reserve’s third interest rate increase of the year largely in stride. As yields rose across maturities, the Bloomberg Barclays US Aggregate Bond Index was flat for the quarter and slightly negative year to date. Global bond markets were slightly negative for the quarter. The commodities sector was also slightly negative, except for oil, which continues to benefit from reduced supply.
In a sign of the changing market landscape, the end of the third quarter and start of the fourth quarter saw equity markets grapple with concerns about future Federal Reserve policy. As I have said in the past, I believe Federal Reserve Chair Jerome Powell has effectively executed the Fed’s agenda to date. However, markets have become somewhat conditioned by the actions of prior Fed chairs to expect accommodation when stocks weaken. In an early October statement, Powell suggested that the Fed could continue to raise rates into 2019; first, because inflationary pressures remain contained and second, because economic growth can continue due to fiscal policy effects. Powell’s viewpoint rang hollow to the market, which saw the economy as healthy, but weakening. The market’s fear of a weaker economy and its inference that the Fed might be less sensitive to equity performance kicked off a significant correction.
Expect the Fed to Hold Course as the New Landscape Evolves
The shift to more normal interest rate levels is likely to have ramifications far beyond 2018. The new phase will likely bring greater volatility in all markets and possibly lower equity returns, though not necessarily a bear market.
By historical standards, the Fed’s transition is progressing at a very measured pace. We believe that can continue, because, as stated above, the Fed has stayed ahead of inflationary pressures and the economy remains healthy. Secular forces – including technology and globalization – are pushing down inflation while fiscal stimulus boosts growth, making this an opportune time for the Fed to implement its policy reversal.
With all eyes on the Fed, there is a chance of misstep. Over the years, many have insisted that the Fed’s easy money policy would inevitably end in a veil of tears. I have always been more optimistic about the cumulative intelligence of the Federal Reserve than the market has been. I believe there is a reasonable probability the Fed can engineer a “soft landing,” similar to 1995, and that the economy will remain more resilient than many observers predict. In short, I believe the economy can withstand more tightening than the psychology of the market can.
Based on recent performance, stock prices seem to be saying that we don’t need another rate hike in December given a softening economy. Whether the Fed interprets the data the way the market does remains to be seen. As we move into 2019, I don’t think the data will show a need for aggressive rate increases. And because the Fed has stayed ahead of inflation, it will have the flexibility to slow or pause its process. That means we may see fewer rate increases in the year to come.
Global Growth May Mitigate Interest Rate Impact
Global economic health will play a critical role in investment results in the normalizing environment. Economies across the globe are in decent shape, as evidenced by strength in global PMIs (Purchasing Managers Index). To be sure, there are risks in foreign markets, including the UK’s Brexit negotiations, a worsening picture for Italy’s economy, and continued trade pressure on China. Europe is slowing more than other developed regions, but is still growing. Emerging markets are also still growing, despite struggles in areas such as Argentina and Turkey, which have been hampered by high debt and weakening currencies. We look for governments around the world to respond with fiscal initiatives to counter these trends, much as China did last July.
US GDP growth remains quite strong and corporate earnings are up 20% post the passing of the Tax Cuts and Jobs Act in December 2017. Consensus forecasts call for a US recession in 2019/2020. I’m not convinced. It’s true, the US economy is not what it was earlier this year, but by no means is it weak. The markets, which are forward looking, apparently believe earnings and profit margins are peaking and that stimulus effects will wane, causing everything to deteriorate from here.
The long-term effect of last year’s tax cuts is a key unknown. There’s an ongoing ideological debate between those who see the tax cuts as an unsustainable sugar high and those who think lower corporate taxes will spur capital expenditures and provide impetus for sustained growth. The US economy is currently projected to grow at 3.2% or 3.4% for the fourth quarter. We believe the market is under-appreciating the long-term stimulus effects.
Our view is that one should at least consider the possibility that the effects of last year’s fiscal stimulus, combined with forthcoming fiscal initiatives, may sustain this cycle beyond the 2020 timeframe that consensus thinking has apparently settled on. I believe fundamental drivers will sustain this economy and that there is a very good chance the next US recession will manifest very, very slowly, just as the interest rate reversal did.
