Wealth Solutions for the Elite Investor

Market Recap

What a difference a year makes. While in 2018, it was very difficult to make money in financial markets, in 2019 pretty much everything went up. Our portfolios meaningfully participated in the global equity rally. And portfolios with fixed-income allocations benefited from the fall in interest rates/rise in bond prices last year that surprised most Wall Street strategists.

You might be wondering why both stocks (risky assets) and bonds (defensive assets) appreciated sharply in 2019? They tend to move in opposite directions. The last time bonds had a similarly great year, the stock market fell in the last-leg of an extended bear market. The reason for the atypical pattern this time was the Federal Reserve’s sharp U-turn in monetary policy. The Fed had been raising interest rates in 2018, but in the face of a weakening global economy, they switched gears and actually cut rates three times in 2019. Late in the year, the Fed also began injecting liquidity into the short-term lending markets.

U.S. equity investors responded to Fed easing much as they have during the past decade—by bidding up stock prices regardless of already high valuations and a lack of earnings growth. The completion of a “phase one” U.S.-China trade deal further boosted sentiment.

Major central banks in Europe, China, and elsewhere also cut rates or provided additional monetary stimulus. This and an increased probability of an orderly Brexit helped European stocks gain 9.9% in the fourth quarter and 24.9% for the year. Emerging-market stocks shot up almost 12% in the fourth quarter and returned 20.8% for the year.

Meanwhile, inflation and inflation expectations remained at or below central bank targets. This lifted concerns that interest rates would be hiked anytime soon, and the bond market rallied as well.

Tactical positions in foreign stocks, flexible bond funds, and selected alternative strategies all made money in 2019. But they couldn’t keep up with the mix of U.S. stocks and core bonds from which they were funded. As a reminder, tactical positions are asset classes or strategies we believe have superior expected returns versus risk compared to U.S. stocks and core bonds, and are used more as a defensive tilt to our portfolios.

A Balanced Mindset

There are reasons to be cautiously optimistic for financial markets in 2020:

• Easy monetary policy should soon trickle down to boost the global economy. Global manufacturing is already starting to turn up and expand again.

• Stock markets tend to rise when central banks are in easing mode.

• Inflation is benign so central banks are unlikely to raise rates in 2020. Along with strong U.S. households, continued low interest rates should support consumer spending and the housing market.

• The U.S.-China trade war has de-escalated and Brexit fears have abated for now.

• And financial market imbalances, which triggered the past two U.S. recessions and bear markets, are not yet at the breaking point as long as the economy grows at a decent pace.

However, to some extent this outlook is already reflected in current market prices—at least for U.S. stocks—especially after the sharp year-end rally. CNN calculates a Fear/Greed meter based on internal dynamics in the U.S. stock market. Sentiment swung 180 degrees to Extreme Greed at the end of 2019 from Extreme Fear a year earlier. High valuations and excessive optimism make asset prices more susceptible to negative surprises. We think the wisest course for balanced investors continues to be a broadly diversified, moderately defensive posture.

We are closely watching and weighing the ramifications of several potential short-term risks beyond high U.S. stock valuations. These include a reigniting of the U.S.-China trade war, the risk of recession, volatility around the U.S. presidential election, a hard Brexit with no new trade agreement between the United Kingdom and the European Union, and as always, the chance of an unexpected geopolitical shock. (Iran tensions are one example.)

In the meantime, clients are invested in portfolios built to be resilient across a range of market/economic scenarios. They are positioned to withstand a market downturn, consistent with each portfolio’s specific risk objective. Yet they also provide tactical exposure to asset classes, strategies, and managers we believe currently offer attractive total-return potential over the medium and longer term.

Closing Thoughts

The last few years’ investment experience has been a roller-coaster ride. Globally diversified balanced portfolios of stocks and bonds generated strong returns in 2017, weak returns in 2018, and strong returns in 2019. The market consensus will likely be surprised again in 2020. The only certainty is the lack of certainty. This is why we focus on the long term and don’t make 12-month forecasts. But through all the ups and downs of the last three years, investors have made a strong average return. The wild ride at times is the cost of doing business in investing. Discipline and patience pay off over the long run—something to remember as the unknowns of 2020 unfold.

