1st Quarter, 2019
Our take from the FED PIVOT: “Save the last dance for me.”
THE MARKETS
The first three months of 2019 produced the best quarterly equity market returns since 1998 with a return of 13.7% on the S&P 500. This was a sharp reversal from the fourth quarter of 2018 when the major stock indices cascaded down some 19% off the high, hovering just one percent above the conventional definition of a bear market. Volatility continues in force driven by both rapid changes in sentiment and unexpected monetary policy changes by the Federal Reserve (Fed).
Global economic momentum began to show signs of weakening in the third quarter of 2018 producing a series of downward GDP revisions from the International Monetary Fund (IMF) and the World Bank. The fourth quarter was also roiled by the US-China trade tussles, on-again off-again UK-European Union (EU) exit skirmishes and Italy waving a socialist banner that was blatantly anti-EU. In Asia, the China transition story showed signs of wobbling and emerging market equities retreated in the face of a stronger dollar and declining exports. Overall, the news was good grist for feeding a spread of declining economic sentiment. This in turn took global markets lower, leaving the USA as the remaining growth story, but not without some caveats that had already moved market valuations down from the highs recorded earlier in 2018. Thus, both equity and bond markets were adjusting to the reality of the return of positive real interest rates and the likelihood of a classic economic recession following late cycle turbulence in 2020.
The markets continued to fixate on rising rates and recession while ignoring concerns about inflation and a looming 5% GDP fiscal deficit despite 2.25% GDP growth in 2019. As we said in our previous letter, one could argue with strong evidence that the economic glass was either half-full or half-empty. Then, in March 2019, the Fed pivoted, refilled the punch bowl, and said “Save the last dance for me.”
At this writing, however, we find ourselves in a market where real interest rates have retreated from the threshold of positive returns and risk assets are once again in the ascendancy. We must bear in mind that despite the Fed’s less restrictive approach, we still face reduced growth expectations, and late cycle vibrations will continue to influence sector rotation, with the markets remaining vulnerable to any major policy shock such as a collapse in the US-China trade negotiations. As long as current monetary policy conditions persist, markets may move higher, however moves will more likely respond to positive sector activity and individual stock earnings performance. The downside to the punch bowl refill is that cheap money will increase market risk and create vulnerability if or when policy changes direction again and resumes positive real rate restoration.
THE ECONOMY
The present economic cycle continues to extend its record as the longest post-WWII period of sustained growth. Domestic GDP is likely to achieve 2.25% to 2.50% growth in 2019, a decline from the 2018 level of about 3.0%. Results in 2018 reflected the impetus from major reductions in corporate tax rates, a factor that will not be repeated this year.
Reflecting strong economic growth and tax cuts, corporate earnings surged 16% in 2018. With growth slowing in 2019 and the impetus of tax cuts waning, profit margins are likely to come under pressure producing profit growth of only 6-8%. Dividend growth rates will also decline since profitability is a major determinant of dividend payout ratios.
Profit growth will continue to rotate through several major sectors due to changes in Fed policy, declining mortgage rates, real wage gains and resurgent energy production. The Fed’s recent decision to curtail further rate hikes in 2019 moves the prospects for a recession out to at least mid-year 2020, if not beyond the 2020 national elections.
European growth is receding back to post-2016 trends of 1.5%, a level that is not supportive of import growth. The political turmoil surrounding Brexit is beginning to exact a toll on both sentiment and inter-European trade forecasts, thus challenging expectations of a green shoot recovery later in the year. European stock underperformance in the last year mirrors the sluggish business conditions.
Chinese dominance of Southeast Asia trade reflects the challenges of successfully repositioning an affluent middle class in an economy where debt to GDP continues to skyrocket and credit bubbles persist. Emerging Markets continue to struggle with servicing dollar denominated debt from domestically denominated earnings.
The U.S. growth outlook could strengthen if the Fed’s more accommodative stance enhances housing affordability by bringing mortgage rates back down to the 4% level coupled with continuing strong growth in the job market. Energy exports are becoming significantly more important as the shale oil recovery continues. A cheaper dollar resulting from the recent decline in interest rates would also stimulate broad export growth further extending our business cycle.
The Fed’s policy pivot to forgo rate hikes is not without risk. If the Fed’s policy is to deliberately stay behind the inflation curve until a rate of 2% is exceeded, any sudden move to play catch-up with an unexpected inflation surge would likely choke off the cycle and present the economy and the markets with the realities of recession.