Positives and Negatives for Stocks, But the Bull May Still Run
The normalizing interest rate trend has both positive and negative implications for long-term equity holders, but without a doubt, there will be negative noise in the short term, especially around the mid-term election.
Time and time again, we have listed the primary factors that end bull markets: an inverted yield curve, excessive valuations or investor exuberance, and an unpredictable, exogenous shock. Even as the higher interest rate environment takes hold, we do not think these exist right now.
At the end of the third quarter and beginning of the fourth, the 30-year Treasury yield moved up, which suggests economic growth is going to push long rates higher, preventing the yield curve from inverting. Meanwhile, there is still a lack of positive psychology in the market.
Though the federal funds rate is slightly above the inflation rate for first time in 10 years, there has never been a recession when the real fed funds rate (the nominal rate minus inflation) has been below 2-3%, significantly higher than it is right now. (See Chart A.)
Last quarter, we said 2018 might be a blocking and tackling year for both stocks and bonds. As the third quarter came to a close, the outlook looked a little better than that for stocks and a little worse for bonds. However, the beginning of the fourth quarter has been difficult. At this point, we are not expecting much upside until after the mid-term election. If election results play out as currently projected – with a Democratic House and a Republican Senate – markets could respond well because that is what they expect. With support from a strong economy and financially healthy US consumers, US stocks could resume their advance.
Consumers are currently driving the US economy about as hard as they can. In fact, consumers are in such a good position, it would be hard for them to get in any better shape. Sentiment measures are strong across the board, with the Consumer Confidence Index hitting an 18-year high in September. (See Chart B.) Still, if wages start to pick up, consumers will have more money in their pocket combined with lower levels of household debt. The equity market has already priced in a good holiday retail season, so if that plays out, it won’t be a surprise, but will support stock prices.
With so many positives, I just don’t see the bottom falling out of this market. And, therefore, I see October’s weak stock prices as much more of a seasonal correction than a secular turning point. I think after the election, US stocks may stabilize and rise a little toward the end of the year.
Look for Better Returns Across a Broader Array of Asset Classes
From a global market standpoint, 2018 has not been the kind of year we prefer. For most of this year, US equities were the only asset driving the train. A year like 2017, when a number of different asset classes are working, is obviously more profitable for diverse portfolios. Normalization of interest rates has the potential to reshape this landscape, creating an environment where portfolios incorporating multiple asset classes, multiple regions, and multiple investment types perform better over the next 10 years than they did during the last 10 years.
For example, competition from higher global interest rates may finally be the catalyst that allows non-US stocks to retake market leadership. And, once 10-year Treasury yields reach the high 3s or low 4s, bonds become competition for equities. (The 10-year yield hit 3.1% during the quarter.) In recent years, it has been difficult to add value by distinguishing between good and bad companies, but higher interest means higher capital costs, which will put pressure on lower quality, debt-heavy companies. When creditors start calling, volatility will increase, which should allow active managers to shine.
New Landscape Demands Perspective, Diversity and Discipline
The third quarter’s most important takeaway for Pitcairn clients is that this is not the same old same old environment we have been navigating for years. Our perspective is that the environment going forward will be much friendlier to diversified portfolios. In short, we think diversity will be critical as a wider array of assets perform well. We think active managers who deliver alpha will have an advantage over passive strategies as higher capital costs begin to cull the strong companies from the weak. And, we believe a targeted and disciplined approach to private equity investments is essential as the potential for a bubble in that segment increases.
Pitcairn portfolios are already positioned for what we expect to happen over the next few years and have been for some time. Though the next major move may be to further reduce risk, we don’t believe that time has come. Already some investors are leaving the market, but early exits often mean missing a substantial portion of the market’s gains. Many of the people leaving early are the same ones who came late. That’s a poor strategy for long-term success.
Markets are resilient, and I think there is still life left in this bull market. There will be a recession in the future, but it’s not clear that will be soon. In this age of heightened political rhetoric, with the fear gauge running high, let me reiterate that political factors exerting a measurable, long-term effect on the markets are few and far between. Don’t be overly influenced by the periphery. There are opportunities out there and we are ensuring that your portfolios take advantage of them.