I’m going to cover the 2018 investment year and then have an outlook to 2019.
2017 was a very calm year. Basically the market went up 24%, there was no reduction beyond 2% for the whole year, volatility was low, everything was easy going and happy.
2018, on the other hand, was a more normal year, with lots of volatility and many significant events that affected the market. The first thing that happened was we had almost daily tweets coming out from the president. We have found many surprising things on early morning tweets such as we’re leaving Syria, we’re putting 10% tariffs on steel and aluminum, et cetera.
Our chief investment officer, John Gullo, in fact has his own Twitter account and he looks at the president’s tweets three times a day to see if there’s going to be things that affect the market. This is very different in the past and it does add to the volatility.
The next thing that happened, we had tariffs during this year, somewhat surprising. When you think of it long term, the Republican party, which controlled Congress and the presidency, has been a long-time proponent of free trade. All of a sudden we had tariffs. Early in the year, people thought they were just negotiating ploys.
As the year went out, they became more and more material. Many times it caused the market to go down. Recently hope that the US and China will come out with an agreement, at least in part, it’s been helping the market recover.
Also this year there was the US/Mexico/Canada trade agreement. It was a replacement for NAFTA. Many people think it’s a done deal, but in fact at this point in time it still needs legislative approval.
Also this year there was a lot of discussion about the FANG stocks, Facebook, Apple, Google, et cetera. For the first nine months they basically went straight up. Our portfolios have a fair amount of those, but not an overweight. It’s a pure momentum play. Just like in the late ’90s, when technology went rocketing up, people thought it would go up forever. Well, as we found out starting from late September on, many of these went down 25 to even 35% over a relatively short period of time, and we found out nothing goes up forever.
Brexit came out, an Brexit was a big deal and it still is. This morning on the way in I listened to a summary. Right now the UK is the seventh biggest economy in the world. It, among itself, is a material participant in the world GDP. They’re also a huge player in Europe. Europe is the second largest economic block in the country.
We invest a significant amount of money in what we call developed international stock, which is Europe, Japan and Australia. This is a big deal. They are supposed to leave the European Union March 30th this year and there’s still not an agreement, so this is something that’s going to move the world markets from now through the end of March, and maybe beyond.
The next big thing that came up, if you look at the screen, was that the Democrats took control of the House of Representatives. On the screen the dark red is where the Republican party picked up seats. The dark blue is the Democratic party. In short, the Democrats picked up 40 seats on a net basis and now have a comfortable margin in the House.
The government shutdown occurred and it’s the longest one in history, 34 days. Prior to this, the longest one was 21 days. This had a very significant effect on a lot of people, not just government employees, but government contractors. I’ll talk more about this, but this is not good for anybody.
As we’re making this tape right now, we still don’t know for sure if the president is going to sign the new bill and avoid another shutdown starting tomorrow.
The other thing that was in the news all year long was Jerome Powell. He’s the head of the Federal Reserve Bank. During the year there were four rate increases. There were times during the year that the market was fearful that they’d raised the rates too much and hurt the economy. Recently, part of the recovery has come from Powell saying they will patient. Too many people thought that there would be just a straight line up with the interest rates and that the quantitative tightening that’s going on would go on unrestricted. Currently the market feels that the Federal Reserve will be patient and not hurt the economy abruptly.
All those significant events led to uncertainty. Uncertainty leads to volatility. As we’ve told long time clients, many times the market reacts more poorly to uncertainty than to bad news. If there’s bad news, you know that you have to take a left or a right. If you’re uncertain as to what would happen you don’t know what to do.
So the VIX, called the fear index, which is the forward volatility on the S&P 500, was normal this year. In 2017 it was extremely low. This index goes back to 1990. It averages about 20. A very low reading is below 10. Prior to 2017, there was only nine readings below 10 on a daily basis. In 2017 there was 52, so extraordinarily low volatility.
This year we averaged closer to regular. If you look at the screen, you’ll see that both in February and December we averaged well above 20. That hits the zone of being concerned, but we never went above 30, which is where we get very concerned. We went above 30 in 2008 and 2009 and also briefly in 2011. So this was more normal volatility, but it felt abnormally high because of how calm it was in 2017.
