April 16, 2018
Dear Valued Clients & Friends:
First Quarter 2018 Market Commentary:
As highlighted in our last Market Commentary, we have been expecting equity market volatility to return to more normal levels on the backdrop of rising interest rates. The combination of increased equity volatility and rising interest rates is a rare market environment, as rates tend to fall when equity markets get more volatile; however, we believe that the extensive central bank intervention since the financial crisis has caused the equity and bond markets to be more closely linked than they have been in the past. Both equity volatility and interest rates rose over the first quarter of 2018, and we expect this environment is going to persist in the near term.
|Figure 1: Global Earnings Growth Consensus|
|2018 Year over Year Growth Estimate||21.5%|
|2019 Year over Year Growth Estimate||9.9%|
|2020 Year over Year Growth Estimate||9.0%|
|Long Term Growth Estimate||9.6%|
Despite our expectations of higher equity market volatility, our outlook for 2018 remains positive for stocks given consensus expectations related to global earnings growth (See Figure 1). The positive trend in corporate earnings led equity markets to record highs in January. So far, second quarter earnings are also coming in strongly. If the trend continues, markets should follow – even if the ride is bumpier than in previous years.
Recent concerns about global trade are currently providing headwinds for markets, as increased barriers to global trade can have a materially negative impact on earnings – especially related to large cap companies. Compass Ion has been particularly attuned to this risk and its potential impact on markets, as we continue to assess President Trump’s evolving proposals related to tariffs and NAFTA.
After years of strength in traditional equity and fixed income markets, there has been a significant flow of capital into passive investing. In recent years, active managers have struggled to generate returns that justify their fees, while the prolonged outperformance of the S&P 500 has made the case for a globally diversified portfolio difficult. Compass Ion believes a more balanced investment approach is warranted for the longer term, and that the merit of both active management and diversification will be clearly seen during periods of market disruption. We were, therefore, pleased with the performance of client portfolios in February and March, as we observed our active managers and diversified exposure generally adding value relative to risk benchmarks during a period of increased market fluctuations and negative equity returns.
Despite the market trends of the last few years, Compass Ion has continued to advocate for globally diversified portfolios, through exposure to both active and passive investments, as we believe performance trends will inevitably fluctuate through time and that diversification will provide more downside protection during market corrections.
Capital Markets Update
After equity markets reached a new high on January 26th, the MSCI All Country World Index (“ACWI”) lost 7.78% to finish the quarter down 1.03%. Interest rates continued the upward trend established late in 2017, causing the Barclays US Aggregate Bond Index (“AGG”) to finish the quarter worse than equities, down 1.46%. Investors saw the rapid return of volatility. The level of the VIX, a measure of market volatility, more than doubled on February 5th—the largest percentage increase the VIX has ever experienced over a single day.
Globally diversified investors were rewarded during this drawdown period, as US equity markets experienced more severe losses than global equity markets. The S&P 500 Index (“S&P”) was down 10.10% from the high at its worst point, while the ACWI only lost 8.98% over the same period (see Figure 2). In addition, allocations to small cap equity added value during the drawdown by outperforming both the ACWI and the S&P.
As previously mentioned, actively managed strategies have generally struggled to outperform benchmarks in recent years. Active equity managers have had a particularly difficult time relative to passive ETF’s and often point to the lack of market volatility and the lack of dispersion within equity markets to explain their difficulty in keeping up with their passive peers.
Though Compass Ion is hesitant to place too much weight on performance over such a short time frame, the first quarter did provide some indication of active managers’ ability to navigate volatile market environments. Given our expectation that the market volatility in the first quarter is likely to continue, we were particularly interested in these results.
The first quarter was promising for active management, with Morningstar’s World Stock Category Average (a composite of actively managed equity funds) outperforming the ACWI year to date by 0.62% and Morningstar’s Intermediate-Term Bond Category Average (a composite of actively managed fixed income funds) outperforming the AGG by 0.13%. We would expect even better results from the active managers we incorporate into our equity and fixed income allocation since our manager selection process attempts to eliminate “closet indexers” to avoid paying managers that are not truly active. To that point, six of the seven actively managed equity mutual funds in Compass Ion model portfolios, outperformed the ACWI, with the entire group earning an average of 1.78% more than the benchmark. The performance of these managers during a period of negative equity returns is one of the primary reasons why Compass Ion prefers to allocate a portion of our equity exposure to active management.
On the fixed income side, the unconstrained bond category comprises a group of funds attempting to allocate within fixed income markets such that they generate positive returns, even in periods of rising rates. To this point, Morningstar’s Non-Traditional Bond Category Average was up 0.16% while the AGG declined by 1.46%. Within this area, our two managers performed even more strongly, with the Blackrock Strategic Income Opportunities Fund and the Goldman Sachs Strategic Income Fund up 0.43% and 0.63% respectively for the quarter.
