Volatility ticked up in the second quarter. There was a minor 7% correction in May as the lagged effects of the Fed’s rate hikes and the negative impact of tariffs sparked fears of a potential recession. Dovish commentary from the Fed, and hope for an eventual trade deal, then pushed the market to a new all-time high of 2,954 on June 20th. While year-to-date gains have been driven by sharp multiple expansion from the severely depressed level seen in early January, the current year P/E of the market is only back to roughly the average 5-year level:
All the while, global economic activity continues to slow. Though US employment is still strong and consumers are in relatively good shape, areas such as housing and manufacturing are not as robust as they were last year. The key question for the economy is whether easing monetary conditions and an end to trade wars can reverse the slowdown and forestall a recession.
The outcome of trade negotiations between the US and China remains the major risk for global economies and financial markets. Trade wars have not yet disrupted domestic corporate results to the point of causing an earnings recession, and many companies that source goods from China have been able to selectively raise prices or modify supply chains to blunt the impact of the initial round of tariffs. Others, however, are already being harmed tremendously. FedEx CEO Fred Smith characterized his company’s experience with the challenging conditions by invoking the old Mike Tyson adage of “everybody has got a plan until they get hit in the mouth.” Uncertainty about future trade policy is beginning to weigh on the confidence of many CEOs, which could eventually affect spending and hiring, putting a brake on future global growth and possibly tipping the economy into recession.
President Trump’s unpredictable tweets, public comments, and actions continue to keep market watchers on their toes. Perhaps most surprising was an out-of-nowhere threat to levy a series of rapidly escalating tariffs on Mexico unless it assists in stemming the flow of illegal immigration into the US. The threat arrived at the same time the updated United States-Mexico-Canada (USMCA) trade agreement was moving through the approval process. In this instance, Trump’s tactic worked as the US and Mexico reached an agreement on immigration aid and the tariffs were never imposed. But the episode exacerbated market weakness, dropped yields, and increased volatility during the May correction.
On a happier note, June’s G-20 meeting in Osaka, Japan served as a chance for US President Trump and Chinese President Xi to discuss trade face-to-face. Though no final deal was reached, the leaders agreed to a truce while negotiations continue, vowing to not impose additional tariffs such as the ones Trump had threatened to levy on an additional $300 billion of Chinese goods. Somewhat surprisingly, Trump also changed course and agreed to allow US companies to sell some lower risk components to Chinese telecom giant Huawei. So, trade uncertainty remains, though the upcoming 2020 US presidential election, set against economic slowdowns in both the US and China, should serve as catalysts for an eventual deal that allows both sides to declare victory.
The 2020 presidential cycle is well under way, and as usual, election poll results and policy discussions are likely to have some short-term impact on the market. With the first Democratic debates having just occurred in the last week of June, however, it would be unwise to make major portfolio changes in anticipation of any specific outcomes at this time. Politically-driven risks and opportunities, especially at the sector level, are a focus of our research efforts.
Following the major market move so far this year, significant further gains are unlikely into December. However, the backdrop of positive expected earnings growth, low interest rates, and low inflation are still generally favorable for stocks. Further, credit indicators do not currently show signs of stress that would normally precede a major economic slowdown and bear market. The Federal Reserve and other major global central banks are now easing their monetary policies. If more accommodative central banks and favorable trade resolution enable global economies to rebound, the stock market could reach new highs. If trade wars persist and help tip the economy into recession, we would expect to see significant market weakness.
At the equity portfolio level, we continue to believe that a balanced approach, neither too aggressive nor too defensive, makes sense at this stage of the economic and market cycle. This positioning will likely continue unless the economy accelerates sustainably higher or lower. Despite the market gains this cycle, we are still able as active managers to identify a broad range of companies that are performing well and have catalysts for further improvement.
Bond prices continued to rally during Q2 as the Bloomberg Barclays Aggregate Index rose 3.1%, bringing YTD returns to 6.1%. Interest rates have marched lower this year amid trade war fears and emergent signs of a global economic slowdown. The yield on 10-year Treasuries closed the quarter at 2.00%, down from 2.69% at year end.
On June 19th, the Federal Reserve left its benchmark interest rate unchanged while also signaling that rate cuts are likely in the coming months. Escalating trade tensions, timid inflation data, and signs of weaker global growth have prompted the committee to reverse its previous bias towards additional rate hikes, and financial markets are now anticipating 2-4 rate cuts this year. This contrasts with the Fed’s own projections and investor sentiment from as recently as last September, when both had assumed 1-2 rate increases in 2019. This shift to a more dovish stance has helped propel both bond and stock returns this year.
Fed Chairman Jerome Powell has come under intense criticism from President Trump for previously raising rates and now for not cutting rates quick enough. As we edge closer to election season, the President is clearly of the opinion that interest rate cuts would likely boost market returns, which of course would improve his reelection chances. Press reports have indicated that the President has looked to either demote or even fire Chairman Powell. While it can be argued that the last two rate hikes were a mistake (the S&P 500 fell nearly 20% during this time frame), protecting the independence of the Fed is of utmost importance. To quote Michael Klein, a former member of the Fed’s Board of Governors, “The Fed’s independence from meddling ensures it can make politically difficult decisions that are in the long-term interests of the overall economy – not merely what a particular politician might like.” Fortunately, the lack of a recent rate cut indicates that Chairman Powell and the rest of the committee have ignored the pressure from the Oval Office and are instead following a data dependent policy discipline.
