The second quarter of 2019 was a roller coaster for investors — lots of ups and downs, some screaming, but mostly smiles when it ended. The US equity market, as reflected by the S&P 500 Index,^a was up a little over 4%, while foreign developed equity markets increased by just under 4% (MSCI EAFEb). Fixed income also participated in the fun, with the broad-based Bloomberg Barclays US Aggregate Bond Indexe up just over 3%. But the asset that caused the most screams (not the good kind) during the quarter was emerging market equities. MSCI Emerging Markets Indexc plunged nearly 10% at one point during the quarter, but finished just in the black, +0.6%.
One of the major contributors to the second quarter’s market gyrations was President Donald Trump’s capricious actions against China and Mexico, the two largest exporters to the US. Frustrated with the progress of trade negotiations with China, Trump raised the tariff on $200 billion worth of Chinese imports from 10% to 25% on May 10 (Trump raised them from 0% to 10% back in September). China retaliated by applying its own 25% tariff on $60 billion worth of US imports. Then on May 15, Trump issued an executive order that effectively banned China-based Huawei, the world’s #1 telecom supplier and #2 phone manufacturer, from selling to, buying from, or working with, companies and organizations that operate in the US. In late May, Trump threatened to raise tariffs on all Mexican goods imports ($346.5 billion last year) by five percentage points a month, up to a maximum 25%, if Mexico failed to slow the flow of illegal immigration into the US.
Trade tensions began to ebb on June 7 with news that Mexico gave in to Trump’s border demands, but promptly ramped back up three days later when Trump threatened to apply 25% or greater tariffs on the remaining $300 billion in Chinese imports still untaxed if Chinese President Xi Jinping didn’t meet with him at the G20 Osaka Summit in late June. However, the trade picture ended on a more positive note with Trump and Xi meeting in Osaka. They agreed to stop escalating the trade war — Trump delayed banning US companies from selling to Huawei, Xi “hoped” China would purchase more American goods, and both agreed to send their trade teams back to the negotiating table.
While US trading relationships with China and Mexico dominated business headlines in the second quarter, there were growing signs that other major US trading relationships will worsen during the second half of the year. In April, the US proposed tariffs on $21 billion in imports from the European Union (EU) in retaliation for illegal the EU subsidies to Airbus. But of more significance was Trump’s declaration in May that auto and auto parts imports pose a national security threat to the US. Trump gave Japan and the EU six months to rectify the situation, with the threat of up to 25% tariffs against these imports. Trump also indicated that he may address the “national security threat” by reopening negotiations to the recently completed US-Korea Free Trade Agreement and USMCA (i.e. NAFTA 2.0).
There was one area of US trade which improved during the quarter — the removal of US tariffs on imported Canadian and Mexican steel and aluminum in an effort to garner support for the USMCA in Congress as well as in Ottawa and Mexico City. With the steel and aluminum tariffs and the threatened five percentage points per month tariffs off the table, the Mexican Senate ratified the USMCA in mid-June. Canada and the US have yet to ratify the agreement.
As Trump’s trade rhetoric weighed on the business confidence and investor sentiment, Federal Reserve (Fed) Chair Jerome Powell and his board colleagues stepped in to calm everyone by reiterating that the Fed would serve as a backstop to any US slowdown, regardless of cause. As the chart below shows, Fed board members lowered their median guidance for benchmark Fed Funds rates exiting 2020 from 3.38% back in September 2018, to 2.13% last month (see red box). For reference, the Fed Funds rate currently stands at a range of 2.25-2.50%. Investors are even more pessimistic about the US economy’s outlook than the Fed, pricing in a late 2020 Fed Funds rate of 1.32% (see red circle). Investors expect the Fed to make its first 25 basis point cut at the next Fed meeting late this month.
Bad news for the economy is usually (non-government bonds can decline in a falling rate environment if their default risk increases sufficiently) good news for the bond market, as slowdowns usually cause yields to decline (bond prices move inversely to yields) — this was the case in Q2. Bad news for the economy can also be good for the stock market, if the benefits of lower yields (e.g. lower borrowing costs) are considered to be greater than the bad news that triggered them — as was also the case in Q2.
While investors and the Fed may be negative on the US economy, recent data points have held solid. Real (inflation-adjusted) Q1 GDP growth came in at 3.1%, and Q2 looks to be tracking near 2%. The employment picture continues to be solid, with the unemployment rate ending the quarter at a low 3.7% and wage growth at a respectable 3.1%. The current economic expansion became the longest in recorded history in June at 121 months, although it has been relatively lackluster in its absolute growth. From the approximate peak of the last expansion 12 years ago, US GDP expanded approximately 48% in nominal (after inflation) terms. The challenge for US equity market investors at this stage is valuation — the value of the US market has nearly doubled over in this time.
