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3Q18 CIO Commentary

Source: Orion Advisor Services, AlphaGlider

The third quarter of 2018 was much like the second quarter, with the US equity market strongly outperforming its international peers, and only minor movements in the US fixed income market.

For the year-to-date period, US fixed income, developed market equities, and emerging market equities all declined. The US equity market rose just over 10%, primarily driven by growth companies in the technology, health care, consumer discretionary sectors.

The US economy continues to grow strongly, stimulated by lower corporate tax rates, deregulation, and higher government spending. Real gross domestic product (GDP) grew by a strong 4.2% in the second quarter, helped out by a “beat the tariff” export surge. Most third quarter GDP forecasts are in the 3-3.5% range. The Institute for Supply Management (ISM) Purchasing Managers Index (PMI) survey of non-manufacturing (i.e. service) firms grew for its 104th consecutive month in September, reaching a 21-year high of 61.6. Readings above 50 indicate expansion in the economy.

Unemployment remained at extremely low levels, finishing the quarter at 3.7%, its lowest since December 1969. Coincidently, an 11-month recession began in that same month. The US economy has put up net job growth in 96 consecutive months, blowing away the previous record of 48 months that ended in June 1990. Hourly wage growth continued its steadily upward rise (2.8% annually in September), but remains abnormally low given the unemployment rate and the high and rising rate at which workers are quitting their jobs for better opportunities. 2.7% of private sector employees quit in August, a rate not seen since the exuberant job-hopping days of early 2001 when wage increases were 4%+.

The positive US employment environment has understandably buoyed consumer confidence. The Conference Board’s measure of consumer confidence reached 134.7 in September, well ahead of the peak reached prior to the last recession, and only exceeded twice over the last 50 years. Those two periods (1969 & 2000) were subsequently followed by economic recessions and bear markets (one being the recession mentioned above in regards to coinciding with a 3.7% unemployment rate).

Source: Wall Street Journal, AlphaGlider

The Federal Reserve (Fed) continues to be concerned about inflationary pressures caused by the tight labor market. In late September it raised its benchmark rate by a quarter point for the eighth time since late 2015, to a range of 2.0-2.25%. The Fed is guiding to one more rate hike before year end, and three next year — pushing the rate to 3.0-3.25% exiting 2019 if it carries out on its guidance.

As the Fed pressured short-term rates higher during the third quarter, the yield curve continued to flatten. The difference between the yields of the 2-year and 10-year Treasuries declined from 33bps (0.33%) to 22.5bps (see my 2Q18 CIO Commentary for more discussion on the mostly negative implications of a flattening yield curve). However more concerning for the economy, and specifically the corporate and individual borrowers within it, was that interest rates continue to increase at all durations. For example, the 2-year Treasury yield increased 36bps to 2.82%, and the 10-year Treasury yield increased 20bps to 3.05% during the quarter.

The Fed is also applied upward pressure on interest rates by unwinding the post-recession build-up of its balance sheet. After peaking at $4.5 trillion a year ago, the Fed’s balance sheet is now down to $4.2 trillion, and is projected to shrink to $3.6 trillion over the coming 12 months.

The Trump administration continued to pressure the US’s largest trading partners for more favorable trading terms during the quarter. In late September, the Trump administration applied a 10% tariff on $200 billion of Chinese imports, to be increased to 25% on 1 January 2019. The current tally of imports into the US affected by tariffs is approximately $300 billion, made up of $250 billion from China, and $50 billion in steel, aluminum, washing machines, and solar panels from countries other than China. As the following chart shows, the proportion of imports into the US affected by tariffs is at a level not experienced since World War II.

Source: @SoberLook

Trump has threatened to impose tariffs the remaining $267 billion of Chinese imports should China continue its practice of stealing American intellectual property.

