“Don’t Do Something, Just Stand There”
Little good can be said about capital market performance in the fourth quarter of 2018, but long-term investors can rest easier in the knowledge that no single quarter makes or breaks investment success. After a solid third quarter, capital markets quickly took a different path. On October 3rd, Federal Reserve Chair Jerome Powell made comments that the market interpreted as evidence the Fed would be more dogmatic in its future actions and might raise interest rates regardless of negative effects on the economy and markets. Fear that the Fed might bring down this great bull market suddenly seemed real.
On top of qualms about the Fed, markets grappled with the effects of ongoing US/China trade disputes on sentiment and inventory data, as well as the US government shutdown. In response, investors pulled back from risk assets. The resulting volatility was intensified by the actions of hedge funds and algorithmic trading.
In this letter, we will consider what fourth quarter results tell us about markets going forward, what we can anticipate from the Fed in 2019, and what investors should or should not do. But first, I would like to acknowledge the passing of one of our industry’s great innovators, Vanguard founder Jack Bogle. Mr. Bogle deserves considerable credit for the advent of index-based investing. Following a period of market turmoil, we may all benefit by taking to heart one of Mr. Bogle’s well-known quotes. When asked to comment on market volatility, he responded, “Don’t do something, just stand there.” With this twist on a common phrase, Mr. Bogle succinctly captured what has long been a core tenet of Pitcairn’s investment approach. Facing market volatility, especially emotion-fueled volatility, it’s always best to stick to your investment policy and reject the impulse to market time.
Fed Softens Interest Rate Stance, Calms Market Fears
After the market’s initial reaction to Powell’s October comments, the Fed softened its stance, affirming its intent to follow the data and signaling fewer rate increases for 2019. While to some this seemed like a capitulation, to me it seemed much more in line with the Fed’s prior stance than Powell’s October remarks.
The US is already ahead on interest rate increases, having first led the world into the monetary easing and now leading it to a more neutral interest rate environment. With no real inflation pressures pushing the Fed to raise rates, we are at a comfortable place to take a pause, which should lead the dollar to retreat a bit. For capital markets to stabilize and advance, investors need to believe the Fed will follow a reasonable, data-driven approach and I feel certain that will happen.
Next, We Need a Deal with China
Now that the Fed appears to be back on the same page as the markets, investors are eager for a trade deal. No surprise, so are the Trump administration and China’s leaders. Investors are correct; the global economy will suffer from a trade war, but I think they are putting too high a probability on one happening. President Trump takes pride in deal making and, right or wrong, equates his administration’s success with the success of the stock market. I believe he understands how much a deal will help the markets. On the other side of the negotiating table, China’s economy is slowing. The most recent GDP report measured 6.6% growth, the lowest in 28 years. China has a very dynamic, but in many ways, rudimentary economy that is more dependent on trade than the US. Clearly, there is strong motivation on both sides to get a deal done, which tells me investor worries about a global trade war are misplaced.
Positive, but Slowing Economic Growth Supports Capital Markets
A year ago, data showed synchronized growth across the globe. Since then, fear has crept into economic expectations, but fundamentals in most regions are still positive, with some signs of weakness. As you can see in Chart A, the forecast for overall global GDP growth is quite stable (coming in somewhere between 3%-4%) through 2020, with most countries showing modest, if any, slowing.
Key US economic indicators, including employment, corporate earnings, consumer sentiment, and inflation, do not signal an impending recession. The government shutdown was certainly costly, but it’s unlikely to take more than a few tenths off GDP and certainly isn’t going to crush the economy. Overall, the US economy appears likely to expand in the neighborhood of 2% in 2019.
Growth in the UK and Europe is definitely weaker, primarily due to the questions associated with the UK’s exit from the European Union and other ongoing political uncertainty. Asia’s economies are vulnerable to the threat of a trade war, but as I said above, I think that risk is overstated. As for China, we look for further liquidity injections by the government to improve manufacturing and stimulate other economic segments.
The low level of real interest rates is another deterrent to a 2019 US recession. It is very hard for a recession to occur when real interest rates are at low levels. As we stated in last quarter’s letter, there has never been a recession when the real fed funds rate (the nominal rate minus inflation) has been below 2%-3% and, currently, it is just 0.25%.
The bottom line is that our base case remains the same as it has been for much of 2018. We see neither a US nor a global recession on the horizon, but rather a mid-cycle slowdown in 2019. This is still a more slowly evolving macro-economic picture than the market currently recognizes, and we have a ways to go before a recession. We do not expect any meaningful inflationary pressure in 2019, which gives central banks greater flexibility to manage monetary policy. Furthermore, we consider it quite probable that governments will use fiscal stimulus (rather than monetary stimulus) to reignite GDP growth.
We often gain valuable insight into global economies and markets from our friends in the Wigmore Association. Our colleagues in Brazil have been quite optimistic as the country has responded well to the election of a business-friendly populist as president. Conversely, our Mexican colleagues initially thought their new president might be pragmatic, but have come to question whether he is up to the task of stemming corruption. Wigmore will be visiting Singapore next month, looking to gain a better understanding of the Asian economies and relationships between China and its regional trading partners.
Bear Market Indicators Remain Muted as US Stocks Tease Leadership Change
The fourth quarter proved once again that stocks are the only asset people want less of when the price goes down. Revisiting the three factors likely to end a bull market, we see that the prognosis is still good. The first factor is an inverted yield curve/recession. We just detailed the case against a 2019 recession. An inverted yield curve is something to watch for, particularly after some technical inversions in the middle part of the yield curve during the fourth quarter. However, the yield difference between 2-year and 10-year Treasuries, which is what we look at, is still flat.
