Commentary | 4Q 2018

If I could turn back time, If I could find a way”

– Cher, “If I Could Turn Back Time”, 1990

2018 Q4 Market Recap

Let us turn back time, if we could, and revisit the halcyon days of September 2018. Equity investors would have felt relatively sanguine heading into the 4th quarter. Markets (particularly in the US) had recovered from the wobble in February, and were at or near all-time highs. Valuations around 15x earnings seemed reasonable especially in light of accommodative monetary policies, global real GDP growth that was positive, and indicators of economic activity such as the Purchasing Managers Index (PMI) that continued to indicate expansion. Inflation, barring countries such as Argentina, Turkey, and Venezuela, also appeared benign.

However, hopes that the markets would end the year on a positive note did not come to pass. The MSCI ACWI Index receded 13% in the 4th quarter primarily due to what we at Affinity have been terming as a growth scare. Investors have become increasingly concerned that the pace of economic (and earnings) growth in 2019 and beyond will be much lower. Estimates for earnings growth in 2019 and 2020 have been gradually reduced in recent weeks, and investors have sought refuge in, and gravitated towards more defensive sectors such as Utilities, Real Estate, and Consumer Staples.

The about-face in the forward march of equity indexes to higher levels mirrored the reversals that took place in performance across equity factors. For instance, investors had placed a premium on growth during the first three quarters of 2018. Value-conscious investors had trailed their growth counterparts as a result. The MSCI ACWI Growth Index returned nearly 8% through September compared to 0% for the Value Index. However, the tables turned in the 4th quarter. The Growth Index lost 15%, while the Value Index was down 11%. As we have previously written1, the performance of the Growth and Value indexes is strongly influenced by sector effects. In recent years, the outperformance (underperformance) of the Growth Index versus the corresponding Value Index has often coincided with the Technology sector outperforming (underperforming) the Financials sector.

Equity factors such as Size (as measured by Market Capitalization), positive Sell-Side Analyst Revisions, and Price Momentum correlated positively with the long-term earnings growth factor. Their outperformance through the first three quarters of the year faced a similar reversal of fortune at year-end. Valuation factors such as dividend yield and the ratio of price to earnings (P/E) had underperformed for much of 2018. While dividend yield found favor with investors during the 4th quarter, other value factors such as P/E and P/E/G (P/E divided by estimated long-term earnings growth) continued to struggle.

Reasons behind the Growth Scare

We believe that the following factors have contributed to the aforementioned growth scare:

1. Fed policy

The roots of the sell-off can be traced back to Fed Chair Powell’s comments in an interview on Oct 3. When discussing the path of the Fed’s monetary policy, he said, “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral.” He added “We may go past neutral, but we’re a long way from neutral at this point, probably.”2 While the Fed had previously signaled three rate hikes in 2019, investors interpreted the latter statement to mean more aggressive monetary policy. By extension, this would call into question the sustainability of the high growth rates that the US economy recorded in the 2nd and 3rd quarters of 2018.

2. Trade negotiations between the US and China

The present administration has attempted to redraw agreements with trading partners globally. The US withdrew from the Trans-Pacific Partnership last year. 2018 saw a re-drafting of the 25-year old NAFTA deal with Canada and Mexico, as well as simmering tensions with Europe on a variety of issues. However, the most contentious trade dispute currently is with China. Both countries have imposed imports tariffs. The effect of these tariffs has been acutely felt in the US agricultural sector, as well as the Chinese manufacturing sector. The uncertainty over resolution of the trade issues between the two countries has roiled the equity market. Both sides have ratcheted the rhetoric by threatening to widen the scope of tariffs as well as increase the tariff rate. Much hope had been pinned on a dinner meeting between the US and Chinese leaders in Buenos Aires on Nov 30 to defuse the situation. Markets reacted positively to the news that both countries had agreed to delay planned tariff increases, and enter into a 90-day negotiation period that will expire on March 1, 2019. The initial relief rally proved short-lived due lack of substantive agreements, as well as notable differences in statements by the two countries following the dinner meeting.

