During the first quarter of 2019 stock markets around the world rebounded swiftly from their December 2018 lows. The United States’ stock market produced a total return of 14.04%; developed international stock markets 9.98%; and emerging markets’ stocks 9.91%. The high yield bond market in the United States returned 6.89%. Commodities returned 6.32%. Even investment grade bonds in the United States had a strong quarter, returning 2.94%.
Heritage rebalanced client portfolios in mid-January of 2019, selling alternatives and adding to stocks and bonds. Few individuals want to buy into stocks after a correction; likewise, it’s difficult to buy bonds when interest rates are trending higher; but doing what’s behaviorally difficult is often the right thing to do. Our investment actions in early 2019 helped clients participate in this recent rebound.
Although the first quarter of 2019 was strong, a few of the themes expressed in our portfolios have continued to be short-term headwinds. Value-priced stocks and small cap companies’ stocks underperformed the market as a whole. After the Fed’s pause on rate hikes, longer-term bonds rallied more than short-term term bonds. And an allocation to alternative investments will lag during periods when traditional asset classes produce strong returns.
Looking forward to the remainder of the year, we’re cautiously optimistic that the landscape for near-term returns is healthy with a smoothly functioning economy. It’s worth noting, however, that a few risks have built up in various parts of the market and early warning signs have begun to blink yellow.
Asset Class Returns
First Quarter 2019
Any quarter with these levels of returns is one investors don’t want to miss. Remaining invested through the first quarter of 2019 was rewarding.
Fourth Quarter 2018 & First Quarter 2019
While the first quarter’s returns look great, one must remember they represent the second half of a “V” that started in the Fall of 2018. Extending the range of measurement to include the fourth quarter of 2018, one may see that the first quarter is merely a recovery from a difficult end to the prior year.
Source: Morningstar, Inc.
As we reached the end of December 2018 and beginning of January 2019 there were two prominent camps. The first thought the onset of a major sell-off had begun and that the economy was heading towards recession. The second thought lower prices represented a buying opportunity while most signs pointed to continued growth in profits.
We sided with the latter camp and—despite the fear that had gripped some market participants—rebalanced portfolios, buying stocks and bonds. In retrospect, it was the correct action to take. This once again shows the importance of discipline. Having a strong hand in volatile markets that continues to hold its positions and even buys more during drawdowns usually leads to better results.
Intra-Asset Class Themes
Value vs. Growth
Growth-priced stocks outperformed value-priced stocks in the first quarter of 2019. A significant part of the recent growth premium has been the success and climbing valuations of the so-called FAANG stocks—Facebook, Amazon, Apple, Netflix, and Google. This in turn helped lead U.S. stock market outperformance relative to international markets.
Source: Wall Street Journal, March 20, 2019
Stock prices reflect businesses’ current earnings and expected growth. Stocks whose prices are largely based on current earnings are termed “value” and those based on optimistic views of future earnings are termed “growth.” Growth-priced stocks have outperformed value-priced stocks as companies like the FAANGs have led the bull market. However, when similar situations have played out in the past, the high-flyers of the day have been disrupted and their optimistic prices have come back down.
After the recent multi-year period of the Fed raising short-term interest rates and thereby arduously, inch by inch, pushing up long-term interest rates, the breaking point was finally reached in 2019. As the Fed paused it contractionary policy and rates fell, long-term bonds outperformed short-term bonds and medium- to long-term interest rates receded to 2017 levels.
Source: Morningstar, Inc.
Cautious Optimism & Risks
Economic Stability & No Obvious Imbalances
From a high level, there’s good reason to be optimistic. The economic backdrop for the remainder of 2019 should provide the right environment for strong revenue growth and business profits.
When there are imbalances, we believe the potential for disturbances that come with higher required rates of return (lower prices) is elevated. From a macroeconomic standpoint, many aggregate measures seem rationally balanced.
Inflation is hovering around 2%, the Fed’s target for stabilized rising prices. At that level, the 10-year treasury yield provides approximately 0.50% as a real return, which is empirically the observed rate required for deferring consumption.
U.S. Stock prices relative to corporate earnings seem reasonable. Their trailing earnings yield is approximately 5%. Add growth in earnings expected in the 2% to 3% range for an estimated total return of 7% to 8% without multiple expansion or compression. Relative to the 10-year treasury yield, the implied equity risk premium would be between 4.50% and 5.50% (also in line with most equilibrium estimates).
The banking sector is well capitalized and well monitored. Unemployment is arguably at or slightly below its natural rate. And per capital real wages have been rising, which results in more discretionary income, demand for goods and services, and production.
Risks & Early Warning Signs
Yield Curve Inversion
In its March meeting the Fed revised its 2019 interest rate projection from two increases of 0.25% to no further expected increases. Shortly thereafter the three-month to ten-year portion of the yield curve inverted (the short-term rate exceeded the long-term rate).
Yield curve inversions mean the bond market expects short-term interest rates in the future to be lower than short-term interest rates at the present time. Although in itself this statement seems rather harmless, expectations of lower rates means the bond market is pricing in many of the factors that typically come with a recession.
BBB Proportion of Investment Grade Bond Market
BBB-rated bonds have historically made up a minority of the investment grade bond market. At the present time, over 50% is rated BBB.
Source: FPA New Income First Quarter 2019 Report
By standard leverage and coverage metrics, a meaningful portion of the BBB market could be downgraded. The U.S. corporate high yield market is $1.2 trillion, while the BBB market sitting atop it is over $3 trillion. Should a downgrade of BBBs flood the high yield market, there would be considerable widening in credit spreads, which would hurt companies in rolling over their financing. Heritage has allocated away from corporate high yield and focused on the higher quality segments (AAA and AA) of the investment grade bond market.
The first quarter of 2019 saw a rapid recovery from the sell-off in the fourth quarter of 2018. It’s another in a long series of reminders that remaining disciplined and rebalancing is the method of the savvy, successful, long-term investor.
While we’re long-term oriented and disciplined investors, we monitor markets actively. We believe value investing remains the right approach within stocks and that the United States’ relative outperformance since the Financial Crisis represents a value investing opportunity in international stock markets.
The major aggregate measures of the U.S. economy appear positive and in balance with each other. GDP growth, inflation, real rates, unemployment and risk asset prices appear rational. A well-functioning economy produces the right conditions for consistent debt servicing and strong business profits.
Yet, a few yellow lights have started to blink in the bond market. An inversion in the 3-month to 10-year segment of the yield curve in late March and the gradual buildup in the lowest-rated portion of the investment grade bond market are negative signals. We are acting with caution in our bond allocations, largely avoiding high yield U.S. corporate bonds and the lower-rated issues within the investment grade bond market.
Monitoring these development while remaining appropriately invested for the long-term is a delicate balance. We pay careful attention to the scenarios that may play out and how to be positioned well to weather them.
We appreciate your continued business and look forward to guiding you through an investment environment that is becoming increasingly complicated.