Dear Clients and Friends:
4th Quarter Market Commentary:
Going into 2019, few investors expected global equities to recover all the value lost in Q4 of 2018, and eclipse previous market highs that were set in January of 2018 by 8.0%. As has been the story of the current economic expansion, this year’s equity returns were buoyed by global central bank intervention. U.S. stocks (+31.6%) outperformed most international markets and the overall global equity index (+27.3%) as well in 2019
U.S. equity markets were once again led by the technology sector. Strong equity market performance is usually commensurate with significant growth in corporate earnings. However, this was not the case in 2019. As the impact of the 2017 tax bill waned, this past year saw a decline in capital investment by U.S. companies. Many firms remained cautious due to a slowing global economy and increased market risk related to trade issues and other geopolitical events. Annual earnings for the S&P 500 companies in 2019 are expected to be basically flat. International corporate profits are more concerning, with most regions expecting earnings to decline for the year. This could provide a somewhat fragile underpinning for equity markets going into 2020.
The fourth quarter saw an expected end to U.S. interest rate cuts for the foreseeable future, as the Federal Reserve signaled it currently expects to make no changes to the Fed Funds rate until 2021. While still accommodative, U.S. central bank policy now stands in contrast to other major central banks (such as the European Central Bank, the Bank of Japan, and the Bank of China), where monetary and fiscal stimulus remains more significant. Emerging markets provided market leadership during this past quarter, as markets began to expect progress on U.S. – China trade negotiations.
While U.S. monetary policy had a positive material impact on equity markets in Q4, the impact on bond markets created a much different result for fixed income returns. As seen in the Chart below, the overwhelming majority of the 2019 bond performance came during the first three quarters of the year.
Bond markets witnessed a decline in interest rates during much of 2019, driven by decreases in the Fed Funds rate and tightening credit spreads. We expect bond yields to be range bound in 2020, with the Fed on pause, unless the U.S. unexpectedly experiences a material economic slowdown. Investors also need to consider that U.S. corporate bond spreads are near the low end of their range over the past 20 years. We believe the current environment will provide a material drag for the bond market going forward. As a result, we anticipate bond returns in 2020 will be roughly equivalent to their current interest yields.
As markets transition to 2020, investors are faced with such bullish signals as the pricing of market risk; declining corporate bond spreads (implying that markets are assigning a particularly low probability to companies defaulting on debt); increasing equity price-earnings multiples; and a historically low level of the VIX volatility index. However, the market’s increasing bullish sentiment is in contrast with fundamental economic data. While the overall business environment generally stabilized midway through 2019, the picture is currently much more mixed than the stock market may indicate.
The bright spots are mostly related to the consumer. These include strong wage growth, historically low unemployment rates, and rising home values. These data points are significant given that roughly 70% of U.S. GDP comes from consumer spending. Other segments of the economy remained weaker at year-end, such as manufacturing activity, corporate capital investment, and the U.S. Conference Board’s Leading Economic Indicators. In many respects, U.S. consumer and business data are currently at odds with one another. As we enter the new year, this poses the question whether consumer spending will eventually drive more business investment and better corporate earnings growth, or will the consumer become less optimistic in line with the current economic indicators?
Additionally, while overweighting U.S. equity markets has been an easy and consistent way to add outperformance in the past, we think this dynamic will not be as favorable going forward. Looking ahead, investors will likely need to be more flexible and responsive to new information and changes in trends.
While the current expansion is now in its eleventh year, we believe there is more room for moderate economic growth and positive equity returns in 2020. We do not expect a recession this year, and we anticipate U.S. corporate earnings to shift back to positive growth. We also expect U.S. GDP growth of around 2% for the year. While we believe 2020 will provide moderate equity returns and fixed income returns roughly equivalent to current yields, we also believe that potential market risks are increasing. This coming year is likely to be more volatile, and geopolitical concerns on several fronts are growing. In this environment, investor should anticipate lower asset returns. Sound asset allocation and diversification will be important and valuable in 2020.
Performance contributors & detractors
- Strategic positioning: Our continued overweight to U.S. stocks added value to our client portfolios as the domestic markets slightly outperformed overseas equities. Within our foreign stock exposure, our emphasis on emerging market stocks helped as this area had substantially better returns than their developed country counterparts.
- Structured Notes: These were a mixed bag this past quarter: small cap notes outperformed their equity benchmarks, while large cap and international lagged slightly.
- Equity Funds: Our two active US large cap managers outperformed in the fourth quarter and for the year. The managers who give us foreign, developed country exposure were particularly strong during both Q4 and for 2019. Our two Pacific Rim funds lagged the markets and were sold as described further on in this letter. Our broad-based emerging market fund experienced benchmark like returns for the quarter and a very strong year overall.
- Fixed Income: While lagging the markets slightly in the fourth quarter, our bond exposure added slightly more than 1.0% higher returns than the index for the calendar year.
- Alternative asset exposure: In aggregate, our stable of alternative holdings performed in line with the fixed income markets, experiencing very tepid returns. This is not uncommon during times of very strong equity performance. The managed futures and reinsurance asset classes both experienced weak periods.
- Structured Notes: Over the course of the fourth quarter, we had two notes mature:
- A 12-month S&P 500 note that returned 11.65% while the index was up 12.33%. This was the modest “cost” of having a 10% protective buffer, that in retrospect, was not needed.
- A 30-month Russell 2000 (small cap, US stocks) note that returned a healthy 32.80% when the index only increased 16.83%.
- We reinvested part of the funds into a new S&P 500 note we created with the following terms:
- A 16.5-month term with a 5% downside buffer and 2X the return of the price index up to a cap of 17.40%.
- We are currently pricing two new S&P 500 notes into which we will invest the remaining funds shortly.
- Finally, you may have noticed significantly fewer holdings in your portfolio. Previously, we had a separate, dedicated investment to hold new client deposits that would then get invested into each individual note when we created them. We have been able to consolidate all of these holdings into the Vanguard Total World Stock Index ETF. Technology has now enabled us to accurately allocate the proper amount from this holding into each new note that we create.
- Manager change: As mentioned earlier, we sold the Matthews Pacific Tiger and Matthews Asia Dividend funds, one of which we owned for eight years and the other for four years. The proceeds were reinvested into the JP Morgan Global Allocation and BlackRock Global Allocation funds. This was one change in a multi-step process that is designed to accomplish a few adjustments to our model portfolios:
- Reduce the overweight to emerging markets within our foreign stock allocation;
- Eliminate the dedicated exposure that we had to the Asia-Pacific Rim area;
- Continue to gradually reduce our substantial overweight to US stocks;
- Bring our overall equity risk closer to parity with the global stock index.
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.