Similar to this, 2% movement in the stock market in one day can be unsettling. If you go back 20-some years, you’ll find out that we average about 20 days, and that’s what we averaged last year, yet it felt very violent. Why is that? Well, if you look for the six years, 2012 to 2017, you’ll see in six years there was only 35 days, including none in 2017. Therefore, this year, which was average, felt very bad. In particular 12 of the 20 days were in the fourth quarter, and that made the fourth quarter feel awful, and in fact the fourth quarter was awful.
If you look at the year through September 30th most portfolios were somewhere between -1 and +1%. Historically the stock market makes approximately 2% per quarter for the first three quarters and 4% in the fourth quarter. So looking at that, most people, us included, expected that this would be a modestly positive year, while it turned out not to be. In fact, December was the worse December since 1931, and any time you go back to the Great Depression for a comparison it’s not comfortable. This year we have already had two 2% days already.
If you look at the entire 2018, it was an unusual year. All the risk categories were negative. That happens very rarely. Usually some risk asset is positive. That wasn’t the case this year. You’ll see that municipal bonds made money, but that is not in the risk bucket. So all diversification did for you this year in the risk assets was determine how much you lost, not whether or not you lost or made money for the year.
Also, last year, as we mentioned 2017, it was a straight up wonderful year, plus 21.8 in the S&P, plus 24% in the world index, and never a drop more than 2%. Well, the first 26 days of January started out very similar. Emerging markets went up 9.9%, the US market 7.5%, foreign developed 6.5%. All the other categories, when you average them together, were modestly positive.
Then on January 26th we got what was perceived to be bad news, even though it was good news. What we found out is that the year-over-year wages increased 2.9%, which was the biggest amount since 2009. The market perceived that the Federal Reserve may increase the rate at which it was increasing interest rates, and that concerned the market a great deal, so much so that in two weeks we had a correction. The US market went down 10.1%, emerging markets 8.6, foreign developed stocks 7.4, and some of our diversifiers, real estate and infrastructure, both went down more than 8%, because in both those cases you borrow to build buildings, you borrow to do pipelines, and with interest rates going up the value of those proceeded to go down.
From there to the end of April, the Federal Reserve calmed down people and said that yes, we’re going to increase interest rates, but it’s going to be at a ratable measured pace, so basically we had a recovery. Looking back on the first four months then, emerging markets were up 1%, the best of the equities. Real estate and infrastructure were both down a little over 3% because of interest rate fears, although modified, and everything else sort of netted out to zero.
Then we had a very unusual period of time, May 1st to September 30th, and that’s when tariffs became real. Prior to that, we knew that steel and aluminum had 10% tariffs. We were struck back with tariffs on motorcycles and bourbon and jeans. China hit back on certain feed grains, but most people felt this was a relatively short term negotiating thing. Between May 30th and September 30th, tariffs became real.
The US economy depends on foreign trade much less than emerging markets and foreign developed, so they were able to go up the 11%. On the other hand, emerging markets that very much depends on international trade went down 8.6%. A 19.6% divergent over five months is extraordinarily unusual. Many people got fearful of emerging markets because of that. By the end of the year, emerging markets on a relative basis recovered a bit and were only down 9.4% more.
Then we came up to October 1st, which I foreshadowed before. And you look at that and you were unsure about the Chinese and US trade deal, you were unsure about tariffs overall, you were unsure about the Federal Reserve raising interest rates, and now a big thing that crept in, people were starting to reduce the growth projections going forward. The IMF in particular keyed this off. The stock market was priced in a way to assume continued good growth.
These three factors went together and from October 1st to September 25th was a very ugly time in the market overall, in particular the US market, which was priced the highest. It went down 18.9% during this period of time, foreign developed 14.4, and emerging markets, quote, only went down 9.1 because they were priced the lowest. Real estate, infrastructure and commodities, three of the diversifiers, all lost over 8%. Bonds went up modestly because there was a flight to quality.