This quarter, both equity markets and interest rates have been on an up-and-down roller-coaster ride. In addition to deflation concerns, which pushed the U.S. dollar higher, markets have been reacting to the ups and downs of the U.S.-China trade war saga. Now we can add a formal impeachment inquiry into the mix.

Amidst this backdrop, stocks rose in July, fell in August, then rallied in September. In the end, larger-cap U.S. stocks gained 2% in the third quarter. They are now up over 20% year to date. Smaller-cap U.S. stocks suffered more acutely during the market drops and ended the quarter down 2.3%. For the year, they are still up a healthy 14.1%.

Foreign stocks outperformed in the September rebound, but it wasn’t enough to see them keep pace with U.S. stocks for the quarter. Developed international stocks fell 0.9%, European stocks fell 1.8%, and emerging-market stocks fell 4.1%. The uncertainty around Brexit continues to hang over Europe. The aforementioned rise in the U.S. dollar also hurt the foreign investment returns of dollar-based investors. Still, developed international and European markets are up by double digits this year (13.2% and 13.6%, respectively) and emerging-market stocks are up close to 8%.

Due to declining interest rates, core investment-grade bond returns have been strong. The core bond index gained another 2.4% this quarter and is up over 9% in 2019! Interestingly, below-investment-grade sectors of the income world shrugged off economic worries to also do well. Floating-rate loan funds and most of our flexible bond investments delivered quarterly gains.

The environment continues to feel like a game of tug of war between trade policy and monetary policy. On one hand, the unpredictability of the trade war has hit U.S. business sentiment and slowed corporate spending. On the other hand, global central banks continue to take action in response to the real impacts the trade war is having, in addition to the weak global economic picture. The Federal Reserve twice cut the federal funds rate by 25 basis points during the quarter. The European Central Bank also cut its policy rate and announced it would launch new stimulus measures. 

Recession fears seemed to crescendo in August. We saw a report at the time that Google searches for “recession” had spiked to levels not seen since 2008. We think the currently inverted yield curve played a role in pushing recession into the public consciousness. An inverted yield curve means long-term interest rates are lower than very short-term rates, which is an unusual occurrence. One interpretation is that bond markets are telling us: “Good times are here … but bad times are coming.” Indeed, an inverted yield curve has preceded the last seven U.S. recessions, albeit by a widely varying time period. This is why many investors are concerned.

No single indicator, no matter how reliable, is sufficient to make an investment decision. An inverted yield curve doesn’t have a perfect prediction record. But we’ve seen several other data points that indicate recession risks have risen: CEO confidence has declined, U.S. manufacturing activity is contracting, interest rates have fallen hard since November of last year, etc. When we increased our exposure to core bonds in our balanced portfolios earlier this year, it was in consideration of all these factors.

We shouldn’t be all doom and gloom, however. There could very well be another cyclical rebound that extends this cycle. Global central banks are easing financial conditions, which may boost growth. Though U.S. manufacturing is slumping, it has contracted twice before since the 2008 financial crisis and turned up each time; it could do so again. Plus, the services sector is still in expansion territory, and it makes up 80% of the U.S. economy. Household balance sheets and consumer spending remain healthy, supported by low unemployment and solid wage growth.

To sum up, we see two widely divergent, if not binary, market outcomes from here: a recession-type slowdown or a cyclical rebound. The economic data is “mixed.” This explains our balanced portfolio approach. Low-risk alternative strategies and high-quality bond holdings should prepare portfolios to weather a recession. While the more economically sensitive international and value stocks we own on the equity side should help portfolios participate strongly if global growth rebounds. It’s also worth remembering our portfolios have already been modestly underweight to equity risk overall, leaving them less exposed to a market drop like what happened late last year (or worse). Together with the broad diversification we employ across asset classes and investment strategies, our balanced tactical positioning should make your portfolio resilient to a range of economic and market scenarios.

Market Recap

Back in January, after the painful market downturn in the fourth quarter, we saw scenarios that could make markets rise or fall in the near term and that the best approach was to take a middle path taking both into account. And both is what we got during the first half of 2019. However, the sharp downturn in May was short, and following a strong June most asset classes posted nice gains for the six months ended June 30, 2019.