Economic conditions overseas are less rosy (but valuations are much more reasonable). Chinese production growth has gone slightly negative under the weight of Trump’s tariffs, but tax cuts and other economic stimulus have buoyed the overall economy. Growth in Europe appears to be rolling over as German manufacturing has been in contraction since the beginning of the year and Brexit causes more uncertainty. European Central Bank (ECB) President Mario Draghi indicated that he may finish his tenure with a rate cut despite its current -0.4% level (yes, it’s less than zero). The current head of the International Monetary Fund (IMF), Christine Lagarde, was nominated to succeed Draghi on October 31st. Lagarde is expected to continue Draghi’s aggressive approach to stimulus while also pressuring European governments to enact politically unpopular pro-growth economic policies.
Coincidently, October 31st is also the new deadline for Brexit. Theresa May, the United Kingdom (UK) Prime Minister, was unable to garner Parliamentary support for the “soft” Brexit plan she had negotiated with the EU, and thus the need for a third extension. After failing to execute a Brexit, May tendered her resignation in late May. A vocal proponent of a “hard” Brexit, Boris Johnson appears set to take over from May in late July. The risk of the UK falling out of the EU without a deal meaningfully increased with these developments.
The most concerning geopolitical development during the second quarter was the rapidly escalating conflict between Iran and the US. Although Trump pulled the US out of the Iran nuclear deal in May 2018, it wasn’t until this April that the US fully enforced sanctions on Iranian oil exports. With a currency that has depreciated 70% over the last 18 months and the loss of about two million barrels (about the volume of a typical oil supertanker) per day in exports caused by US sanctions, Iranian leadership has its back up against the wall. But instead of standing down, it came out swinging. Iranian forces and its proxies appear to have damaged six oil tankers with limpet mines just outside of the Strait of Hormuz, fired on a Saudi oil pipeline with drones, and downed a large US drone which they claimed was flying over their airspace. Iran also declared that it breached the 3.67% uranium purity limit allowed by the deal. Prior to the deal, Iran had achieved 20% purity, and was estimated to be about a year out from achieving the 90% purity required for a nuclear weapon. Iran also declared that it would violate additional, but unspecified, deal limits every 60 days if the US does not lift its oil sanctions. To date, the US and its allies in the region have not retaliated.
The price of oil has been relatively stable during this period of rising Iran-US tensions. The upward pressure on oil prices caused by the removal of Iran oil from the global market, and by rising fears of a full blown military conflict affecting oil shipments coming out of the Persian Gulf, has been neutralized by the continued rise in US shale oil production as well as demand weakness caused by US-initiated trade wars. As expected, OPEC and Russia agreed to extend current oil production caps into the first quarter of 2020 to support prices.
AlphaGlider’s defensive posture held back its strategies during another strong quarter for bonds and equities. AlphaGlider strategies captured between 70% and 90% of their benchmarks’ gains during the second quarter.
One of the leading causes of our relative under-performance came from our overweight positioning in emerging market equities. The MSCI Emerging Markets Index was up only 0.6%, well below the MSCI All Country World IMI Index’s +3.4%. Emerging markets trade on approximately 12x forward earnings whereas US equities, which we are underweight, trade on approximately 18x forward earnings.
The other leading driver of our relative underperformance was the shorter duration of our fixed income investments (shorter duration equates to less interest-rate sensitivity). Interest rates fell in most geographies during the quarter as global growth expectations fell. Our strategies’ average effective durations are approximately 3.5 years whereas our benchmarks’ are approximately 5.5 years.
Our worst performer in Q1, the Vanguard Market Neutral Fund (VMNFX), was also our worst in Q2 despite owning it for only six weeks. Unfortunately one of the securities we transitioned into, the Fidelity MSCI Energy Index Fund (FENY), declined a further 0.9% during the quarter (but less than the 3.4% that VMNFX went on to lose in Q2 after we sold it). More about our position in US energy companies in the next section.
A winner across all of our strategies during the quarter was the iShares MSCI Singapore Fund (EWS) — it was up 6% during the quarter, including two percentage points from its healthy dividend.