Then starting on December 26th through the end of January, and currently as I’m dictating this now on Valentine’s Day, the market has recovered. What happened? Well, one of the things that happened, there is some optimism that we’ll get the trade deal done with China. As I’m dictating this right now the president is contemplating extending the March 1st deadline for the tariffs 60 days because there’s been good progress made on the US/China negotiations.
The other thing that happened was Chairman Powell of the Federal Reserve coming out and saying they will be patient, which has taken some of the heat off of the concern of interest rates going up, and further the fourth quarter projections for earnings, or reporting for earnings, has been pretty good and the projections going forward weren’t as robust as they have been, but they weren’t horrible either, so we’ve had a very nice recovery. The US is up 15.2, emerging markets 10, and real estate in particular is one that keyed up 14.1%, and infrastructure 12.4, and that’s the big market perception, that interest rates won’t go up as much as we expected.
Now one of the things that causes an enhancement or a detriment to your foreign returns is the relative strength of the US dollar. If you look back from January 1, 2017 to January 25, 2018, the US dollar depreciated almost 14%, so foreign investments had a 14% wind behind their sails. Since then the US dollar has strengthened 7%, and therefore has been a detriment to owning foreign assets.
The US economy … One of the things that has been wonderful about this economy is jobs. If you go back to the Great Recession, U6, which is the broadest measurement of unemployment and includes people working part time that want to work full time, people that have given up, and the official unemployment rate, it was 17.4% and it’s dropped to well below 10.
The official employment rate at the peak was 10%. It’s currently 4. Now it was as low as 3.7, but 4% is not a bad number, because what’s caused that is more people entering the workforce, so workforce participation rates are starting to recover.
The next thing is job openings. This slide shows us a little bit over 6 million. This Tuesday the jobs opening report came out and it was 7.3 million, which is the biggest number ever since this statistic was kept, and in fact is more than the unemployed people. So right now we’re running out of workers and we clearly have a skills mismatch at this point in time. Many of our clients who are employers have complained about the lack of skilled people in their industries for some time now.
The other thing that happened is that on a year-over-year basis as of 12/31 wages went up 3%. That’s the highest since 2009. January 31st just came out, and on a year-over-year basis it was 3.2%, so finally some of the workers are participating in the better economy. This is a good raise, but not so good that it’s causing a lot of fear of inflation at this point.
Now speaking about inflation, another component of it is producer prices for commodities. They went way down in 2014 and ’15 in combination, and they’ve been going up since 2016, 2.6, 4.3, and 3%. Query, is the combination of the wage inflation and producer prices enough to make inflation too high?
When you put them in combination, increases in productivity moderates the increase in wages, and if you look at the last three years it was 2.1, 2.1, and last year 1.9. The Federal Reserve targets 2% because they want to have some inflation, because they want you to be incentive to buy something today and not wait for it to be cheaper in a year. So at this point in time inflation doesn’t look too bad.
One of the things you always get a little concerned about, sometimes the Federal Reserve is so fearful of inflation coming up that in anticipation of it they raise interest rates. Sometimes in the past they have overdone it and caused a recession.
Economic growth … This right now are the four quarters. The first three have been reported. The fourth quarter, 2.5% is the best educated guess John Gullo, our chief investment officer, can make based on the facts. We don’t have the first reading, but that appears to be a very good guess at this point in time. When you add that together it makes 2.9% growth for last year, which is the best growth since the Great Recession.
Looking at the screen, the dotted yellow line is 2.2%. That’s the average since the Great Recession. Some people are disappointed with that, but it’s actually a pretty good number in the developed world. Many of us at my age remember when growth could be higher than that, 3.5% and so on. When I came into the workforce the workforce was going up 1.8% per year. That’s what it was doing in the ’70s and ’80s. Currently the workforce is going up approximately .4% per year, so GDP is output per worker times the number of workers. If the number of workers is going up slow, it makes it difficult to have big numbers of growth unless there’s a tremendous increase in productivity.
The Federal Reserve feels that our sustainable increase in GDP is 1.8, so 2.9% is actually a very good number. At this time the best guesses for 2019 are 2.2 to 2.5%, which is still very solid. We also have to remember we may have had a bit of a sugar high because we had a massive tax decrease in a time when the economy was relatively strong. The effects of that on a comparison basis are starting to wear out already.