INVESTMENT STRATEGY
Our long-term strategy of seeking to achieve real returns in excess of inflation remains in place. The sudden halt of the Fed’s normalization policy has made fixed income returns less attractive as they have retreated to only the threshold of real returns. Stock returns have moved ahead, owing largely to sentiment shifting in favor of risk assets. While this may boost total returns in the near term, a longer-term view suggests that the postponed realities of recession may deal more harshly with valuations once the specter of recession becomes undeniable.
To counter this expectation and with it a likely increase in market volatility as the economic high tides ebb, we maintain our focus on low-beta stocks with strong forward cash flow prospects and continued real rates of dividend growth. In addition, we choose to avoid companies that continue to seek out major merger and acquisition targets to compensate for lack of organic growth. Experience suggests that large late cycle acquisitions or mergers have difficulty meeting their financial objectives during recession.
We remain wary of excessive share buybacks where companies have incurred significant goodwill on their balance sheets, as the risk of impairment and write-offs rises with the onset of recession. While some of the recent buybacks have been funded by reduced corporate taxes, others have been financed by increased borrowings. Increased leverage late in an economic cycle is cause for concern and keeps us focused on the balance sheets of our portfolio companies.
Although the U.S. economy continues to grow, without the added thrust of the 2017 corporate tax reform, a 2.25%-2.5% GDP rate will not contain a projected fiscal deficit of nearly 5%. Further, while the fall in interest rates temporarily eases the servicing cost of the wider deficit, the inevitable normalization of real rates will take deficits and their servicing costs to new highs, raising the stress levels on the working population who must support the upward demographic curve of retirees. We disagree with the proponents of “Modern Monetary Theory” (MMT) that deficits do not matter and that a government with the ability to create its own currency can finance any program it deems socially beneficial without limit. Markets support debt expansion when it is consistent with an economy’s underlying growth. Markets become wary of monetary expansion when it becomes untethered from a sustainable growth trajectory. Whatever course events take in years ahead (including the national elections of 2020), it is difficult not to envision interest rates eventually moving above current levels.
At this juncture, we believe our clients should be willing to take capital gains as necessary to reduce exposure to risk assets and ensure that accounts are in line with long-term asset allocation targets. Even though 2-Year Treasury yields have declined from 2.875% several months ago to the present 2.33%, they are still much higher than two years ago and are on the threshold of a positive real return. Such a return, while modest, serves as a safe harbor for reserves that will be welcome and useful in the next spell of volatility.
As we enter the second quarter, equity markets continue to respond positively to the Fed’s new policy of patience. In the absence of any significant, unexpected economic events, we can expect the current business cycle to continue but at what level of strength and with what kind of sector rotation is uncertain. One must also ask whether there will be a sustained renewal of G7 (ex U.S.) growth that will benefit sectors of the U.S. economy that have been penalized by the slowdown and the resurgence of the dollar. Our best insight suggests that the dollar will trend lower against the Euro later this year and this will bring a much-needed lift to U.S. based exporters, particularly industrial equipment manufacturers and technology providers.
CYBER SECURITY AND SYSTEMIC RISK: THE PUBLIC NEEDS TO PARTICIPATE
As the depth and breadth of cyber malfeasance continues its exponential growth, in an environment of linear response, what then is the threat level of unintended consequences from offensive cyber-attacks? We probably do not have a verifiable answer to the question. However, we can make a basic assumption that the growth of offensive capabilities continues to increase the odds of a major cyber event conflicting with the interconnectivity of systemic risk. The unfolding of such a scenario would clearly defy most of the defensive cyber capabilities we can deploy today and cause economic damage not heretofore contemplated.
On a daily basis, we see serious escalation of the offensive cyber threat. We have developed national security capabilities for both an offensive and defensive cyber warfare with the Army Cyber command now exceeding 18,000 personnel. The FBI has embarked on a crash program to intensify cyber training for some 3,500 agents and so the beat of government response continues at a wartime pace. In the background, our intelligence agencies continue to sharpen the cutting edge of our cyber deterrents. However, what is lacking is a public embrace of the cyber threat, which needs to be accepted as a clear and present danger to our way of life. If we do not raise the level of public awareness and support for cyber protection, we may not enjoy the luxury of combatting issues like global warming! An enlightened citizenry is a resource we must deploy in this fight.
IIM has recently achieved two major milestones: we have passed our twelfth anniversary and our assets under management now exceed half a billion dollars. We could not have achieved these notable events without the loyalty and support of you, our clients. We have endeavored to always put your interests first, and we thank you for your continued confidence in our ability to serve you.