We continue to position the portfolio with mostly short-to-medium duration securities to protect client portfolios from the risk of eventual rising interest rates. The vast majority of the fixed income portfolio is still comprised of investment-grade corporate bonds. As discussed previously, we have been purchasing short-term Treasury securities for those clients with maturing bonds or excess cash. While we are comfortable holding existing corporate bonds to maturity, the reduced incremental yield of new corporate bonds over Treasuries makes corporate bonds relatively less attractive from a risk/reward perspective. We continue to believe that a reasonable estimate of 2019 fixed income total returns is the mid-single-digit range. While fixed income returns are likely to 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.
Global equity markets continued to post gains in Q2, despite the macro backdrop of trade concerns and slowing growth, as central banks transitioned from a stance of synchronized tightening to one of synchronized global easing. In the quarter, the S&P 500 led the way up by +4.3%, US small cap stocks rose 2.1%, and developed international markets increased 3.9%. Emerging markets increased 0.7% despite elevated US trade sanctions, and the US dollar weakened -1.0%.
As with domestic US markets, a successful outcome on trade negotiations and monetary policy remain significant variables in the outlook for global financial markets. Despite the macro uncertainty and slower economic growth, we expect accommodative global monetary policy, continued earnings growth, and higher dividend yields to continue to drive at least mid-single-digit annual returns in global markets over the next several years.
Following a decade of above average returns, it is important to remember that the nature of capital market cycles means that investors will experience negative drawdowns in their portfolios. Risk is inherent to the markets, and one of our core purposes as advisers is to help our clients assess and manage it.
We believe managing risk requires working with our clients to understand both their risk tolerance and risk capacity. While similar in meaning, risk tolerance and risk capacity are actually quite different. Risk tolerance stems from our emotional response to market volatility, and simply defined, is the ability to sleep well at night during times of market stress. Risk capacity is the quantifiable amount of risk one can accept in order to achieve desired goals. Where tolerance is a function of psychology, capacity is a function of time horizon, income and overall financial position. A conversation with your adviser to evaluate both is an essential component to maintaining a wealth plan to achieve your goals.
The foundation of risk management is diversification, both within and across asset classes. As discussed before, we have adopted a more conservative stance within equities and fixed income over the past year, a tactical shift based on late-cycle market conditions. We believe these shifts can continue to add value for our clients within each asset class. However the underlying portfolio asset allocation, or diversification across stocks, bonds, REITs and cash, is ultimately the primary determinant of portfolio returns.
Predicting the exact end of the market cycle, the beginning of the next recession, or where interest rates will be in five years is difficult, if not impossible. Our approach then is to customize an asset allocation strategy designed to meet long-term goals and objectives through all market conditions, in accordance with our client’s risk tolerance. Much as a physician wouldn’t prescribe medication without an understanding of a patient’s medical condition, ongoing portfolio check-ups and client risk evaluations are critical to ensuring your asset allocation is aligned to meet your financial needs.
In the quarter ending June 30, 2019, the MSCI US REIT Index (Bloomberg: RMZ) produced a total return of 1.3%, bringing the year-to-date total to +17.8%. First quarter earnings season reflected optimism in property types across the board, and the pullback in the 10-year US Treasury yield buoyed REIT prices. Even so, the spread between the RMZ dividend yield and the 10-year Treasury yield ended the quarter at 210 basis points (bps), almost 80 bps above the long term average. Thus, REIT prices could appreciate further if the 10-year yield stabilizes, or REIT prices could be stable even if the 10-year yield rises. As REITs continue to post impressive total returns, we would like to remind our readers about the importance of maintaining a REIT allocation throughout the economic cycle.
Commercial real estate is an essential component to the construction of a diversified portfolio. As shown in the chart below, commercial real estate represents $15 trillion (or 13%) of the US economy. Excluding residential homes (because a primary residence should not be considered an investment), commercial real estate is over 17% of the US economy. Commercial real estate provides annual income with growth that protects it from inflation. At the same time, returns exhibit a low correlation with equities and fixed income, which helps to lower portfolio risk, while enhancing total return.
Publicly-traded equity REITs exhibit all of these same qualities, while also offering investors instant liquidity and, in our opinion, many other benefits that make them superior to private equity or non-traded REITs. REITs employ extremely low leverage, averaging only 31% debt to gross assets as of April 30, 2019 (this compares to 50-80% for most private vehicles). In addition, the low payout ratios of REITs (around 74% of cash flow) enhance flexibility and allow for predictable future dividend growth. In contrast, the average private REIT had a payout ratio of 192% as of June 30, 2017, according to FactRight. Finally, private fund fees are notoriously high, and historically opaque. Initial investments are typically associated with fees to the broker of 5% to 15%, meaning only $0.85-$0.95 of every dollar invested is actually going to real estate. In addition, annual investment management fees, asset management fees, transaction fees, and other expenses can total 2% or higher! In contrast, the average annual REIT General and Administrative (or G&A) expense equates to 0.4% of the historical cost of assets (even less on market value).
Public REIT investors also enjoy favorable tax status, eliminating the ‘double taxation’ issue that arises from investing in traditional equities. In their case, the corporation pays taxes on its income, and then distributes dividends to shareholders, where the income is taxed once again. In contrast, the REIT does not pay any corporate taxes, so the investor is taxed just once when he or she receives the dividend. In a recent development, taxable REIT investors had their tax status significantly improved in 2018 due to the Tax Cut and Jobs Act, which lowered the tax rate on the ‘ordinary income’ portion of the REIT dividend by 1,000 basis points!
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
Matthew R. Werner, CFA, email@example.com, (713) 243-3234
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