OUTLOOK & STRATEGY POSITIONING
We made some changes around the edges of our AlphaGlider Strategies during the second quarter. Most significantly, we liquidated the five percentage point Vanguard Market Neutral Fund (VMNFX) position held in each strategy. VMNFX is a quantitatively run mutual fund which takes equally-sized long and short positions in each industry sector of the US stock market in an effort to isolate, and profit from, both undervalued and overvalued companies without taking on any net exposure to any one sector or to the market as a whole. We entered the position four and a half years ago in an attempt to eke out a return above cash’s nearly non-existent yield at the time, while not taking on duration risk. The fund served us well in the first years that we owned it, but over the last year it consistently underperformed, in both up and down markets. The fund managers’ process appeared to be broken and with short-term interest rates back to reasonable levels (>2%), our original reasons for owning the fund were no longer valid.
We redeployed the bulk of the VMNFX proceeds into new two securities, the Vanguard Global ex-US Real Estate Fund (VNQI) and the Fidelity MSCI Energy Index Fund (FENY). VNQI invests in commercial real estate investment trusts (REITs) and real estate operating companies (ROECs) located in foreign developed and emerging markets. It sports a 4.3% dividend yield, and trades at only 12.1x forward earnings and 0.9x book value. For comparison, Vanguard’s equivalent US real estate fund (VNQ) has a decent 3.5% dividend, but expensive 38.2x forward earnings and 2.5x book ratios. After a prolonged period of US dollar strength, and the prospect of dollar weakness triggered by Fed Funds rate cuts, we like the exposure to foreign currencies that VNQI provides.
Our new position in FENY, which invests in US energy companies, is more tactical in nature and is meant to provide downside protection in the event of war breaking out between Iran and the US. While severely outgunned by the US military, Iran’s forces have been built with a goal to shut down its Sunni-ruled enemies’ oil exports. With approximately 30% of the world’s seaborne oil coming out of the Persian Gulf (~18m bbl/day), Shiite-ruled Iran has the ability to severely reduce global oil supplies if it so chooses. Given the current price of oil (WTI: $58/bbl), and its movements over the last year (down ~20)%, we believe the market is underestimating the probability and/or magnitude of an oil supply shock should Iran and the US go to war.
Commercial Ship Traffice in the Strait of Hormuz — July 10, 2019
We believe Trump and his advisors are naive in believing that they sanctions will force Tehran to agree to more restrictive conditions on its nuclear and missile programs than those specified by the 2015 nuclear deal Iran struck with China, France, Russia, UK, Germany and the US. While we don’t rule out this possibility, we think the more likely outcome is greater nationalism and anti-western sentiment among its population, and in its political and religious leaders. There would be great economic hardship, but the Iranian population would blame this on the US, not their own leaders. Tehran is incentivized to race to nuclear power status instead of negotiating with a foe which just reneged on the previous nuclear agreement. Trump’s coddling of Kim Jong-un has only hammered home the point to Tehran that they will be in a much better negotiating position with nuclear weapons in hand than without.
Besides the downside protection FENY provides our portfolios should US-Iran relations deteriorate, we believe FENY also provides upside potential should the US-China trading relationship improve. In such a scenario, investors would likely upgrade their projections of global growth, and in turn, their projections of energy usage. The key downside risk to the position is if a China-US trade war escalates and triggers a global recession, torpedoing energy demand.
Switching gears, I am pleased to announce that AlphaGlider launched five ESG investment strategies during the second quarter. ESG is an acronym for "environmental, social, governance," and it describes a form of investing which incorporates these factors into security selection. It effectively screens out, or lowers the weighting of, companies that score poorly in these factors. So no FENY in the ESG Strategies!
Two years ago, AlphaGlider became a 1% for the Planet company out of our concern over the many negative impacts of climate change. At the time we also wanted to offer an investment solution that would allow like-minded clients make a positive ESG impact while also generating good long-term returns, but the building blocks were not sufficiently mature. There were were some ESG funds available back then, but they were generally expensive, illiquid, and absent from some of the investment asset categories we needed. Today it’s a different story. We now have access to relatively liquid, low-cost, indexed ESG exchange-traded funds (ETFs) that cover nearly all of the stock and bond categories we own in our original “Core” strategies. And as of last month, most of these ETFs began to be traded commission-free at our custodian, TD Ameritrade Institutional (TDAI). We can now build complete, diversified ESG portfolios at a reasonable cost — at a fund management fee premium to our Core Strategies of less than 10 basis points (0.1%). ETF investing was moving into the mainstream when we launched AlphaGlider in 2013, and now ESG investing is moving into the mainstream! You can check out our ESG strategies on the new ESG section of alphaglider.com.
If you think you may be interested in an ESG investment strategy, please set up a time on my calendar so that we can discuss the various options and implications of such a change to your AlphaGlider investments.