Tariffs act as taxes on the purchaser (not the seller, as Trump continually misstates), so US corporate and individual consumers are paying taxes, or higher prices from alternative suppliers, on the purchase of the $300 billion of goods that they weren’t paying only months ago. The reduction in tax rates have been the main driver of US corporate earnings and higher US equity share prices this year, however taxes as a category are shaping up to be a headwind for US corporates and individuals in 2019. Adding to 2019 concerns, the US’s trading partners have retaliated by applying tariffs on approximately $135 billion of US exports, $113 billion of which are US exports to China.

On a more positive note, the Trump administration backed off its threats against the European Union (EU), and agreed to restart negotiations to lower tariffs between the two trading blocks. The US and EU had been working to lowering tariffs as part of the proposed Transatlantic Trade and Investment Partnership (TTIP), but that trade deal, along with the Trans Pacific Partnership (TPP), were immediately scrapped by Trump when he took office in early 2017.

Another positive development during the quarter was the minor update to the North Atlantic Free Trade Agreement (NAFTA) — as opposed to its dissolution that Trump had threatened. The updated trade pact, now creatively renamed USMCA (acronym for US, Mexico, Canada), includes much needed provisions on intellectual property and digital trade that had been in the TPP, requirements for more local content and higher worker wages in the auto sector that will change little for North American production and supply chains, and a modest increase in US access to the Canadian dairy market ($70 million over levels provided by the TPP). Perhaps the most impactful change in the USMCA is a “poison pill” provision that removes favored trade status from members that negotiate a trade deal with a “nonmarket” economy — such as China. We anticipate that the trading relationship between the US and China will continue to deteriorate in the near term.

Brexit negotiations between the United Kingdom (UK) and the EU entered its third year with little visibility on what will happen when the UK is scheduled to leave on 29 March 2019. The proposed terms pushed by UK Prime Minister Theresa May, the so-called Chequers plan, was unanimously rejected by EU leaders, as well as by many members of May’s own political party, the Conservatives. Meanwhile, companies and government agencies on both sides of the Channel are preparing for a potentially harmful “no-deal” scenario.

 

PERFORMANCE DISCUSSION

Trump Tweet re stock market.png

Casual American followers of the markets should be forgiven for believing that 2018 has been a great year for investors. Jobs are plentiful and home values are up. Apple and Amazon became the first companies to break the $1 trillion market capitalization threshold. And Trump triumphantly reminds us every time the Dow Jones or S&P 500 reaches a new high.

However, the strong performance about which those casual followers hear and read emanates from a rather narrow set of asset classes. In contrast, a large majority of global assets have experienced a rather lackluster year. Responsibly diversified investment portfolios have struggled as a result, including AlphaGlider’s five strategies.

Let’s look at AlphaGlider’s down-the-middle (in terms of risk-reward) investment strategy, AG-B (Balanced), which has a benchmark of 60% global equities and 40% US fixed income. This benchmark is up only 1.6% year-to-date. Digging in a little deeper, and we find a rather barbell distribution of asset class/sector returns within this aggregate 1.6% number — one end of the market doing extremely well, the other end not doing so well, and not much in between.

 Source: AlphaGlider, Vanguard, Orion Advisor Services

Source: AlphaGlider, Vanguard, Orion Advisor Services

Only three US industrial sector equities returned significantly more than the benchmark’s 1.6%: technology (+23.6%), health care (+17.8%), and consumer discretionary (+16.4%). It just happens that these three sectors, which make up only 18.1% of AG-B’s benchmark, are the aggressive and “sexy” parts of the market that the financial press likes to cover — think Apple and Microsoft, Pfizer and Merck, Amazon and Nike.

The remainder of the US equity market — financials, industrials, consumer staples, energy, utilities, real estate, materials, and telecom — barely treaded water this year (+1.3%). And yet these US “laggards” still did better than developed market equities (-1.4%), emerging market equities (-7.7%), and US fixed income (-1.6%).