All asset classes rose during the second quarter, as progress in U.S.-China trade negotiations and a newly dovish (accommodative) Federal Reserve buoyed investors. The S&P 500 hit a new high near the end of June. Fixed income also gained, as the 10-year Treasury yield fell below 2.0% on the heels of the Fed’s willingness to cut, rather than raise rates at their June meeting. When bond yields fall, their prices rise.

A Mix of Risks Persists

Could the second half of 2019 also deliver such positive returns? We don’t say “never,” just as we don’t rely on short-term predictions to drive our investing. However, risks to global markets have increased somewhat – including the potential escalation of a trade war and conflict with Iran – and with valuations even higher than they were, similarly robust second-half 2019 returns seem less probable, meaning we likely “front-ended” gains for the whole year in the first half.

The Fed’s changing stance and a shift toward loosening by other central banks, including the European Central Bank and stimulus by the People’s Bank of China, were a plus and this typically lifts global markets and asset prices. However, the market now generally anticipates at least one Fed rate cut during 2019. It’s possible that stock prices already fully reflect the impact of potential Fed rate cuts, so an actual rate cut may not have the power to lift prices further. And if the Fed fails to cut rates that could potentially hurt stock prices as it rattles markets that were expecting more.

Another concern is the length of the U.S. economic cycle. The U.S. is now experiencing one of the longest runs of economic growth in our history. Each quarter brings this economic cycle closer to its end. Of course, there’s no way to know how long an economic cycle can run. However, quite a few leading economic indicators have turned negative. It seems likely that the U.S. will experience a recession at some point during the next few years. And it’s certainly possible that we could see a recession in the next 12 months, which is why making modest adjustments to our portfolios to provide more explicit protection against that possibility is something we have already begun.

The increasingly stretched valuations of many riskier assets like stocks are a related concern. This is less true in Europe and emerging markets, where stock prices reflect expectations that may be overly pessimistic. That’s why we’re slightly underweight U.S. stocks, and will be adding to our international stock positions.

If global economies and markets turn negative, our core bond holdings, other fixed income, and alternative investments will provide cushioning against broader stock market declines.

This has been an extraordinarily long U.S. economic and market cycle. But we firmly believe it is still a cycle, so our patience and our emphasis on fundamental valuation will eventually be well-rewarded again, as it has throughout our history.

After posting their worst December since 1931, U.S. stocks surged to their best January since 1987, followed by further gains in February and March. Once again, the markets surprised the consensus and demonstrated the folly of trying to predict short-term performance. Investors who bailed out of stocks during the year-end selloff experienced severe whipsaw as the market rallied. Larger-cap U.S. stocks gained 13.6% for the quarter, placing it in the top decile of quarterly market returns since 1950. As a reminder, last year’s fourth quarter 14% drop was a bottom-decile dweller.

Foreign stocks also rebounded sharply in the first quarter. Developed international markets gained 10.6% and European stocks were up 10.9%. Emerging-market (EM) stocks rose 11.8%, after holding up much better than U.S. stocks on the downside in the fourth quarter of 2018.

Fixed-income markets were also strong: High-yield bonds gained 7.4%, floating-rate loans were up 4%, and investment-grade bonds rose 2.9%. The 10-year Treasury yield fell to 2.39% during March, its lowest level since December 2017.

The market rebound was predominately due to a U-turn in Federal Reserve monetary policy. After hiking interest rates four times in 2018, Fed officials suddenly reversed course. They emphasized they would be “patient” and pause any further rate increases. Admittedly, there were other positives for the markets as well: The federal government shutdown ended in late January, signals from the U.S.-China trade talks turned more positive, and the likelihood of a “hard Brexit” seemed to wane.

It certainly feels better to see strongly positive portfolio performance this quarter compared to the losses in the fourth quarter of 2018. But just as we wouldn’t extrapolate last year’s losses when looking out over the coming years, it’s equally important to temper our expectations on the upside after this quarter’s strong rebound.

