PGAM First Quarter 2018 Investor Letter
April 9, 2018
After extending the 2017 rally through most of January, equity markets corrected through the end of the first quarter – the first meaningful correction in two years. Fears that an acceleration of inflation would cause the Federal Reserve to hike short-term rates more rapidly combined with worries over a potential trade war between the U.S. and China led to the cause of the correction. We anticipated higher volatility in 2018 after an unusually steady 2017 and volatility has increased dramatically so far in 2018. Through April 4, 2018, the Standard and Poor’s 500 Index had moved by 1% or more 26 times, triple the number for all of 2017. The Dow Jones Industrial Average had moved by 2% or more 8 times through April 4. Headlines of “Dow plunges (or gains) 500 points” are sensational, but for context, a 500 point move on the DJIA equates to about a 2% decline or advance. 500 was the number of points the DJIA declined during the crash of October 19, 1987, but that decline translated into a move of 20%! We focus on the percentage moves of the global indices vs. the DJIA. Below is a summary of performance for various markets for one quarter and one, three, five and ten years prior to March 31, 2018:
|1Q 2018||1 Year||3 Year*||5 Year*||10 Year*|
|MSCI All-Country World Index||-0.9%||15.4%||8.7%||9.8%||6.2%|
|Standard & Poor’s 500 Index (U.S.)||-0.8%||14.0%||10.8%||13.3%||9.5%|
|MSCI EAFE Index (Developed International)||-1.6%||15.2%||6.1%||7.0%||3.3%|
|MSCI Emerging Markets Index||1.2%||25.1%||9.2%||5.4%||3.3%|
Trade tensions have escalated in recent weeks, beginning with the announcement of $3 billion of tariffs on steel and aluminum and continuing with the announcement of $50 billion in tariffs by the U.S. with China and the U.S. upping the ante to a potential additional $100 billion in tariffs on April 5. It appears to us that these announcements are more likely to be part of a negotiating strategy rather than the beginning of a so-called trade war. The U.S. tariffs avoid areas which directly impact consumers and are focused on intellectual property. China is focusing on products, such as soybeans, which emanate from areas which heavily supported President Trump in the 2016 election. While a trade war seems unlikely, we see major tariffs as a major risk to current synchronized global growth and will continue to monitor developments closely as deteriorating trade relations would have an adverse impact on global growth and profit margins/earnings for many companies. It would also adversely impact U.S. consumers by raising the prices on many goods while threatening a rise in U.S. interest rates should the Chinese retaliate by reducing its purchase of U.S. Treasury obligations (China owns $1.17 trillion or 5.3% of U.S. debt and Japan owns $1.07 trillion). On a more positive note, negotiations continue among the U.S., Canada, and Mexico over NAFTA and as of this date, there are indications that an agreement over revisions could be achieved.
Globalization, competition, and technology have a deflationary impact on many goods and services. Major tariffs could result in a resurgence in inflation:
As for monetary policy, the Federal Reserve Open Market Committee is adhering to an approach of gradually increasing rates under the new Chairman, Jerome Powell. A 25 basis point increase in Federal Funds to 1.50-1.75% was implemented at the March meeting. Wage gains remain restrained despite a tight labor market in the U.S., so the Federal Reserve is unlikely to aggressively increase interest rates and place the economic recovery at risk.
A pattern of global synchronized growth should continue, resulting in positive economic data and a favorable trend in corporate earnings. 2018 corporate earnings revisions have been outstanding to start the year driven by solid revenue growth, margin expansion, and lower tax rates – this has compressed the valuations of global markets to more attractive levels near historical averages. We have frequently discussed “is this as good as it gets” for the global economy and whether leading economic indicators are peaking (i.e. the ISM Manufacturing PMI Index is at one of its highest levels in 25 years). We have concluded even if the ISM Manufacturing Index does peak in the months ahead, it will most likely remain deep in expansionary territory. Further, past peaks have generally been followed by solid U.S. equity returns. So long as these conditions prevail and recession risks remain low, equity prices should work higher on balance, accompanied by the higher volatility that has prevailed so far this year.