Additionally, four of our five remaining bond managers outperformed the AGG, with this overall part of the portfolio declining 50% less than the benchmark.
|Figure 3: Economic Indicators for Consumer Spending|
(Last 7 Years)
|Consumer Confidence (as of 3/31)||127.7||90.3|
|Wage Growth (as of 3/31)||2.6%||2.2%|
|Unemployment Rate (as of 12/31)||4.1%||5.7%|
Although early indications in April signal a continuation of the volatility seen in capital markets during the first quarter, Compass Ion remains optimistic about equity markets, as well as the positioning in our client portfolios. While this year is likely to be more volatile than previous years, our expectations around earnings growth—and thus, market returns—remain positive. With strong readings of unemployment, consumer confidence and wage growth relative to historical averages (see Figure 3), consumer spending, which is the primary driver of corporate earnings, should continue to increase.
Our view of the current market environment is that the recent increase in market volatility is more of a return to normal market behavior than an indication that a recession is imminent. As we have discussed previously, the average intra-year correction for the S&P is roughly 14%, so the volatility experienced thus far in 2018 is still well within historical norms.
For Compass Ion clients, if the value provided during the first quarter by our diversified portfolio positioning and our actively managed strategies continues, portfolios should be well positioned for volatile markets during the rest of 2018.
Year-to-Date Portfolio Updates
Thus far in 2018, we have made several portfolio changes to reposition our clients’ equity exposure. These are highlighted below:
- In January, we rotated out of some U.S. large cap active equity managers. Our goal was to better target the risk level of our equity holdings to be more in line with the benchmark. We invested the proceeds into the SPDR Total Market Cap Index ETF (SPTM), as an extremely low cost way (0.03% expense ratio) to get pure U.S. market exposure (beta) across companies of all sizes.
- In early April, we created four customized Structured Notes. There were numerous reasons for these changes as described below.
Note Maturity and Early Liquidation: One of the new notes was funded via the maturity of an EAFE Structured Note at the end of March. The EAFE index is made up of the stocks of international developed companies domiciled primarily in Europe, developed Asia, and Australia. This 18-month EAFE note was obligated to pay clients a fixed 13.25% return if the EAFE Index had increased in value at maturity, which it did. Our investment committee also decided to liquidate three S&P 500 notes prior to their maturity. Two were significantly appreciated with 29.83% and 28.33% returns, and were approaching their maximum return caps. Hence, the remaining upside of these notes were limited. The third S&P note was also positive with a 9.08% return, but we chose to liquidate this one as part of our plan to trim U.S. large cap exposure.
Asset Class Decisions: Our investment committee also decided to bring the balance between U.S. and international equity exposure more in line with the MSCI All Country World Index, which is about 53% comprised of U.S. stocks. Pricing for international Structured Notes provided significantly better terms than U.S. exposure. This allowed us to capitalize on that pricing disparity while also helping to reposition our U.S. vs. international equity weightings. Previously, our portfolios were about 65% U.S. stocks and 35% international. Clients’ equity weightings are now about 57%-43%. We also made a small shift from U.S. large cap to small cap stocks to better align our portfolios with the index.
Note Structure and Timing: One of the key benefits of using Structured Notes is their ability to provide protection against moderate market losses at maturity via their protective buffers, which are based on the index level at the note issuance date. Liquidating the old notes allows us to “step up” these buffers to the much higher current levels of market indexes. All four of our new structured notes have 10% buffers, meaning they provide first dollar protection against market losses “at maturity” of the notes.
Additionally, EAFE terms were not that attractive. By combining broad Europe exposure via the Euro Stoxx 50 index, along with Japan and U.K. exposure, we’re able to essentially replicate the EAFE market, but achieve much better terms on behalf of our clients. Lastly, the Russell 2000 Structured Note has the longest maturity as the terms for shorter term notes were unfavorable in the U.S. small cap marketplace.
As always, we seek to make sure our entire portfolio of note maturities are well staggered to help smooth out the payoff profile and limit reinvestment risk. For additional details on this note and structured notes in general, please read “April 2018 Structured Notes Program” PDF.
Final Note Terms: A different investment bank received the winning bid for each note.
- Broad Europe Note: Euro Stoxx 50 (SX5E)
- Term: 14 months
- Buffer: 10% geared
- Leverage: 1.815x
- Max ret: Uncapped
- Bank: Morgan Stanley
- Japan Note: Nikkei 225 Index (NKY)
- Term: 23 months
- Buffer: 10% geared
- Leverage: 1.4x
- Max ret: 61.6%
- Bank: Deutsche Bank
- U.K. Note: FTSE 100 Index (UKX)
- Term: 26 months
- Buffer: 10% geared
- Leverage: 2.355x
- Max ret: uncapped
- Bank: BNP Paribas
- U.S. Small Cap Note: Russell 2000 Index (RTY)
- Term: 32 months
- Buffer: 10% geared
- Leverage: 1.3x
- Max ret: 42.12%
- Bank: Goldman Sachs
We are honored to serve you and would welcome any questions or comments you may have.
James C. Baird, Chairman | Founding Principal
Compass Ion Advisors, LLC