Investment Update from James C. Baird, Founder

October 14, 2019

Dear Clients and Friends:

3rd Quarter Market Commentary:

The 3rd quarter presented investors with a continuation of themes that have been permeating capital markets, namely U.S. large cap leadership within the equity market, declining U.S. interest rates and sporadic market volatility caused by a myriad of geopolitical issues.  Below is a summary of quarter-end performance for major market indices.

The S&P continued to lead the equity market with a positive return during the 3rd quarter, while emerging markets continue to be the weakest performer amongst the major equity market indices.  U.S. investment-grade bonds (both Treasuries and corporates) have performed exceptionally well this year, as U.S. interest rates continue to decline.  The 10-year Treasury yield finished the quarter at 1.67%, a 0.34% decline during the quarter and a 1.02% decline for the year.

It is undeniable that the global economy has been experiencing a growth slowdown, led by China and a worldwide slump in manufacturing.  Data also suggest that the U.S. economy is holding up reasonably well, driven by a tight labor market and strong consumer demand.  Investors are also grappling with a geopolitical landscape that is becoming more complicated and influential in market performance.  In this environment we are seeing two competing narratives emerging for investors to consider going forward – one bullish and one bearish.

The bullish narrative is predicated on the notion that the shift this year toward increased monetary stimulus by the U.S. Federal Reserve and other global central banks will begin to improve global growth, as it did in 2012 and 2016. This should create a renewed positive backdrop for equity markets to finish the year.  The competing view argues that the effectiveness of monetary stimulus after a decade of post-financial crisis policy is waning, the economic downturn in China and Europe will continue, and that this will increasingly weigh on U.S. growth.

While economic data has deteriorated since October of last year, we do not believe the U.S. economy is going into a recession within the next six months.  We observed that U.S. economic data improved moderately during September, from mostly negative to a more mixed outlook.  We also noted that 2nd quarter S&P earnings quietly came in above expectations with positive year-on-year growth (expectations were for a decline in annual earnings).  However, we also believe the geopolitical landscape is deteriorating and becoming more of a challenge for investment returns.  The issues impacting markets include the U.S.-China trade negotiations, Brexit, the Hong Kong protests, and impeachment.  A negative outcome with respect to any of these issues has the potential to cause a significant selloff in equity markets.

While we do not think a recession is imminent, we do see market risk increasing going forward.  We believe this is an environment where investors should have a balanced posture and stick close to their long-term portfolio risk target.  We do favor an overweight to U.S. equity exposure based on the relative strength of the U.S. economy.

Performance contributors

• Strategic positioning: Our continued overweight to large cap, U.S. stocks added value to our client portfolios as the S&P 500 continued to outperform small cap equities as well as both international developed and emerging market stocks.
• Structured Notes: All nine of the notes that were in place for the entire quarter outperformed their equity benchmarks.
• Alternative asset exposure: In aggregate, our lineup of alternative holdings increased about 2.5% for the quarter, which exceeded both stock and bond indices over that period. On the equity alternative side, our US REIT ETF grew by 7.6%. In the fixed income alternative sleeve, our managed futures and gold positions continued to do well, with both increasing over 4%.

Performance detractors

• Overweight to Emerging Markets: the ongoing trade war tensions between the U.S. and China continued to penalize the emerging markets overall relative to equity returns in developed countries. However, all three of our managers outperformed the index for the quarter, and our holding that emphasizes high dividends especially helped to cushion the price declines in this area of client portfolios.
• Fixed income underweight to Treasury bonds: When we construct our client bond holdings, our firm uses a market benchmark that has a lower exposure to U.S. government bonds and a higher weighting of investment grade corporate holdings. In times when interest rates drop significantly, government bonds typically outperform other areas of fixed income. That was the case this past quarter where the Barclays US Aggregate index (treasury heavy) increased 2.3%, whereas the Government-Corporate index appreciated just 1.4%. However, four of our six managers were able to match or slightly exceed the return of the treasury-heavy aggregate bond index due to favorable positioning of their respective portfolios.
• Fixed income exposure to global bonds: One of the lagging bond funds invests world-wide and the global index declined this past quarter, unlike the U.S. bond market. However, the Hartford fund we own actually managed to gain about 0.6% despite this negative environment for foreign bonds.
  Portfolio changes

• Structured Notes: In late September, we had a five-year note mature that was tied to the MSCI EAFE index (international, developed market stocks). Over this period, the index barely moved, closing up 0.09%. The note returned us 0.15%. We reinvested the proceeds into three new S&P 500 notes we created:
  • A 13-month note with a 5% downside buffer and 2X the return of the price index up to a cap of 14.3%;
  • A 15-month note with a 5% buffer and 2X leverage to a cap of 16.5%;
  • An 18-month note with a 5% buffer and 2X leverage to a cap of 19.8%.

We continue to be very cognizant of having Structured Note proceeds maturing every month or two to minimize the reinvestment risk we incur when creating future notes. Also, we have been shortening the overall length of our note portfolio as a way of further guarding against a market environment with a significant number of major short-term systemic and geopolitical issues unresolved.

This recent change to our note portfolio will not be further overweighting our exposure to U.S. large cap stocks. This is step one of a two-step process. We will soon be replacing a U.S. large cap ETF (exchange traded fund) that we own with one or two active funds with exposure to international developed stocks. So effectively, the MSCI EAFE note that matured will be getting replaced by an active manager or two; the three new S&P notes that we created will be replacing a large cap U.S. ETF.

• Manager change: For quite a few years, we have had a portion of our international equity money invested in overseas small-cap growth stocks. Exposure to this part of the market has added considerable value during the bull market, but the performance of our long-standing fund had been below its peers recently and they were suffering significant asset withdrawals. After having a call with their portfolio team and doing due diligence on several alternative options, we decided to move our position into the Brown Capital Management International Small Company fund. Brown is a 36-year-old boutique firm in Baltimore that specializes in small cap growth stocks. In addition to lowering expenses, reducing turnover which leads to better tax efficiency, we believe the very tenured and credentialed team that is managing the Brown portfolio will also give us more predictable and stable returns going forward.

Securities offered through APW Capital, Inc., Member FINRA/SIPC. 100 Enterprise Drive, Suite 504, Rockaway, NJ 07866 (800)637-3211.
This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable. This presentation may not be construed as investment advice and does not give investment recommendations.
The securities presented may not be representative of the current or future investments for Compass Ion clients.
Additional information, including advisory fees and expenses, is provided on Compass Ion’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Compass Ion does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The investment return and principal value of an investment will fluctuate so that an investor’s portfolio may be worth more or less than its original cost at any given time. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.