The obvious question after experiencing such a rebound is, what’s next? It’s easy to be enamored with the U.S. equity market, especially when the Fed is playing its cards face up. However, the reality is the market rebound was due more to improving investor sentiment and risk appetite—caused largely by the shift in Fed monetary policy—than any meaningful improvements in underlying economic or business fundamentals.

From our vantage point, looking out over our longer-term investment horizon, seemingly little has changed after the roller coaster ride of the last six months. The first quarter of 2019 was certainly a nice respite from the losses of 2018, but we remain prepared for renewed market choppiness as the economic cycle gets later and later (and closer and closer to the inevitable downturn).

While the U.S. economy is still arguably the strongest market, growth expectations have been coming down. At its Federal Open Market Committee meeting on March 20, the Fed downgraded its median GDP growth estimate to just 2.1% for 2019 and 1.9% for 2020, citing the effects of economic slowdowns in China and Europe, fading stimulus from the 2017 Trump tax cuts, and ongoing uncertainty around Brexit and trade policy.

U.S. corporate earnings growth expectations also continue to decline. Consensus earnings-per-share growth estimates for the S&P 500 have dropped from 12% (as of 12/31/18) to just 4.1% as of mid-March. Even with the Fed now on hold, earnings growth will need to improve for stocks to appreciate meaningfully from current levels, given their sharp rebound in the first quarter and high valuations. Our annualized return expectations for U.S. stocks are in the low-single-digit range over the next five years.

On the other hand, there are a number of short-term scenarios that could see further equity gains, in particular in foreign markets. The Chinese government is once again trying to boost their economy via fiscal and monetary policy (including tax cuts, lower interest rates, and expanded bank lending). A revival in Chinese growth would have positive ripple effects across the global economy. It would benefit other emerging markets and Europe in particular, as China is a major importer of their goods. This foreign stimulus, combined with the Fed’s policy U-turn, may enable equity markets to extend their positive run for another few years. This outcome would certainly benefit our portfolio positions in developed international and emerging markets, among other riskier assets.

While we’d prefer to see global growth rebound with continued strong performance, we believe it is wise to be prepared (mentally, emotionally, and financially) for shorter-term downside and negative market surprises. If and when a recessionary bear market strikes, we will look to our holdings in core bonds as well as our other higher-yielding hybrid and alternative strategies to provide ballast to our portfolios and limit the impact of equity declines.

Any prolonged downturn will also likely present us with opportunities to tactically increase our exposure to riskier asset classes, such as U.S. stocks, at lower prices and higher prospective returns.

2018 Market Review

After logging strong returns in 2017, global equity markets delivered negative returns in US dollar terms in 2018. Common news stories in 2018 included reports on global economic growth, corporate earnings, record low unemployment in the US, the implementation of Brexit, US trade wars with China and other countries, and a flattening US Treasury yield curve. Global equity markets delivered positive returns through September, followed by a decline in the fourth quarter, resulting in a –4.4% return for the S&P 500 and –9.4% for the MSCI All Country World Index for the year.

The fourth quarter equity market decline has many investors wondering how equities may perform in the near term. Equity market declines of 10% have occurred numerous times in the past. The S&P 500 returned –13.5% in the fourth quarter while the MSCI All Country World Index returned –12.8%. After declines of 10% or more, equity returns over the subsequent 12 months have been positive 71% of the time in US markets and 72% of the time in other developed markets.

Market Volatility

The increased market volatility in the fourth quarter of 2018 underscores the importance of following an investment approach based on diversification and discipline rather than prediction and timing. For investors to successfully predict markets, they must forecast future events more accurately than all other market participants and predict how other market participants will react to their forecasted events.

There is little evidence suggesting that either of these objectives can be accomplished on a consistent basis. Instead of attempting to outguess market prices, investors should take comfort that market prices quickly incorporate relevant information and that information will be reflected in expected returns.

While we cannot control markets, we can control how we invest. As Dimensional’s Co-CEO Dave Butler likes to say, “Control what you can control.”

Conclusion

2018 included numerous examples of the difficulty of predicting the performance of markets, the importance of diversification, and the need to maintain discipline if investors want to effectively pursue the long-term returns the capital markets offer. The following quote by John “Mac” McQuown, a Dimensional Director, provides useful perspective as investors head into 2019:

“Modern finance is based primarily on scientific reasoning guided by theory, not subjectivity and speculation.”

