Island Light Quarterly Commentary (Oct 2019)
“It was the best of times, it was the worst of time, … it was the epoch of belief, it was the epoch of incredulity” Charles Dickens
More than 9 months into 2019, investors are confronted with uncertainty and hyperbole; the economy is great, the economy is terrible, the news is awful, the sky is falling, the unemployment rate is at a record lows, the stock market is at record highs. Trying to divine the signal for the noise all around us (and there is a lot of noise) is a challenging and perhaps impossible job; thankfully we are not market timers and thus, perhaps, able to able to remain skeptical but purposeful. So as we rush headlong into these uncertain times, lets look back at what has happened this year.
The equity market, as measured by the S&P 500, rose modestly from June 30th (+1.7%) and strongly from the beginning of the year (+20.6%). For the one year ended September 30, however, the index has returned a more modest +4.3%. US large cap stocks again outperformed US small cap stocks in the third quarter (+1.7% vs. -2.4% for the Russell 2000) and for the year (+20.6% vs +14.2%). In the last 12 months, US small cap stocks are down -8.9%. Growth stocks outperformed value stocks again in the third quarter and continue a long streak of outperformance with growth beating value all but one quarter since the end of 2016. (Russell 1000 Growth, Q319 1.5%, YTD 23.3%; Russell 1000 Value, Q319 1.4%, YTD 17.8%).
International equity returns were dragged down by dollar strengthening in the third quarter, with the MSCI EAFE index returning 12.8% for the year-to-date and -1.1% in the third quarter. This follows a -13.8% loss in 2018. Emerging markets, as measured by the MSCI Emerging Markets index lagged their developed market counterparts in the third quarter, off -4.3% with year-to-date returns up a modest 5.9%. The US tariff and trade war with China, coupled with the strong dollar, contributed to the weakness in this segment of the global economy.
The real story in the third quarter was the rapid and unexpected drop in US Treasury yields from a quarterly high of 2.13% on July 15th to a drop to 1.47% on September 5. While a mid-September rally returned the 10 year to 1.90%, the yield has since returned to 1.52% on October 5. These are historically low nominal interest rates, especially for this point in time in the business cycle. Real interest rates are negative as inflation hovers just short of 2.0%. In the face of this low and volatile interest rate environment, the Fed has little choice but to further cut the fed funds rate, probably to 2.0% in late October.
Because bond prices move in inverse proportion to their yields, bond returns were positive with the Bloomberg BarCap US Aggregate Bond index up 2.3% for the quarter and 8.5% for the year to date. Corporate bond spreads remained unchanged from last quarter, near 1.2% at the end of September (ICE BAML US Corporate Master Option- Adjusted Spread.)
One of the longest economic growth cycles in US history is showing signs of its age, becoming increasingly fragile and responsive to pressure and perception. The good news is that unemployment is at a 50-year low and real wages are increasing. The job market is tight and opportunities for employment are readily available. Corporate earnings look to be stable, not growing, and the equity market, a leading indicator, is near 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 has once again turned expansive. The cyclical sectors that have driven recessions in the past (residential investment, business fixed investment, change in inventories, auto consumption) appear to be healthy. But not all cylinders in the economy are working smoothly. Never-ending increases in the tariffs, trade war rhetoric, overnight changes in policy, impeachment proceedings, Brexit, unrest in Hong Kong – the list goes on and on. All the news above causes uncertainty. Business leaders hate uncertainty; corporate investment slows, the appetite for risk is lower; economic activity turns down and a negative cycle of news can feed further declines.
The other big thing going on in the background, and not getting nearly enough attention, are negative nominal interest rates in Europe and Japan. Overseas, $15 Trillion of debt pays no interest at all and the effective nominal interest rate is negative. What does it mean when the price of money is zero and you have to pay for the privilege of owning a government bond? Something fundamental between borrower and lender has broken. Even if the technical reasons for negative rates are plausible; regulatory and insurance requirements to balance assets and liabilities, central bank purchases, fear of higher losses in other assets; negative rates are still worrisome and, to a some degree unprecedented in their longevity.
Studies have indicated that negative real interest rates have a negative impact on growth, consistent with the uncertainty cycle above. When rates are low, investment slows leading to slow growth, low inflation, lower rates and expectations of slowdown. Counter-intuitively, at very low nominal interest rates, the behavior of businesses and investors is not to borrow to take on more risky ventures; it is to borrow to eliminate equity positions on the balance sheet or to not borrow, anticipating bad times ahead. It is really hard to find any plausibly valid reason for negative interest rates to remain in place for extended times, unless they are an indicator of future deflation or negative growth. What we don’t understand fully, or what appears to be implausible, leads us to become cautious.
While the odds of a recession have increased, we remain unconvinced that a recession is imminent. But we do expect that the low interest rate regime will be with us for a long time; the Goldilocks cycle, not too hot or cold, is likely to stay in place. The price of money will stay very low. In time, we expect that the US and non-US interest rate gap will close leading to a weaker dollar and lower inflation. Earnings in the US and developed markets will be stable and, like the economy, grow slowly. Emerging markets, led by China, will be subject to the tariff uncertainty and appear to be less attractive, although the potential for higher growth rates remain in place.
In the face of this equity market uncertainty, we look to retain a neutral outlook for the rest of the year and may look for some defensive positioning in equities to offset the risk of higher losses. We will continue to seek yield from corporate and mortgage bonds. Ex-US investments are attractive on a valuation basis, but overseas economic growth is weaker than in the US. Trade policy remains a big uncertainty and we do not expect to see any clarity until after the next election. In the long term, fixed income helps to insure against equity loss; as uncertainty in the direction of equity markets increase, we want to keep that insurance component in perspective.
We look forward to your helpful comments and suggestions.