The government shutdown … I indicated this earlier before. The longest prior to this was 21 days. This was 34 days, and hopefully we’re not going to have another one starting 12:01 midnight tomorrow. Now there are costs with the shutdowns. There’s loss of productivity of government workers. They have hours spent for the shutdown, preparing for the shutdown. They have hours spent re-gearing up. There is going to be retroactive pay, but many of the people got hurt by that. Statistics coming out say approximately 25% of the federal workers missed either a rent payment or a mortgage payment. Also approximately the same numbers tapped their retirement accounts, so this is a big deal.
There’s also lost revenue from government museums and parks, interest on missed payments. One of the big things that we found out with one of our clients is government contractors. We’ve all heard about the push for privatization, so we’ve had the private contractors doing the work for the federal government that maybe in the past was done by workers. Those people are not getting back pay, so the companies with that went without cash for approaching two months. That was hard.
There’s also economic disruption from delayed permit and licensing, a halt to the SBA loans, tourism disruption, lack of economic updates. John just updated two of these slides yesterday waiting for numbers to come out, and that’s real. A funny thing is two days ago on the news I saw Chuck Schumer in a microbrewery and he was complaining about the shutdown. This caught me by surprise, but apparently in order to sell certain kinds of microbrews you have to have it approved by the Bureau of Alcohol and Firearms, and if they’re closed down they can’t approve it, so it hits even areas you don’t think it would.
Interest rates … This has been on our minds for some time now. If you go back to January of ’16, the short term interest rate was virtually zero, .17%. Then in November 18 this hear it was up to 2.1, February it’s 2.41, so a very steady increase. That’s the gray line on the chart.
When you look at the 10 year Treasury, not as pronounced. It was 2.24 back in ’16. It peaked this year at 3.24, and right as of today as I’m dictating it, it’s 2.7. Now what’s happened here is the interest rate on 10 years versus one month are very tight together. What this means, it’s very hard to justify taking the risk of a 10 year bond to be paid very little above what a one month bond or a bill is giving you.
Also, one of the things that’s usually a very bad sign for the economy is what they call an inverted yield curve, in other words short term rates higher than long term rates. Yesterday the five year rate was 2.52. The two year rate was 2.53. So although that’s a minor inversion it is in fact an inversion at the lower end of the curve.
So as I mentioned earlier, there were nine rate increases in the US, four of which were last year, and we put a graph on that. If you go back to ancient history, that is December of 2018, the Federal Reserve dot plot said that we should expect two more rate increases in 2019. Now in the middle of February, the next year, the market is telling us to expect no more rate increases this year.
It still appears that there may be one or two this year, and there is it would be in the second half of the year, and it would probably be good news because it would probably mean that the economy is doing very well.
One of the things we’re concerned about is who absorbs the debt. If you go back to September 18, 2008, when Lehmann failed, the Federal Reserve’s balance sheet was approximately $880 billion. At that point in time we were concerned that the entire world’s economy might fold, or at least the banking system may fold, so there needed to be help. The US government on fiscal policy limited its help to the TARP. TARP was $700 billion. Bush got to spend 350 of it, Obama 350 of it. Between the two, they helped the banking system, and the automobile industry arguably was saved, but that’s all we could get done for physical stimulus.
Fortunately, the Federal Reserve is independent and the other central banks are, so they said they wanted to in effect lower interest rates, but the US didn’t want to lower it below zero. So a way to effectively lower interest rates was quantitative easing, in other words going out and buying a whole bunch of bonds, Treasury securities, mortgage backed securities, and others.
This lowered the interest rate, and the reason you want to do that … For instance, if your mortgage rate is 3.5% instead of 5.5 or 6%, you’re encouraged to buy a house, et cetera. The balance sheet was built up to about $4.5 trillion. For approximately a two year period of time the Federal Reserve reinvested all the maturities. Starting a little over a year ago, they started allowing the maturities … Some of them not to be reinvested.