So let’s move the discussion from our benchmarks to our five investing strategies. Their performance landed relatively closely to their benchmarks in the third quarter, with slight relative outperformance in our more conservative strategies and slight relative underperformance in our more aggressive strategies. The relative performance of AlphaGlider strategies was similar for the year-to-date period.

For the third quarter, our strategies benefited from their short fixed income duration. In general, bonds of all durations suffer as interest rates across the yield curve rise, as happened in the quarter, but shorter duration bonds suffer less relative to bonds of longer duration.

Although our strategies were held back by their underweighting of US equities, many of the US equity funds they did own outperformed the S&P 500’s 7.7% increase, notably Fidelity MSCI Health Care (FHLC; +13.6%),2 Fidelity MSCI Telecommunication Services (FCOM; +11.7%), Fidelity MSCI Information Technology (FTEC; +9.3%), and Vanguard Dividend Appreciation (VIG; +8.9%). Our strategies also benefited from its market neutral fund, Vanguard Market Neutral (VMNFX; +2.3%),3 which we view as an alternative to holding cash or other short duration fixed income securities.

The principal drag on strategies during the third quarter was our overweight position in emerging market equities. Our fund in this area, SPDR Portfolio Emerging Markets (SPEM), was down 1.4%. The strategies’ small overweight position in developed international markets also dented performance. Our Singapore fund, iShares MSCI Singapore (EWS), and our diversified developed market fund, SPDR Portfolio Developed World ex-US (SPDW), were both up only 1.2%.

The list of key benefactors and detractors to AlphaGlider strategies for the year-to-date period was similar to that for the third quarter. On the positive side, FTEC was up 21.4% and FHLC was up 18.2%. And while the fixed income portion of our benchmarks was down 1.6% for the year, our large relative positions in shorter duration bond funds held up well, with VMNFX up 3.2%, iShares 0-5 Year TIPS (STIP) up 0.9%, SPDR Portfolio Short Term Corporate Bond (SPSB) up 0.7%, and SPDR Portfolio Short Term Treasury (SPTS) down only 0.2%.

On the negative side for the year-to-date period, SPEM was down 7.9%, EWS down 4.5%, and SPDW down 1.3%. The strategies’ relative overweighting of defensive US equities also dragged on performance, with Vanguard Consumer Staples (VDC) down 2.8% and SPDR Portfolio S&P 500 Value (SPYV) up only 3.4%.

 

OUTLOOK & STRATEGY POSITIONING

Not a lot has changed in our view of the markets over the year, so I won’t go into too much detail about our strategies’ most significant deviations from their benchmarks. We continue to find US company valuations to be pricing in sustained optimistic outcomes, particularly as it relates to profit margins. Our view places much higher probabilities than the market to lower corporate net profit and cash flow margins going forward as 1) rising interest rates increase borrowing expenses, 2) rising oil prices increase input and transportation expenses, 3) the rising US dollar increases costs relative to revenues for exporters, 4) tariffs increase input costs and reduce revenue, 5) tight labor markets increase labor expenses, 6) much needed and overdue increases in capital expenditures increase depreciation expenses, and 7) unsustainably large federal government deficits require corporate tax collections to eventually rise, all as a percentage of revenue. And a decade into the economic cycle, we are concerned about the next recession and its negative gearing effects (lower operating margins caused by revenue falling faster than expenses). On the fixed income side, we continue to run on the short end of the duration scale as we expect the Fed to continue to raise rates in an environment of full unemployment and aggressive government stimulus in the form of lower corporate tax rates, deregulation, and higher government spending.

During the third quarter we moved much of our cash allocations from still low yielding money market funds into a much higher yielding ultra short-term Treasury bill fund, SPDR Bloomberg Barclays 1-3 Month T-Bill (BIL). Thanks to sustained Fed interest rate increases, BIL is now yielding around 2%, whereas TD Ameritrade Institutional’s money market funds (and most checking and savings accounts), are still paying out little. BIL’s yield adjusts in near lockstep with Fed rate changes, so our strategies will benefit if the Fed executes on its projections of another quarter point rate increase before year end, and another three increases during 2019.

