October 10, 2019
Global markets turned in a mixed performance during the third quarter and were characterized by an increase in volatility and multiple crosscurrents underneath the index returns. Concerns over the outlook for the global economy continued to be exacerbated by trade tensions. On the other hand, evidence that monetary policy in the U.S. and Europe was turning increasingly accommodative partially offset the uncertain outlook for economic growth. In the summary table of global equity market performance below, U.S. returns continued to exceed those of other developed and emerging markets over all depicted time periods:
Weakness in global manufacturing activity in developed markets continued to accumulate in the third quarter. The slump was most evident in Europe, where the German purchasing managers index for September declined to 41.4 from 43.5 in August – readings below 50 indicate contraction. In the U.S., the ISM manufacturing index in September declined to 47.8 from 49.1. Contrary to the region’s stock market returns last quarter, Emerging markets’ manufacturing activity remains in expansionary territory led by improvements in Brazil and China.
The increase in trade tensions led by the dispute between the U.S. and China was a major cause of the global manufacturing softness. A key factor in equity market prospects will be the outcome of renewed trade discussions this month between the two countries. The most likely result is a limited agreement which will ease tensions at least temporarily. On the U.S. side, the political problems for the President caused by the impeachment investigation should increase incentives for some sort of agreement to avoid an overall slowdown in the U.S. economy. China is facing an economic slowdown and is being adversely affected by the increased tariffs to date while tensions over Hong Kong also factor into the Chinese trade stance.
The key positive for sustained growth has been the Federal Reserve’s efforts to preserve the decade long economic expansion. To date, the Federal Open Market Committee has reduced short term rates by 50 basis points this year and at least one additional reduction seems likely to be approved at the October 30 meeting. The Federal Reserve is also likely to reverse the multi-year policy of shrinking its balance sheet (or quantitative tightening) —the impetus for this switch is the need to support the key overnight repo market with adequate reserves. This move toward increased accommodation has and should continue to offset the impact of trade tensions on the U.S. economy. The U.S. consumer which accounts for 70% of Gross Domestic Product, has held strong and the job market remains strong. However, risks are increasing that consumer confidence could begin to erode if a trade agreement is not reached.
Proposed tariffs by the Trump adminsitration would cause the U.S. to have the highest tarriff rate of the G7 countries and major emerging markets. No trade resolution would undoubtedly lead to rising consumer goods prices and pressure consumer confidence:
On the surface equity market volatility appeared minimal in the third quarter, but there were episodes of elevated volatility, particularly within the Momentum/Growth styles. September 9 was a microcosm of this volatility, when Growth and Momentum factors has their worst day of relative performance vs. Value (-3.11% vs. +3.22%) dating back to their inception in early 2013. “Unicorn” IPO’s also faired poorly in the third quarter as investors are no longer enamored with aggressive sales growth and are becoming increasing skeptical of money losing businesses with questionable corporate governance (e.g. the failed WeWork IPO). We believe these unwinds are the result of crowded positioning and valuation distortions. Our equity strategies weathered the volatility due to our adjustments year-to-date, diversified exposure across major investment styles and our bottom-up security selection process.
Equity markets are characterized by a complete lack of investor euphoria. Investor sentiment is frequently a contrarian indicator. Fearful investor behavior rarely leads to bear markets and speculative investor behavior can lead to panic and poor future stock market returns. In our previous letter, we cited the Bank of America Merrill Lynch Global Fund Manager survey for June which showed that investor confidence was at its most bearish level since the Global Financial Crisis of 2008-2009. This month, according to the American Association of Individual Investors (AAII), the percent of bullish investors is a pessimistic 21.4%, levels also only reached during the financial crisis of 2008-2009 and the surprise Brexit referendum surprise of 2016. Similar backdrops have rewarded long-term equity market investing:
We continue to believe the trend toward increasingly accommodative monetary policy of developed economies (the U.S., Japan and Europe) should support economic growth and bode well for global share prices. In the post- war period and recent years, central bank monetary easing has led to improving economic growth outlooks and higher stock prices. Financial conditions and global GDP forecasts (Growth GPS) have had a strong relationship:
Our overall strategy remains focused on maintaining a balance between durable growth and attractively valued economically sensitive stocks. While the outcome of global trade negations remains uncertain, our recent purchases continue to focus on companies with attractive secular themes we forecast will deliver solid earnings growth in various macroeconomic environments. We continue to see very attractive valuations for stocks in the cyclical sectors and we have been creating a list of prospective ideas with healthy free cash generation and healthy balance sheets, which will require an economic boost to reverse recent underperformance. We continue to avoid stocks that offer high current dividend yields at the expense of future growth and balance sheet health. Despite their recent correction, we continue to see very frothy valuations of high momentum stocks.
In our Global Equity strategy, our largest sector weights are Technology and Healthcare representing our focus on quality growth and Financials as opportunistic value. We believe the recent underperformance in the Healthcare sector due to developments in the Democratic primary polls is creating an attractive long-term buying opportunity within select Healthcare industries and stocks. In addition, we remain patient with our Emerging Market equities exposure and continue to see attractive long-term price appreciation potential. The strength of the U.S. dollar has weighed on EM performance and a positive outcome of trade negotiations is likely required for sustained EM relative outperformance.
In our Dividend Growth strategy, we continue to selectively increase our exposure to companies we perceive as quality long-term growers (both earnings and dividends) trading at reasonable valuations – or “YARP”, yield at a reasonable price. For example, within the Real Estate sector, we hold an owner of data centers and an owner of cellular towers that should benefit from the build-out of 5G infrastructure compared to the Real Estate index holdings of many commercial real estate and retail property owners. Dividend paying stocks performed well in the third quarter (particularly September) and the strategy fully participated. A low global interest rate environment has increased the attractiveness of companies paying healthy dividends with above market growth.
In our managed Exchange Traded Fund portfolios, our equity exposure remains tilted towards Value, Quality, and Mid-Cap fund styles. We favor Equity Income funds for value style exposure and maintain healthy exposure to Emerging Markets, which we favor over International developed markets. Within fixed income, we favor investment grade short duration funds for ballast and Preferred Stock and Emerging Markets funds to generate income. Tracking error, liquidity, and low expense ratios remain key considerations in fund selection.
Fixed Income Strategy
U.S. interest rates continued their year-long decline during the third quarter although a rebound took place from the low point in late August. The yield on two-year Treasuries declined to 1.6% on September 30 from 1.7% as of June 30. Over the same time period, yields on five- year Treasuries declined to 1.5% from 1.8%. Ten-year Treasury yields declined to 1.7% from 2.0%.
In our opinion, rising U.S. interest rates and a steeper yield curve are likely. The Federal Reserve is willing to reduce short-term interest rates to assure that growth in the economy is extended. Inflation in the form of wage gains seems to be accelerating, with the rise in wages overall exceeding the 3% level. At some point the wage gains seem likely to be reflected in an overall inflation rate which rises past the long stated 2% target. This trend is not being reflected in the current level of intermediate and longer-term U.S. interest rates, increasing potential for an upward adjustment. With this outlook in mind, we adhere to a strategy of maintaining shorter than average durations in our taxable and tax-exempt securities. As bonds mature or are called, we are temporarily retaining assets in short term instruments as a means of reducing downside risk in fixed income portfolios.
As always, our highest priority is to ensure that you have the proper investment portfolio that enables you to stay invested during our long-term journey. We are always available to discuss any investment or financial matters with you.
Princeton Global Asset Management, LLC