Island Light Quarterly Commentary (Jan 2020)
“To every time there is a season under heaven.” Ecclesiastes
If you measure happiness by the performance of your investment portfolio, it has been a happy season indeed. US investors who began the past decade (2010s) owning US equities enjoyed a superb period of positive real performance. This followed a decade of negative real performance (2000s), which followed two decades of outstanding positive real performance (1980s and 1990s). Forty years of pretty great investment performance – happy days indeed. But does past happiness lead to future happiness? In other words, is there another season around the corner?
While we can’t know what the next decade will bring, it should be safe to say that the next decade will be less financially rewarding than the past decade. We begin the twenties from a place of strength, high valuation and low interest rates, a very different starting point than at the start of the tens. It is not clear what the major engine of growth will be for the next decade. We think that it will be hard to repeat the successes of the past and even harder for those who haven’t been investing for forty years to achieve their financial goals through investing alone. Like the squirrel preparing for winter, we have a good supply of nuts on hand and want to manage them carefully.
Most every major asset class returned healthy positive returns in 2019. The US equity market, as measured by the S&P 500, rose 9.1% for the quarter and 31.5% for year, a truly impressive performance, following a loss of 4.4% in 2018. For the ten years ending Dec. 31, 2019, the S&P 500 returned an amazing annualized 13.6% per year with a minimum return of -4.4% in 2018, a maximum return of 32.4% in 2013 and an annualized standard deviation of 12.4%. US small cap stocks outperformed US large cap stocks in the quarter (+9.9% for the Russell 2000) but lagged for the year (+25.5% for the Russell 2000). US large cap value stocks modestly outperformed US large cap growth stocks (S&P 500).
International equity returns were boosted by dollar weakness in the fourth quarter, with the MSCI EAFE index returning 22.0% for the year and 8.2% for the fourth quarter. This follows a -13.8% loss in 2018. Emerging markets, as measured by the MSCI Emerging Markets index beat their developed market counterparts in the fourth quarter, up 11.8% with year-to-date returns up 18.4%. A drop in trade tensions between China and the US and improvement in the European economic outlook contributed to the rise in the fourth quarter.
US interest rates declined during 2019. The benchmark US 10-year treasury interest rate began the year at 2.69% and ended the year at 1.92%. While low by any historic measure, especially at this point in the business cycle, the year-end rate has risen from its historic low of 1.47% on September 3. Very low and negative interest rates overseas, trade tensions, fears of economic slowdown recession and low US inflation appear to be the principal reasons for the change in rates. Partly in response to these fears of slowdown with little sign of inflationary pressure, the Fed lowered the Federal funds rate 3 times in 2019 to its current level of 1.75%, providing a weak monetary stimulus.
As a result, because bond prices move in inverse proportion to their yields, fixed income returns of nearly every variety performed well, producing returns that few would have expected at the end of last year. The Bloomberg BarCap US Aggregate Bond index rose 8.7% for the year. Corporate bond spreads dropped to 1.0% at the end of the year, down from 1.6% in early January and 1.2% in October, returning to the historically low levels last reached in early 2018. This helped corporate bond returns relative to treasury bonds but may indicate lower relative returns for corporate bonds going forward. (ICE BAML US Corporate Master Option- Adjusted Spread.)
Fears of imminent US recession that were present at the end of the third quarter have dissipated during the fourth. While recession remains a possibility, we believe that the likeliest scenario for the US economy remains a growth rate hovering around 2.0%, staying at the slow annual growth rate that we have come to expect over the last decade.
Repeating our themes from the third quarter, the good news for the economy is that unemployment remains near its 50-year low and real wages are increasing faster than inflation. The job market is tight and opportunities for employment are readily available. Consumer confidence is high. Corporate earnings look to be in stable slow growth mode and the equity market, a leading indicator, is flirting with its all-time highs. The fiscal policy expansion due to a drop in corporate and marginal tax rates continues to help the economic outlook and monetary policy remains expansive. The cyclical sectors that have driven recessions in the past (residential investment, business fixed investment, change in inventories, auto consumption) also appear to be healthy.
On the other side of the economic ledger, tight labor markets could limit future economic growth if companies can’t find enough qualified workers. Excessive federal debt could lead to a liquidity crisis if there aren’t enough buyers. Negative interest rates overseas indicate that something is fundamentally wrong in bond markets. Change in European leadership, uncertainty about what a negotiated Brexit will really mean for the European economy, declining population in Japan, trade conflict, regional conflict in the Middle East and a divisive US Presidential election may create headwinds for the global economy.
One of the downsides of such a rapid rise in equity prices is that we now have a high price to earnings ratio relative to the historic average. If earnings don’t fall in line with expectations, then we might see a drag on future performance. It is not unrealistic to imagine that equity markets could take a breather from their rapid gain in 2019. At least we should curb expectations about equity returns in 2020. On the other hand, a decade or more of relative underperformance makes non-US equity markets attractive on a valuation basis. We also expect for the dollar to weaken as global interest rates converge which would provide US investors in overseas markets an additional boost. However, overseas developed markets are not the US market. Sclerotic economic policies, low population growth and trade uncertainties may keep these markets from attaining their true potential in 2020.
It is also hard to imagine that fixed income will have the same performance in 2020 that it enjoyed in 2019. The yield curve is low and flat relative to long term averages. Unless low overseas interest rates pull US interest rates down further, we have a hard time imagining a long sustained fixed income rally. Corporate spreads versus treasuries are also tight, so we shouldn’t expect much more than the interest rate coupon from corporate bonds.
In the face of this market uncertainty and low expectations for positive growth, we really don’t have much of a choice but to retain a neutral positioning for 2020. Given that fears of recession have dropped, we will make opportunistic allocations to asset classes that we think will benefit from better than average growth or have factors that may contribute to growth. Even though corporate bonds look relatively expensive, they still offer a higher yield than treasuries and we will continue to seek yield from corporate and mortgage bonds. Ex-US equity investments are attractive on a valuation basis, even if overseas economic growth is weaker than in the US. Staying on our investment course, patient and consistent with our long term investment goals, remains the best course to navigate in all seasons.
Matthew V. Pierce