3. Rest of the World

The US and China are not only the largest economies in the world, but they have also been the fastest growing. No other country or economic region has the combination of growth rate and size to meaningfully step into the void created by any slowdown arising from the dispute between these economies. For instance, the UK and Europe are in a stalemate over Brexit despite the looming deadline in March 2019. Japan’s growth is still anemic and the Japanese central bank recently abandoned the goal of achieving a 2% inflation rate. Meanwhile, rising energy prices, US Dollar appreciation, lack of meaningful reform as well as the slowdown in China have constrained most emerging markets from realizing their growth potential. In short, the prospects for global economic growth (and investment returns) would appear to be primarily dependent on a detente between the US and China on trade.

Market Outlook and Positioning

Investors are fond of channeling Aristotle and adapting his phrase to say that “markets abhor uncertainty”. However, uncertainty is a feature of all investment decisions, for who knows the future with any certainty? That said, the level of uncertainty at present (as measured by the Global Economic Policy Uncertainty Index3) has spiked to its highest level in over 18 months. The implication has been increased volatility for risk assets, and investors seeking refuge in assets considered low-risk such as US treasuries (in fact, the yield on 10-year treasuries has receded nearly 50 bps since early November).

As the old investing cliché goes, “trees don’t grow to the sky”. This has been borne out as prior equity market leaders have turned laggards, and their once-lofty valuations have descended to levels approaching reasonability. This has created opportunities for value-conscious investors to purchase businesses that were previously out of reach due to their extended valuation.

We are seeking opportunities in this sell-off because we don’t see signs of an imminent economic recession yet in the US which would indicate that we are in the midst of a classic equity bear market. We think that the sell-off is a return to fundamentals that have been ignored by investors in recent years.

This outlook is informed by signs of slowing (but not negative) economic growth in the US:

  1. The Federal Reserve Bank of Atlanta is forecasting GDP growth of 2.7% for the 4th quarter of 2018, down from the 4.2% reading for the 2nd quarter, and 3.5% for the 3rd quarter.
  2. Institute of Supply Management (ISM) reported readings of 59.3 on their manufacturing index for the month of November, down from 61.3 in August.
  3. The Conference Board’s Index of Leading Economic Indicators grew 5.2% year-over-year in November, lower than readings of 7% in September, and 5.9% in October.
  4. The slope of the yield curve (defined as the spread between 10-year treasuries and 3-month T-bills) has flattened to 30bps, but is still positive.
  5. Credit spreads on investment and high-yield corporates have widened to their highest levels in 2 years.

We remain optimistic with the broader markets, and in this transitional period would employ a constructive valuation focused approach to diversification and portfolio risk. Fed policy is in flux – the Federal Reserve signaled two rate hikes for 2019 in December, down from an estimate of three rate hikes in September. We would maintain adequate diversification, and seek lower-beta as well as less financially-levered securities when rebalancing the portfolio.

If anything, the recent bout of heightened market volatility has driven home the point of not only having a well-defined investing process, but also the discipline to adhere to it despite market gyrations. Investing styles will cycle in and out of fashion, but staying true to a disciplined process will lead to superior investment outcomes over the long term.

There are those who will cling to hopes of a grand trade bargain between the US and China before March 1, and the Fed signaling a pause in its rate-hiking cycle. These developments may yet come to pass, and it could lead to a “risk-on” environment again. However, hope is not a strategy, but a disciplined investment process is.

Please do not hesitate to contact us should you have any further questions.

References
1Value and Growth Indexes – Style or Sector Bets, Affinity Investment Advisors, May 2018
2https://www.cnbc.com/2018/10/03/powell-says-were-a-long-way-from-neutral-on-interest-rates.html
3http://www.policyuncertainty.com/