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PGAM 4Q2018 Investor Letter

January 9, 2019

Global equity markets declined across-the-board during the fourth quarter of 2018 leading to declines in total return for 2018. The negative annual returns for the S&P 500 being the first in a decade. The major catalysts behind global equity market weakness were concerns over slowing economic growth. These concerns had centered upon China throughout the year and were accentuated by the perception of the growing risk of a trade war between China and the U.S.  Concerns over the durability of the U.S. economic recovery were exacerbated by worries that the Federal Reserve is in the process of committing a policy mistake by overtightening. Below is a summary of performance of various equity market indices, which shows outperformance of the U.S. equity market over most time periods, excluding the most recent quarter:

Volatility also increased significantly during 2018. 2018 saw the most moves of 2% up or down in the U.S. market since 2008 (2% is equivalent to about 500 points on the Dow Jones). This is in stark contrast to 2017 where the number of moves of 1% was the fewest in 50 years. We expect the volatility of global equity markets to remain high in early 2019 with ongoing geopolitical problems (i.e. the Mueller investigation) and sentiment swings related to trade discussions and economic data releases. The global stock market sell-off in the fourth quarter combined with the elevated volatility has caused investor sentiment to plummet. Citigroup’s investor “panic level” was recently reached, which historically is a good contrarian indicator for positive future stock returns:

The direction of global equity markets in 2019 will be driven by the outcome of the U.S. trade negotiations with China and Federal Reserve policy. Positive outcomes will lead to a continuation of the current solid economic trends and business cycle, while negative outcomes will lead to a deterioration in consumer and business confidence increasing the odds of a U.S. recession. Tariffs are not good for global economic growth.

The current business cycle has been long in duration but underwhelming in terms of GDP growth. There is “plenty of gas in the tank” for further expansion under accommodative conditions:

We believe the major uncertainties besetting global equity markets should abate as the year progresses, leading to an improved environment for stocks worldwide. There is strong impetus for the U.S. and China to ameliorate the trade tensions which intensified in 2018. The Chinese economy has been slowing throughout 2018, the most recent evidence being the decline in the Caixin China manufacturing purchasing managers index to below 50 in December, a level which is the difference between expansion and contraction. On January 2, Apple provided anecdotal evidence of a slower Chinese economy by lowering its quarterly revenue forecast for the first time in more than 15 years, citing a downturn in sales of iPhones in China as a major cause of the lower guidance.  China will likely take further action to alleviate a slowdown, such as reducing reserve requirements.  There will also be a willingness to offer trade concessions to the U.S. in order to avoid an intensification of protectionism on the U.S. side.  As for the U.S., the intensifying pressure on President Trump from a Democratic majority in the House of Representatives and the Mueller investigation will increase the incentive for the President to succeed in reaching a trade deal with China that can be characterized as a “win” for the U.S.

As for the Federal Reserve, the December increase of the Federal Funds rate to a range of 2.25% to 2.50% was expected.  However, the U.S. equity market reacted negatively to the press conference following the announcement in which Federal Reserve Chairman Powell indicated that the reversal of quantitative easing was on “autopilot” with the Federal Reserve allowing its security portfolio to decline at a steady rate month-to-month. As of now, the Federal Reserve is meeting its dual mandate of full employment and low inflation with the underlying rate at 2.0%. Consequently, the only argument for raising short term rates is “normalization” or increasing rates to a level that provides a margin for the Fed to cut rates for monetary stimulus, should that become necessary. Subsequent to the December meeting, there is a rising belief that the Federal Reserve has increased rates sufficiently to meet its goal and that further increases will not take place in 2019, contrary to earlier expectations of several more increases this year. During a seminar on January 4, Chairman Powell indicated that the Federal Reserve will be flexible regarding interest rates and the reversal of quantitative easing.  Based on these remarks, there is a good chance that the Federal Reserve will take the reversal of quantitative easing off autopilot and follow a more data dependent approach. The overall easing of concerns should have a favorable impact on U.S. share prices. At the same time, longer term interest rates should resume an uptrend in response to more favorable economic expectations.

