4th Quarter, 2019
The education of a cyber-literate citizenry is not negotiable.
THE MARKETS
During the last quarter of 2019, markets continued to react more to short-term changes in sentiment from geopolitical and global economic events rather than longer term fundamentals. The cumulative effects of some twelve years of global central bank quantitative easing and the unique influence of negative interest rates on major economies have created a series of market risks that pose uncertain outcomes.
Illustrative of this is the Fed’s early year reversal from a policy of tightening to one of accommodation. This action has been the major monetary lever that has pushed the equity markets to new highs and moved the likelihood of recession out to 2021. Refilling the punch bowl with very cheap money has accelerated the outflows from fixed income products into stocks in what is likely the late stage of the business cycle. In the present scenario, stock yields have fallen faster than expected dividend growth rates have increased, thus raising the risk of a collision if bond yields become more attractive.
In the equity markets, sector rotation played an important part in 4th quarter returns. Pharmaceuticals, which had long underperformed in the face of strong positive news, finally joined the bulls with many beating the overall averages. Biotech and diagnostic companies took the lead. Technology, which stumbled out of favor earlier in the year, largely influenced by tariff concerns, rebounded to end 2019 in a leadership position. Energy and materials remain under-performers, responding on the upside only to the search for yield and on the downside to resistance from climate change concerns. Consumer non-durables have responded positively to rising personal incomes. Financials have overall performed well as the economy is more favorable to fee-generated revenue than interest rate spreads.
Activity in the bond market reflects the mid-year spread of negative rate fever and the subsequent subsidence of this phenomenon, which still remains a concern in Europe and Japan. Significant redemptions from fixed income products have found their way into equities, pushing stock prices higher. Concerns about declining credit quality continue to populate the financial news with a particular focus on debt issued for private equity and leveraged buyouts. Very recently, we have noticed activity that is pushing the long end of the yield curve up. Hopefully this will continue and a discernible trend toward a normalized positive yield curve will develop.
THE ECONOMY
Domestic GDP growth during the 4th quarter appears to have regained some momentum, but it is unlikely to exceed 2.5%. This level of growth should be sufficient to keep corporate profits up and at the same time accommodate wage growth. If inflation remains subdued, the major factors supporting growth should continue to move the current business cycle into 2021 and perhaps beyond. However, with extended economic growth, there are attendant risks that will loom larger due to the extraordinary stimulus that has been deployed globally for nearly twelve years. The morphing of geopolitical and fiscal influences has created structural faults and it is this interconnectivity of risk that needs to be recognized by all participants, as uncertain outcomes put inflated asset classes at greater risk as the cycle plays out.
There are several economic and political factors in play, which if suddenly disrupted, could cause a serious risk-off scenario, leaving some asset classes in a liquidity vacuum and others in a sudden down draft. We would point to five major factors that should be acknowledged: the global value of the US dollar, inflation, Federal Reserve interest rate policy, fiscal policy and geopolitical crises.
At present, the geopolitical threat level continues to recede from the high point created by trade wars, Iranian attacks on Saudi Oil Fields and the full throttle of Brexit. Safe haven dollars are now being repatriated. A more promising economic outlook in Europe is beginning to emerge and with it a demand for Euros at the expense of the U.S. Dollar. A soft decline in the global value of the dollar would import some inflation but would also help U.S. exporters that have been penalized by an overvalued dollar. A continuation of this trend would add further strength and help push the growth cycle to 2021 and beyond.
Inflation has been more or less benign since the end of the Great Recession, thus the markets have not fully priced in the probability of any sudden spike or contagion scenario. Because of complacency rooted in the benign inflation of recent years, the greatest risk now would appear to be an inflation scare, which could trigger a sudden change by policy makers who have stated their preference to play catch-up rather than act preemptively. Should this turn of events materialize, the dollar would strengthen due to loose global funds chasing higher rates, causing disruption in the stock and bond markets as a quest for liquidity would prevail. Similarly, a market stress scenario might unfold if there is a left leaning election outcome that engenders fear of ever greater government on top of the present 5% GDP deficit.
Other areas of risk worthy of concern are global political disruption, whether it be self-inflicted tariff wars, hostile cyber activity, or unanticipated military intervention, which would create a flight to safety in dollars and gold. Overall, we expect growth to continue at a modest trend for the near future, however, we must remain vigilant in monitoring a growing list of potential market risks.
INVESTMENT STRATEGY
As we begin the new decade of the Twenties, we must briefly reflect on what the markets have returned during the last ten years that followed the Great Recession of 2008-2009. Overall, the performance of our domestic markets has been spectacular given the fact that we escaped the abyss of deflation and entered a period of benign inflation, delivering real returns, albeit with several market corrections along the way.
Much of the firepower has been delivered by near quantum enhancements in technology that have reshaped more traditional business models, guiding mainstream business into improved productivity and global competitiveness. In a majority of cases, disruption has created greater opportunities for value creation over time. In others, the failure of managements to react positively to disruption has seen corporate icons of the past become present day casualties. It is against this background that we constantly test our own ideas and conclusions in maintaining a viable investment process to seek out strategic themes and develop our methodology to capture the benefits of innovation and management skills for your portfolios.
At present, we face an investment environment where portfolio risk rests as much with fixed income as with stocks. given ultra-low yields and very tight credit spreads. We continue to favor low beta stocks in well diversified positions in order to better balance overall equity risk. This requires discipline in pruning out-performers from time to time. However, it also provides funds for adding new ideas opportunistically. We continue to maintain this policy as a means to protect the overall integrity of your portfolios.
At present, stock valuations in general are at the upper end of historic ranges driven in large part by investors’ quest for return in an environment where real returns in fixed income are marginal. Late cycle economic and market risks are in classic ascendancy, however, this cycle holds more global risk factors than previous ones.
We continue to favor both domestic and international technology and medical technology stocks, select consumer staples, diverse financials, global industrials, defense-related manufacturers and energy. Our fixed income investments are largely of short duration US government securities and high-grade corporates. When and if the yield curve begins to steepen we will adjust our strategy accordingly.
A PRIMER FOR CYBER SELF-EDUCATION
Individual Cyber illiteracy has become a serious national shortcoming across all segments of the population. As a nation, we are fortunate to have the protective cyber shield maintained by the Department of Defense through its agencies such as the NSA, Army Cyber Command as well as the cover provided by the Department of Homeland Security. This national effort is primarily focused on national security in an environment of persistent engagement where foreign state or privateer operatives constantly probe our cyber domains for nefarious purposes whether to attack critical national infrastructure, conduct disinformation campaigns and commit outright theft of money and technology.
Our government can take the lead in developing technology and cyber defense and offense responses but cannot extend its resources to encompass individual security. Total cyber protection requires the extensive support and cooperation of a cyber-literate citizenry working in various collaborative efforts primarily with our government to achieve mutual goals of national and personal security.
In a recent conversation with Dr. Henry Kissinger, he made the point that Americans must give up the idea that their historic reliance on isolation will protect them in the cyber world. The education of a cyber-literate citizenry is not negotiable.
There is room and a role for every one of us who is willing to begin the process of self-education. Please take your internet device and connect with the Department of Homeland Security and avail yourselves of the STOP. THINK. CONNECT. toolkit for different audiences. This is the best New Year’s resolution you can make in 2020. A cyber-armed citizenry is vital to the overall protection of our American way of life
As always, your comments and questions are welcome.
On January 7, we celebrate our 13th anniversary as your team at IIM. We began with $65 million and enter 2020 with well over $500 million. We could not have achieved this milestone without your loyalty and willingness to refer others to us.
Happy New Year!