Geopolitically, Iran and North Korea remain the principal areas of risk. Should the Trump administration follow through on its threat to pull out of the nuclear agreement with Iran, tensions would escalate. In the case of North Korea, the announcement of a meeting between Trump and Kim is encouraging, but a favorable outcome remains highly uncertain. While our overall equity outlook is positive, we will continue to closely watch the geopolitical risk areas.
Our overall positive assessment of global equity markets and expectations for gradually rising interest rates and inflation has led us to retain the strategy outlined previously. Financials and the commodity complex (Energy, Materials & Industrials) remain areas of focus as prime beneficiaries of global economic growth and should act as an “inflation-hedge”. While the Technology sector was under pressure in February and March, the valuations have become more attractive for companies with strong secular earnings prospects. Given our expectation for rising interest rates, we remain underweight high-yielding sectors such as Telecommunications and Utilities as their shares seem likely to continue to underperform as they behave like bond proxies (although valuations are less expensive following their recent underperformance).
U.S. Equity valuations are near the 25-year average following positive earnings revisions and the recent correction:
*Source: J.P. Morgan
In our Global Equity strategies, we continued to increase our exposure to emerging markets. Even after a strong outperformance in 2017, emerging markets remain laggards relative to the U.S. and there is room for strong relative performance driven by earnings growth and multiple expansion. We have also increased our commitment to Japan, given the attractive relative valuations in that market and favorable monetary and fiscal policies. We also enlarged the commitment to defense related companies as we believe defense stocks could be the new “Staples” for next several years with highly visible U.S. Department of Defense spending growth, earnings growth from lower tax rates, and they are geopolitical risk buffers.
In our Dividend Growth strategy, we continue to find more attractive stocks in the cyclical areas over traditionally more defensive sectors and high-yielding “bond proxy” stocks. We have increased our commitment to U.S. regional banks, as we believe regional banks are in the early innings of a multi-year cycle after many years of underperformance and are prime beneficiaries of current monetary and fiscal policy. Corporate tax reform and the resultant significant lowering of corporate tax rates has provided companies additional “firepower” to increase cash dividends. The dividend yield of the Dividend Growth strategy is now over 3.0%, which is a healthy increase from late 2017 levels – we continue to look for companies that can increase their dividends over 10% annually for the next 3-5 years.
Yields in the U.S. continued to increase gradually during the first quarter of 2018, even with a partial retracement late in the period. Yields on two-year U.S. Treasury obligations ended the first quarter at 2.27% versus 1.88% at the end of 2017. The yield on ten-year Treasury notes rose to 2.74% as of March 31, 2018 as compared to 2.41% on December 31, 2017. Outside the U.S., yields were little changed during the first quarter, with ten-year German obligations yielding 0.49% on March 31, 2018 versus 0.42% on December 31, 2017. The yield on ten-year Japanese bonds remained at 0.4% throughout the quarter.
We expect the Federal Reserve to continue to gradually increase short term rates during the remainder of 2018 after the 25-basis point increase to 1.50% to 1.75% at the March FOMC meeting. Two additional increases seem the most likely outcome, which would bring the Federal Funds rate to 2.0% to 2.25% by year end. These increases should be reflected in interest rate rises across the maturity spectrum although to a lesser extent than is the case for short term rates. With this outlook and the tail risk of rising inflation we adhere to our strategy of maintaining shorter than average durations in our taxable and tax-exempt portfolios and we expect to re-invest shorter-term bonds at higher rates over the next several years. Below is an illustration from a recent PGAM presentation demonstrating the risks of longer-term bonds in a rising rate environment:
Princeton Global Asset Management LLC
This report is for informational purposes only and contains data based on information Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data.
Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security.
It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited