Health Care, Industrials, and Information Technology were the top performing sectors for the quarter, while Materials, Energy, and Real Estate lagged.
Corporate earnings continue to surprise to the upside and fuel market gains. American companies are generating record sales, operating margins, and earnings per share, while guiding toward even better results going forward. Earnings growth will likely slow next year due to the lapping of the tax reform benefits, but it should remain positive.
Market gains in the third quarter have raised valuation slightly upwards to roughly 18.5x 2018 estimated earnings and 16.5x 2019 estimated earnings. We would expect earnings multiples to remain near these levels until inflation and interest rates are much higher.
After a first half characterized by a narrow set of names such as Apple, Amazon, and Netflix driving modest market gains, market leadership shifted somewhat in the third quarter, and a broader swath of previously out-of-favor sectors and names began to aid the push to new highs. This action can be considered a healthy sign. With breadth, or the number of stocks rising or in an uptrend, expanding, the broader market move is perhaps less likely to be derailed, even if a few leaders stumble. The Advance/Decline line, a measure of breadth, is currently trending upward as the cumulative number of stocks moving higher outpaces the number of stocks moving lower.
Interest in marijuana stocks reached a fever pitch in the quarter as stocks like Tilray (TLRY) saw extremely volatile moves, reminiscent of last year’s cryptocurrency craze (note, the price of Bitcoin is down about 66% since late December).
The cannabis industry is certainly large and growing, with an addressable market that continues to expand with every legislative approval. Currently, nine states and Washington D.C. have legalized recreational marijuana, while 31 states have legalized medical marijuana. Many public companies, including Coca-Cola, have expressed interest in cannabidiol, or CBD, a chemical derivative of marijuana plants that can be used for pain relief and other wellness purposes. So, the long-term outlook for the cannabis industry is favorable, but many of the related stocks have been trading at irrationally high valuations. At times, the market cap of individual companies has even surpassed the market size of the entire industry. We therefore believe that most of these names are un-investable at this time.
President Trump has followed through with his promise to implement tariffs on imports from China, pending negotiation of new trade agreements. He has taken an even more aggressive than expected stance, choosing to largely ignore the concerns of many politicians and corporate leaders, who worry about potential negative consequences of the protectionist actions.
Late in the quarter, President Trump implemented a 10% tariff on $200 billion of additional Chinese imports, a figure that will rise to 25% beginning in 2019. China responded soon thereafter with tariffs of 5-10% on $60 billion worth of US products, and the threat of further measures. Then came the news that the US will consider placing tariffs on an additional $267 billion of Chinese imports. Since US economic momentum is currently strong and there is time between now and the end of the year for negotiations, the market has taken these new tariffs in stride. We will continue to watch for any negative impact affecting our portfolio companies, but we believe that the principals will eventually reach a cease fire that avoids meaningful harm to the US economy and stock market. Some higher inflation is a likely outcome, but many companies currently have pricing power and can make supply chain adjustments to deal with the new trade environment.
The first nine months of 2018 have seen the S&P 500 exceed our full-year base case expectation for a total return approaching 10%, though continued positive earnings revisions could result in modest further upside into year end. Where markets ultimately close out 2018 will largely depend on 2019 earnings expectations, mid-term election results, and trade war developments. Currently, we expect earnings to grow again in 2019, at perhaps around a 10% rate. This would represent a slowdown from 2018 but could possibly support gains in stocks next year as well.
We continue to position portfolios with a pro-cyclical tilt, though we are finding some new process fits in defensive areas as well. This is likely to continue as the current economic and market cycle matures.
The rise in interest rates continued to pressure bond returns in Q3. The yield on 10-year Treasuries closed the quarter at 3.06%, up from 2.40% at the beginning of the year. As a result, the Bloomberg Barclays US Aggregate bond index has returned -1.6% year-to-date. In September, the Federal Reserve raised short-term interest rates for a third time this year and the eighth time since 2015. Financial markets anticipate an additional hike in December, with perhaps another one or two hikes in 2019.
Chilton’s fixed income portfolio has actually seen modest gains this year due to our short duration positioning and the yield advantage of our overweight position in corporate bonds.
As has been the case throughout the year, the credit markets are not telegraphing a recession in the near-term. The two major leading indicators we monitor are credit spreads and the shape of the yield curve. Corporate credit spreads (the incremental yield of a corporate instrument over an equivalent-term risk free, i.e. Treasury, investment) have moved slightly higher year-to-date, but remain well below pre-recessionary levels. An inverted yield curve, when longer-term rates are lower than shorter-term rates, has preceded each recession in the past 50+ years. The yield curve, which has flattened throughout the year as the Fed continues to raise short-term interest rates, has not yet inverted. Many market pundits point to this curve flattening and likely eventual inversion as a reason to believe that a recession is around the corner (recessions cause sustained equity bear markets).
However, since the 1960s, the median time lag between a yield curve inversion and the start of a recession is nearly twenty months (see table below). In addition, with the exception of one inversion, stocks have actually rallied post-inversion (median +21% to peak). The one exception was in 1973 when stocks peaked 2.5 months prior to the inversion, then declined by about 4% until the yield curve actually inverted. When/if the yield curve inverts and/or credit spreads begin to meaningfully widen, we will likely adopt a more defensive posture across the entire portfolio.
Given our view that interest rates will move higher over time, we continue to position our portfolio with mostly short-to-medium duration securities. Floating rate bonds, whose coupons reset higher as interest rates rise, continue to make up an increasing proportion of our overall fixed income portfolio. We believe that a portfolio structured with these types of bonds can generate returns in the range of 2.0%-2.5% in 2018, with the majority of return deriving from interest income, which should offset a modest level of capital depreciation. Although fixed income returns may remain muted over the short-to-medium term, bonds play an important role in the asset allocation process by providing both income and stability within a diversified portfolio.