The second factor, investor euphoria, is the polar opposite of current sentiment as people are quicker to abandon stocks on every downdraft and slower to return. Third, valuations are far from excessive, down from September’s high of 16.7x forward earnings to a low of 14.2x in December and, as of early January, trading in the high 14xs, still below the 24-year historical average. No inflation, 2%-2.5% GDP growth, a price-to-earnings ratio of 14x forward earnings – I certainly want to own stocks under these conditions.
Always mindful of risk, we can’t downplay the reality that as each year of the expansion and each year of the bull market go by, investors question whether this is the year of the recession and bear market. There are some factors at play that could increase the short-term chance of a recession, foremost being the status of global trade, and we are watching them closely. Even given these factors, we don’t see a 2019 recession as a high probability right now.
Equity sector results for the fourth quarter showed a significant shift from earlier in 2018. Between January and September, performance was led by growth stocks and, notably, the large tech companies. These stocks found themselves on the downside of a vicious reversal in the fourth quarter as investors gravitated to previously out-of-favor stocks. Additionally, energy stocks were hit hard by the fourth quarter decline in oil prices.
US equities recovered about half of their decline in January. During this time, growth stocks have come back, but they may not hold that leadership for long. The growth/value dynamic is cyclical, and we are beginning to position portfolios to benefit from a rotation favoring value stocks.
Non-US Stocks Lag, but Signs Point to Future Outperformance
Non-US stocks paralleled the weak US performance of the fourth quarter, but significantly lagged the US for the full year. Emerging markets also had a difficult 2018, with poor performance spread across the period in contrast to US stocks, which held firm until the fourth quarter.
This past year’s performance does not dissuade us from longer-term optimism for non-US markets. Three key factors suggest non-US stocks should outperform US stocks over the next decade: greater relative GDP growth outside the US, a balance of trade among nations that favors exporters and emerging market countries, and probable weakening of the artificially high US dollar. We see notable potential in emerging market stocks, which remain inexpensive relative to both developed and US stocks.
Bond Market Yields to Recession Fears
For the first time in over two years, we saw real stress in the bond markets during the fourth quarter. At the start of the quarter, rates rose on inflation fears, but when inflation data remained soft, the 10-year Treasury yield started to fall as buyers bought into a pre-recession mindset. Non-Treasury sectors, particularly, the high-yield segment, suffered as yield spreads over Treasuries rose sharply. For the quarter, the Bloomberg Barclays US Aggregate Bond Index delivered a positive return, reflecting recession expectations. The index was flat for the year.
Bond prices currently reflect a lot of potential bad news. If that bad news doesn’t transpire and better conditions come into line, the credit sector, high-yield, and other risk segments could surprise us with good performance.
Shifting Political Tides Call for Greater Awareness
Early on in his term, I stated that Donald Trump would not be a low volatility president. For almost two years, it seemed I might be wrong. Markets shrugged off the uncertainty associated with his administrative style until, finally this past quarter, Trump volatility came home to roost. His unconventional governing manner is a factor in renewed volatility and the market is still coming to terms with that reality.
Events around the globe have shown the 2016 US election to be part of a broader shift in the political climate. Donald Trump was elected on a populist platform here in the US and we have seen populist leaders emerge in other areas of the globe such as Italy and France. In my view, this is less about opposition between conservative and liberal philosophies and more about potentially detrimental effects on policy. Whether from the right or the left, populist solutions can be far off market expectations and often anti-capitalist. Populist politics did not have a good outcome in the 1930s/40s. However, I am an optimist, so I believe the collective intelligence of our society can solve problems without suffering the negative effects some populist policies might bring to bear. Given our role to lead families to success over multiple generations, it is incumbent on Pitcairn to recognize and adapt to potential sea changes, whether in capital markets or global politics.
Stay in Tune with the Market, Not Away from It
The promise of long-term wealth building is predicated on investors earning a high, single-digit return over time. The caveat is that markets won’t deliver that return with any year-to-year consistency. Some years are up 22%, others are down in single or double digits. The Russell 3000 Index’s -5.2% return for 2018 is disappointing, but by no means a disaster for long-term investors. It will not alter the ability of your 10-20-30 year plan to deliver a high single-digit annual return that will achieve the results you expect.
Going forward, earnings and GDP growth may slow somewhat, but capital markets are currently pricing in much worse scenarios, so we stand firm in our belief that now is the wrong time to be overly defensive. Many investors missed robust gains in 2009, 2013, and 2017 because they thought the recession and bear market were imminent. Higher returning asset classes still have room to deliver and the discounted valuations resulting from fourth quarter turmoil support this contention.
Given the maturing cycle, it’s important to stay in tune with the markets while not stepping away from equities. Diversity remains the guiding force in our portfolios, not market timing. Diversity includes commitments to non-US markets and diversifying asset classes like real assets and hedge funds, which underperformed during the extended period of low volatility, but could do well in the higher volatility we are likely to see going forward.
We are beginning to incorporate more defensively-minded managers, a move we initiated in the international space during the fourth quarter. We have begun trimming exposure to the most expensive portions of the US market in favor of US equity managers who would perform well in a leadership rotation from aggressive growth to value-oriented stocks, as well as other asset classes that have been unloved in recent years.
The fourth quarter was unsettling for many investors, but I hope Pitcairn clients were reassured by the knowledge that their investment policies are well-crafted and durable, and their diversified portfolios are built to be resilient. Periods of uncertainty, particularly emotional uncertainty, are the reason why we put investment policies in place. In the current environment, my advice to Pitcairn clients is to reiterate Jack Bogle’s prudent words, Don’t do something, just stand there.