 

Equity Strategy

Given our base case view that U.S. growth remains solid but slowing, no recession is imminent, and the investment environment should become more favorable as 2019 progresses, we are staying the course and maintaining a similar approach to prior quarters. We strive to build diversified portfolios with strong, high-quality companies that have positive long-term prospects. Stocks overall are reasonably valued and corrections in sectors such as Diversified Financials, Semiconductors, Energy, Industrials and Materials have created exceptional value, so we retain significant representation. These areas should benefit from an abatement of concerns over an impending recession, particularly in the U.S.

Economically sensitive cyclical stocks are the “relatively” most inexpensive they have been in over 40 years. There are risks to cyclicals, but patience could be rewarded handsomely:

We also maintain a significant commitment to the sectors of Technology, Communications Services, and Health Care focusing on companies with above-average earnings growth potential.  We remain underweight in higher yielding sectors or “bond proxies” including Utilities and REIT’s. Understanding the risks of the “bi-furcated” macroeconomic environment and a change to our outlook, our investment committee has assembled a list of “Durable Growth Defensive” stocks that we believe should perform well regardless of economic conditions. We are also highly scrutinizing or avoiding companies with leveraged balance sheets.

In our Global Equity Strategy, we have recently increased our commitment to Emerging Markets. After an extended period of underperformance and valuations trading at a significant discount to the U.S.’s S&P 500 index, Emerging Markets have begun to exhibit improving relative strength. Long-term price appreciation looks very attractive for Emerging Markets looking at the metrics of forecasted earnings growth and market value as a percentage of GDP. As the Federal Reserve becomes less aggressive toward tightening monetary policy, the U.S. dollar should weaken, a condition which historically has a favorable impact on the relative performance of emerging markets.  An improvement in the Chinese economy due to stimulus and a lessening of trade tensions with the U.S. should also have a positive impact on emerging economies and are likely prerequisites for the beginning of Emerging Markets outperformance. We remain underweight Europe and maintain significant exposure to Japan.

Following a solid 2017 and first half of 2018, our Dividend Growth Strategy had a challenging second half of the year. Companies that generate healthy free cash flow with high dividend growth historically perform well in the middle and later innings of a market cycle, but this strategy did not work in 2018. We believe this underperformance is a combination of aggressive growth stock leadership in the first nine months of 2018 and bond proxy/defensive stock leadership in the fourth quarter – areas we have modest exposure. We are trusting the process, remain disciplined to our stock selection criteria, and see the opportunity for better returns going forward. The strategy maintains select exposure to economically sensitive areas, while the majority is invested in companies we are confident will grow earnings, grow dividends, and create shareholder value over the long-term.

In our managed Exchange Traded Fund portfolios, our equity exposure is tilted towards Value, Quality, and Mid-Cap fund styles. We have also increased exposure to Emerging Markets. Within fixed income, we are looking to initiate exposure to interest rate hedged High-Yield funds and currency hedged Emerging Market to provide yield and take advantage of recent spread widening. Tracking error, liquidity, and low expense ratios remain key considerations in fund selection.

Fixed Income Strategy

During the Fourth quarter, the concerns over the durability of the U.S. economic recovery led to declining rates in the two-to-ten-year range even as the Federal Reserve instituted a 25 basis point increase in the Federal Funds rate to a range of 2.25% to 2.50%.  Yields on two-year Treasuries declined from 2.81% to 2.49% during the quarter.  The yield on five-year Treasuries declined from 2.95% to 2.51%, while ten-year Treasury yields declined from 3.06% to 2.68% during the fourth quarter.

As indicated previously, we believe that the Federal Reserve will pause its program of quarterly short-term interest rate increases and will institute a more data dependent approach to reversing quantitative easing, rather than automatically reducing the balance sheet each month.  While this approach means short-term rates will remain stable, renewed optimism over U.S. economic prospects should result in a renewed uptrend of interest rates for securities other than those of shorter maturities (or curve steepening).  Given this expectation, we continue a strategy of maintaining shorter than average durations (maturities) in our taxable and tax-exempt portfolios with a focus on U.S. Treasury and high-quality corporate obligations in tax-exempt accounts. Our main goal for our fixed income exposure is to provide income and portfolio ballast during the current volatility.

The recent stock market volatility has tested our mettle at times and the volatility will likely remain, but we remain patient and long-term focused. Our top priority is to ensure you have the proper portfolio asset allocation to enable you to stay invested during these uncomfortable periods. We are always available to discuss any investment or financial matters you may have.

 

Sincerely,

 

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 important Disclosures:

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

 

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