October 16, 2018
Dear Valued Clients and Friends:
Third Quarter 2018 Market Commentary:
As we send you this third quarter commentary, the stock market is experiencing some negative volatility after six months of fairly steady gains. In two short weeks, observations about the last quarter can feel somewhat out of touch with where we are today. Keep in mind that these price fluctuations are not only expected but necessary for successful investing. Investors historically have received greater returns from stocks than other less risky investments due to something called the equity risk premium. The premium is the long-term reward for taking on the risk of volatility. Without equity risk there would be no premium.
With that in mind, let’s look backward at the quarter that just ended. Summers are usually quiet, but this past one felt extraordinarily serene. During the third quarter, the S&P 500 neither gained nor lost more than 1% in any trading day. The two prior quarters experienced thirty-six days (one or two a week on average) with at least a 1% move. That was quite the summer vacation! This point illustrates the theme for the quarter: inertia. Those economic and market forces in motion in the first half of the year stayed in motion in the third quarter.
Economic and survey data remains positive: 75% of indicators rate “strong”, while only commodity prices scored poorly. We have been observing the increasingly strong consumer confidence data along with nearly 3% wage growth and it seems to support the consumer-as-the-engine-of-growth story. We think this delays U.S. recession risk.
Table 1 shows the results of major stock and bond markets. Domestic stocks pressed higher. Emerging markets again were the weak link in global equities, as trade concerns continued to weigh on their more export-intensive companies. Bond prices continued to fall as ten-year rates moved up 0.2% in the quarter. The U.S. bond market return for the quarter was flat because income perfectly offset the price decline. The Fed raised short-term rates by 0.25% last quarter, just as they did in the second quarter and as they are expected to do in the fourth.
When the markets take a volatility vacation, it provides an opportunity to zoom out for a longer-term view. We passed a milestone last quarter. It has been ten years since the depths of the Great Financial Crisis. The decade since has seen a few dominant themes: a strong equity market rally led by the U.S., in particular technology stocks; the continued economic emergence of China; and persistently low interest rates manipulated by extraordinarily accommodative Central Bank policy but without associated problems with inflation. Taking the wide-angle, decade-long view is helpful, as we are long-term investors, but it also creates competition between two reads on the themes, the optimistic (this is the new normal) and the pessimistic (something’s gotta give). We think this is particularly true of three big questions.Table 1 shows the results of major stock and bond markets. Domestic stocks pressed higher. Emerging markets again were the weak link in global equities, as trade concerns continued to weigh on their more export-intensive companies. Bond prices continued to fall as ten-year rates moved up 0.2% in the quarter. The U.S. bond market return for the quarter was flat because income perfectly offset the price decline. The Fed raised short-term rates by 0.25% last quarter, just as they did in the second quarter and as they are expected to do in the fourth.
First, why do we invest in non-U.S. stocks? Why buy anywhere else when the U.S. has outperformed by 6% a year over the past decade? Our answer is that there are many periods when non-U.S. wins. If we were writing this commentary ten years ago, the story would be flipped. Developed non-U.S. stocks outperformed by 2.5% and emerging markets won by a whopping 11.5% over the ten years prior (1998 – 2008). A more scientific approach that examines all three-year periods since the early 1970s shows that non-U.S. outperforms 44% of the time. It’s not normal for the U.S. to always outperform so we should hold a meaningful portion of our equity target allocation in non-U.S. stocks.
Second, why bother with bonds in this environment? Recently we have finally seen something start to give as ten-year rates have moved above 3%. We can see the trend continuing so we control for interest rate risk (the chief risk of high-quality bonds) in the portfolio and currently have reduced it below the benchmark. However, we do not set it at zero; some interest rate sensitive bonds are worth owning because they have a good chance of performing well if the stock market surprises to the downside. We also search for other strategies that can play a diversifying role in portfolios similar to bonds but without the interest rate conundrum. Examples of these are reinsurance, liquid multi-strategy funds and managed futures.
Last, is the bull market about to give? Everyone knows uninterrupted stock appreciation is not normal. Even without an economic downturn or recession, there are typically periods when the market takes a pause or even corrects a bit. We do not know when, but we expect some kind of correction along the way. It is helpful to understand the downside risk in your portfolio related to an equity sell-off. Our Balanced portfolios, for example, which represent the middle range in risk tolerance, can expect to participate in about 40-60% of equity downside. In the event of a 10% stock market correction, this would mean a portfolio decline of about 5% give or take. We regularly review these risk tolerance issues when we meet with our clients. Prior to experiencing a correction this remains hypothetical. Before or during the next market correction, do not hesitate to talk with us about your expectations and reactions to make sure you remain properly allocated.
Client portfolios benefitted from positive equity market performance and the calming of bond headwinds during the third quarter. Portfolios continue to be well served by active managers on both the equity and fixed income sides as both have contributed outperformance this year. The previously mentioned underweight to interest rate sensitive bonds has also been a win for investors. In the alternatives section, strategies that act as natural disaster reinsurance (Stone Ridge) are contributing this year as hurricane season, so far, has been calmer than last year. Some style judgements – that small caps will outperform large caps and emerging markets will outperform developed markets – detracted this quarter. Nonetheless, this positioning is supported by long-run analytics that do show short-term periods when this decision does not work, but a higher success rate during longer horizons.
The world, and the U.S. in particular, continues to negotiate the rules of global trade. Britain is fast approaching its deadline to finish negotiating how it will interact with the European Union going forward. Both matters hold potential for surprises. But, as of this writing, we do not see anything here that changes our thoughts on portfolios. The recent news of a new trade deal between the U.S., Canada, and Mexico is a positive.
Regardless of when we hit the next volatile patch, our advice, as always, is to prepare now by affirming your portfolio has been designed with the right amount of risk for you. As always, we appreciate your trust in us and are grateful for the opportunity to serve you. Should you have any questions or concerns, please contact us at any time.
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Sources: Bloomberg, Keel Point, Tamarac