Currently we’re doing $50 billion of that per month, so we have lowered the balance sheet. We’re not sure where the balance sheet is going to end up. Most people think between $2 trillion and $3 trillion dollars, as illustrated on our chart. So right now at $50 billion a month, or $600 billion a year, the market has to absorb that additional US borrowing, and there’s deficits.
If you look at the US government deficit right now, it was $751 billion for the nine months ended September 30th, even though we had a very strong economy. Now there was only nine months of the tax cut in that. It’s estimated that the US deficit will increase by $5 trillion over the next five years. When you add that to probably about $2 trillion of quantitative tightening, the market has to absorb $7 trillion of additional US debt.
We think the only way the market will do that is if you increase interest rates. After all, one of the big buyers, the Federal Reserve, isn’t going to be buying. Another big buyer is the US government itself, Social Security in particular, and that’s no longer running in excess, so two of the big buyers are gone. It has to be US and foreign investors, thus interest rates going up. That’s one of the reasons we’re being very careful with our maturities on the bonds.
2019 and beyond … When President Trump was elected we had these soft sentiments. Soft factors soared because we thought we had a president that was going to be very pro business, reduce regulations, et cetera, so these surveys were positive. The hard data followed later. So the surveys were positive first, then that led to action, which led to good hard numbers.
Purchasing managers survey has reduced, still at a good level, but it’s reduced from where it was, and there was a bit of a recovery last month. Small business optimism, however, is not recovering. As you can see, that’s a pretty sharp drop. Small businesses creates the majority of new jobs, so this is a concern.
Another area is consumer confidence. The US economy is driven 70% by the consumer. If you decide to wait until next year to buy a car or a washing machine, or if you decide to go to Cedar Point for a vacation instead of going to Disney World it hurts the economy. So consumer confidence is still high, but it’s getting lower at this point in time, so it’s a warning going forward.
Expansions and contractions … We are now in the second longest expansion ever, 116 months. The biggest between 1991 and 2001, basically the technology surge, was 120 months. It doesn’t mean that we’re going to end at 120 months, but it’s something to be cautious about. There’s a reason history is a required course.
Now we think that we can go beyond 120 months. Why is that? Well, if you look at … We already talked about we had a relatively slow but steady increase in GDP, which basically stops excesses from being formed too fast, which causes some recessions. Another way to look at it is the business cycle. If you go from the peak of one cycle to the peak of the next and measure the increase in GDP, approximately 23.2% is the average. We’ve currently increased from the last peak GDP 19%, so we have a way to go prior to hitting the average.
Also, as you can see on the chart, there are four times when we went beyond the average. So in other words this appears likely that this will be the longest expansion ever.
The looming budgetary deadline … I’ve talked about this more than I want to, but at this point in time we don’t know. This creates uncertainty. It’s not good news. Hopefully it looks this time that we will have an agreement and that this just becomes a historical footnote, but 12:01 am January 15th, right now we could have another slowdown. I read the news this morning, which is on the 14th, and there’s still not a for sure agreement.
There is a cost to the shutdown. Not just the human cost, but an economic cost. Roughly it’s estimated that for every week the government is partially shut down the GDP goes down 1/10th of 1% per week. Some of it will come back, but some of it won’t come back. Whatever the first quarter GDP growth is, it’s going to be lower than it would have been had there not been a shutdown, and hopefully there’s just going to be the one.
One of the things, particularly those who have known us for a long time, we are concerned about valuations, because they do in fact matter in the long run. One of our favorite measurements is the cyclically adjusted PE ratio, or Shiller ratio, named after the Nobel Laureate economist of Yale. What he has said is in effect public companies may be able to slightly manipulate earnings on a quarter-by-quarter basis, even a year-by-year, but for 10 years it’s a pretty accurate indication of the money made.
So what he does is goes back and takes 10 years of earnings adjusted with inflation and compares it with the long term average. If you go back to 1947, the average in the US was 19.06%. As you can see in the chart, we were well over 30 a couple of times recently. Currently we’re in the high 20s, so on a relative basis we’re higher than normal.
That has some predictive qualities. So what that would say is to expect over the next cycle to have the US returns be less than normal. On a relative basis, as you can see on the chart, both foreign developed, the dark line, and the gray line, emerging markets, are well below the long term average of the US and well below the US on a relative basis.