In Q3, the MSCI US REIT Index (Bloomberg: RMZ) produced a total return of +1.1%.
Originally referenced in a Federal Reserve paper from 1997, the ‘Fed Model’ states that the earnings yield of equities should approximate the 10-year Treasury yield over time. The implication of this model is that equities are overpriced if their yield is below the 10-year Treasury yield, and vice versa.
For purposes of this report, we use the FTSE NAREIT Equity REIT Index (Bloomberg: FNRE) so that we can reference data as far back as 1972. Figure 1 shows that the FNRE dividend yield tracked the 10-year Treasury yield fairly well over certain periods – but not all periods. As of September 30, 2018, this spread had declined from more than 200 bps earlier in the year to 113 bps, the lowest since 2014. Thus, subscribers to the Fed Model of thinking would also conclude that REITs are above fair value.
However, there have been five periods where the spread between the FNRE dividend yield and the US 10-year Treasury yield has been below the historical average since 1994. Each period lasted a minimum of 10 months, and the average period was 22 months. On average, these five periods produced an annualized total return of over 22% for REITs.
The relationship was only significant when the spread was extremely wide. In fact, the correlation for periods where the spread was greater than 100 bps from average was over 80% since 1994, while the correlation drops to negative 4% for periods where the spread was within 100 bps. So, we concede that the Fed Model can work, but only in extreme scenarios. With the spread only 14 bps below historical average as of September 30, we would argue that the Fed Model is ineffective.
When looking back at periods in the past when the dividend yield spread was higher, REITs employed much higher payout ratios. The dividend/AFFO (or Adjusted Funds from Operations) payout ratio has averaged 80% from the start of the modern REIT era in 1994 to June 2018, and averaged 90% from 1994 to 1997. Those high payout ratios contrast to the 72% payout ratio as of June 30, 2018.
We can adjust the historical payout ratios to the 72% employed today to make an ‘apples-to-apples’ comparison of today’s yield spread to the historical spread. Our calculated historical comparable dividend yield spread average is actually 76 bps, instead of the 127 bps used in the Fed Model. Therefore, the current yield spread of 113 bps screens attractive versus the historical comparable yield spread, implying there is another 37 bps of potential dividend yield decline (or US 10-year Treasury yield increase) to reach the comparable historical average. For illustration purposes, a 37 bps decline in the REIT dividend yield would result in a 9.7% increase in REIT prices, holding all other variables constant.
We would warn those using the Fed Model that this could be an extended period of below average yield spreads. Dividend payout ratios are near all-time lows, the capital markets are wide open, REITs are making very few net acquisitions, and cash flow is growing at a mid-single digit pace. While the other indicators may be predicting a rise in the 10-year Treasury yield, it is our confidence in the REIT fundamentals that allows us to remain positive on near term REIT performance. And, per our research above, the spread has historically contracted when the economy is growing and inflation is increasing.
US markets continued to outperform international markets in the third quarter with the large cap S&P 500 up +7.7% and US small cap stocks up +3.6%, while developed international markets rose +1.4% and emerging markets fell -1.0%. The US dollar strengthened +0.2% in Q3, and has risen +2.1% so far in 2018, a headwind for US investors in international stocks. For example, in local currency terms, developed international markets are +2.4% in Q3 and +1.4% year-to-date. Of note, currency variations have proven to be unpredictable in the short-term due to a variety of factors. Over longer time periods, however, currency fluctuations are mitigated by the convergent relationship between interest rates and global exchange rates.
The global economy remains resilient despite new tariffs and trade fears, however there are developing pockets of instability. The currency dislocations in Argentina and Turkey currently appear idiosyncratic, although they have clearly weighed on all international markets. Within China, the trade dispute and recent tariffs have roiled markets and currencies, even though the vast majority of Chinese companies within emerging market funds have minimal exposure to US exports and are predominantly exposed to domestic Chinese consumption and development.
China’s GDP growth is slowing as the economy transitions from export and infrastructure driven toward domestic consumption. Unlike previous periods of consternation over Chinese growth in 2008 and 2015, Chinese policy has recently moved from a position of tightening to a position of net easing in response to increased tariffs, and monetary conditions are improving. Also, industrial profits are rising, and electricity production, a leading economic indicator and one that is more difficult to misrepresent, is growing at an increasing pace.
We believe the decline in international equities amidst continued global strength is predominantly driven by currency weakness and tariff concerns, and that it is not symptomatic of a global contagion. As we seek to structure portfolios that benefit from the growth of global capitalism, international markets remain an attractive asset class with faster growth driven by rising standards of living and the ascension of a broader middle class consumer. Emerging markets also provide lower correlations to US markets and valuations that are at decade lows relative to the US.
In prior writings, we have discussed the importance of broadly diversified allocations to meet client goals and reduce portfolio risk. Historical evidence supports this assessment, however the powerful returns recently experienced in the US have perhaps dulled the timeliness of broadening allocations. As seen in the chart below, US equity markets have regularly outperformed international markets in recent years. Global market leadership does tend to alternate with long periods of outperformance, suggesting the cycle of US leadership may be overextended, and the benefit of adding global diversification to equity portfolios appears timely.
Bradley J. Eixmann, CFA, firstname.lastname@example.org, (713) 243-3215
Brandon J. Frank, email@example.com, (713) 243-3271
R. Randall Grace, Jr., CFA, CFP®, firstname.lastname@example.org, (713) 243-3223
Julia J. Cauthorn, JD, email@example.com, (713) 243-3282
Matthew R. Werner, CFA, firstname.lastname@example.org, (713) 243-3234
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