MSCI and Standards & Poor’s (S&P) threw us a curve ball during the third quarter by changing up some of its classifications within its jointly run Global Industry Classification Standard (GICS). Most domestic sector funds are based on GICS classifications, including all of the Fidelity sector funds that we use in our strategies. The biggest impact from the GICS changes will be to our recently purchased telecommunications fund, FCOM. The Telecommunication Services sector, which is the basis of FCOM, was morphed into the Communication Services sector. As the graphic below demonstrates, this newly created Communication Services sector includes all of the old Telecommunication Services sector, and picked up some major components of the old Information Technology and Consumer Discretionary sectors — including some large companies, such as Amazon, eBay, Alphabet (Google), Facebook, Electronic Arts, Comcast, Disney, and Netflix. The old Telecommunications sector had been the smallest of the 11 GICS classifications, making up less than 2% of the S&P 500. The new Communication Services sector is the fourth largest GICS classification, representing over 10% of the S&P 500.

Source: Fidelity

The change in GICS categorizations changes went into effect late September, but Fidelity will not update its sector funds, including FCOM, until late November. At this point we are undecided on what we will do with our FCOM position as it will soon transform into something that we did not necessarily desire — an aggressive and richly valued, but fast growing, fund of companies.

Following up on my sporadic “must read” recommendations (in my 1Q18 CIO Commentary I recommended Bill Browder’s Red Notice as a great primer on understanding Vladimir Putin and the current state of his control over Russia), I think that Tim Ferriss’ podcast interview of Oaktree Capital Management’s co-founder and co-chairman, Howard Marks, CFA, is a good listen. Marks is an experienced and highly successful value investor with a knack for succinct and thoughtful explanations of his investment strategy, and this interview is classic-Marks. I found myself affirmatively nodding my head repeatedly throughout it. So load it up on your phone and enjoy it on your commute, your next long drive, or over your next couple of workouts. Hopefully it will give you better insight into how I think about investing and the psychology of the markets, but have been unable to clearly relate to you, my clients and readers.


NOTES & DISCLOSURES

1This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete, and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
2Mutual funds, exchange-traded funds and exchange-traded notes are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
3Alternative investments, including hedge funds, commodities and managed futures involve a high degree of risk, often engage in leveraging and other speculative investments practices that may increase risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are subject to the same regulatory requirements as mutual funds, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. The performance of alternative investments including hedge funds and managed futures can be volatile. Often, hedge funds or managed futures account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, including hedge funds and managed futures and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products including hedge funds and managed futures often execute a substantial portion of their trades on non-US exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in the US markets. Additionally, alternative investments including hedge funds and managed futures often entail commodity trading which can involve substantial risk of loss.
4Rebalancing can entail transaction costs and tax consequences that should be considered when determining a rebalancing strategy.
^Indices are unmanaged and investors cannot invest directly in an index. The performance of indices do not account for any fees, commissions or other expenses that would be incurred.
aThe Standard & Poor's 500 (S&P 500) Index is a free float-adjusted market capitalization weighted index that is designed to measure large cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization in the US equity markets.
bMSCI Europe, Australasia and Far East (EAFE) Index is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of developed market equities outside of the US.
cMSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization weighted index that is designed to measure large and mid-cap equity market performance in the global Emerging Markets.
dMSCI All-Country World (ACWI) Investable Market Index (IMI) is a free float-adjusted market capitalization weighted index that is designed to measure the investable universe of global equity markets.
eThe Bloomberg Barclays US Aggregate Bond Index is a market capitalization weighted index that is designed to track most investment grade bonds traded in the United States. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds and a small amount of foreign bonds traded in the United States. Municipal bonds and Treasury Inflation-Protected Securities (TIPS) are excluded due to tax treatment issues.

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