Some people say that those long term numbers are a bunch of bunk. We like them, but we also look at the short term valuations. So as of January 31st what are the short term measurements? Price to book, the US is selling at 3.2, for developed international 1.5, for emerging markets 1.6. The US is twice as expensive on that basis.
Some people feel the only thing that really matters is free cash flow. How is that? The US is selling at 13 times cash flow, foreign developed 8.5, and emerging markets 8.1. The US is most expensive by a wide margin.
Other people say the only thing that really matters is the PE ratio. Many PE ratios are quoted. What we like is the trailing, because it is historical. Many times forward PE ratios turn out to be overly optimistic. On the 12 month trailing as of January 31st, the US is selling at 19.6, foreign developed 14, and emerging markets 12, so in all the current valuations the US is the most expensive, and by some margin.
Another way … What about for buy and hold people that really want dividends? The US is 2.1%, foreign developed 3.5, emerging markets 2.8. So all of these measurements, it’s hard to argue that the US isn’t the most fully priced, if not in fact overpriced.
Geopolitics can matter in the short term. Again, right now technically March 1st there’s going to be a 25% tariff on most, if not all, of the Chinese imports. That’s a big concern. If you look at some of the large retailers, for instance Walmart, the shelves would have a lot of room on it if you eliminate everything that comes from China.
Also, my iPhone cost a fair amount of money. If I had to pay a 25% tariff on the components of it, that would be a lot more expensive again, so this is a big deal. It’s a big number. And as I mentioned earlier, currently the president is hoping for a 60-day extension in this and hopefully will have some kind of reasonable, even if it’s a partial agreement, to take some of the sting out of these tariffs.
The US dollar is affected by tariffs. As we mentioned earlier, in that May to September period of time when the US market did so well and the emerging markets did poorly, the US dollar also went up on a relative value. Our exporters, manufacturers, and farmers hopes that the US dollar goes down to make their exports more attractive. Many times we, as consumers, like a strong dollar because we can buy things cheaper that we import. Over the long run, probably having the US dollar a bit weaker makes more sense. It also in theory makes it easier to repay debt, and as we talked about earlier, the US is certainly going to have a lot of accumulated debt. A big deal this week, we topped $22 trillion on accumulated debt. That’s an all-time record.
As we talked about interest rates, US short terms going up, the 10 year not going up nearly as much, there was a real fear of a bond inversion, and as I mentioned that many times is a forward warning to a recession. So what the people are worried about is that the Federal Reserve could crush the momentum in the economy. It was wonderful that Chairman Powell came out and said that they will be patient in evaluating the outlook before making any other adjustments, and this is a big part of what’s driving the current rally.
In conclusion, 2017 is gone. 2018, with all the volatility, is much more normal. Expect more volatility going forward. Also, because interest rates on the long term are so close to the short term, it’s hard to justify having long term maturities at this point in time, so shorten your bond holdings.
Another thing to keep in mind, look at where you have your equity dollars. Embrace foreign stocks. Yes, the US has led on a five-year basis, but a long time ago, 2017, emerging markets were the best, foreign developed the second, and the US the third. Looking forward, that appears to be likely again. The US produces 26.5% of the world GDP. That’s about half the world’s stock market.
It’s hard to argue that for a long term basis that one should be heavily overly allocated to the US at this point in time. Foreign developed is 35.6% of the market, and emerging markets is 37.8% of the world’s GDP. We think, and there’s pretty much a consensus across the board of people in our industry that the best equity asset class over the next market cycle will be emerging markets. It was in ’16, ’17, and even last year where it was bad on an overall year basis, it led in the first and fourth quarter.
Next, the cheapest insurance involved is being broadly diversified. One might try and guess what will be the best asset class, but over the long run if you’re well-diversified you will on a risk adjusted basis have the best return. Thank you very much.
This publication contains general information that is not suitable for everyone. All material presented is compiled from sources believed to be reliable. Accuracy, however, cannot be guaranteed. Further, the information contained herein should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this publication will come to pass. Past performance may not be indicative of future results. All investments contain risk and may lose value. © October 2019 JSG