A theme for the third quarter of 2018 could be summarized as trade tensions, plus a strong dollar and rising interest rates, equals uncertainty in most markets. The U.S. market was positive, and most international markets were negative for the quarter. This was primarily due to the tax cuts and the overall deregulation in the U.S., coupled with a strong economy which has propelled individual company earnings in excess of 20% per quarter.

The fourth quarter and into 2019 the economic expansion, which is the second longest on record, is widely expected to continue. The pace of this growth will likely moderate, but continue in the 2.50% to 3% area.

While we are experiencing more volatility as of late, we feel the long term secular bull market remains intact. Continued fears of tariffs, the outcome of the mid-term elections, as well as a general drop in overall liquidity in the markets (due to the Federal Reserve moving from an accommodative posture to a restrictive policy) are likely the culprits.

We remain positive on the U.S. markets but understand while valuations are not excessive, they could put a ceiling on future returns. We are more positive on the international markets from a valuation standpoint, and their upside is significant over the next 5+ years. However, we remain cautious as to the timing of being invested in those markets.

All in all we are positive and committed to a globally-diversified portfolio and are constantly looking for opportunities to improve returns.

In the second quarter of 2018 investors were caught in the middle of a battle between global growth and geopolitical tensions. While the U.S economy is growing solidly with GDP at 3%+ corporate earnings coming on a quarterly basis of 20%+ boosted by tax cuts, the Fed continued to tighten or raise rates which contributed to reducing global liquidity and a stronger dollar.

As a result the clear winners were the U.S. stocks, up 3.4% as evidenced by the S&P 500 and small stocks which were up 7%+ which are less exposed to global trends and trade risks. The rising U.S. dollar provided a headwind for non-U.S. assets and emerging markets equities suffered the biggest losses.

As for the bond market, we are in a rising interest rate environment and during the quarter U.S. interest rates ticked up modestly resulting in weak returns across most bond categories.

The biggest potential change facing the economy is the evolving rhetoric surrounding trade, the imposition of tariffs, and retaliatory tariffs, and the potential for a wider trade war. At this point it is difficult to determine whether this trade rhetoric is simply a negotiating tactic and all sides will ultimately work toward a fair trade outcome or whether a trade war develops which would have widespread repercussions ultimately increasing inflation and slowing global growth.

The current economic expansion is nine years old. Economists are not calling for a recession anytime soon. They expect the Fed will continue to raise rates, although gradually, as inflation has thus far been around 2%. Until inflation accelerates we expect the economy to continue to expand and the U.S. stock market is likely to grind higher.

We continue to look for opportunities within the fixed income market, as well as the stock market. Recently, we initiated positions in the high-yield municipal bond market and depending upon how the potential trade war develops we are looking to selectively add to our international exposure as is it significantly less expensive than the U.S. markets.

After becoming accustomed to consistently robust equity returns throughout 2017, the first quarter of 2018 ushered in a bout of volatility unlike the low volatility of 2017, with the markets experiencing two 10% drops and ending the quarter about where they started. In our judgement, the playing field in 2018 has changed. We are now in a rising interest rate and potentially rising inflation environment.

The recent Federal Reserve minutes indicate that the Fed is on a fairly aggressive path of hiking interest rates. It should be noted that one of their main mandates is to control inflation and with the recent rise in oil and gasoline prices, as well as the CRB Broad Commodity Index, it appears that inflation is rising. Thus, it is quite possible we will see four rate hikes from the Federal Reserve in 2018. In addition, it is quite possible that the 10-year bond yield will creep up to 3.2% by the end of the year.

The recent passage of the tax bill and the continued de-regulation across many industries have been a tailwind for corporate earnings and equity prices. However, higher levels of inflation and higher interest rates represent a possible risk for equities, creating a sort of tug-a-war between the two.

One concern we have is that the U.S. market generally is a discounting mechanism. It is quite possible that the tax cut and enhanced earnings projections were discounted and paid for in 2017. Evidence of this can be seen from 2016 to January 2018, when the market was up 44% versus 14% growth in earnings thus, market gains may be muted until it is possible to see continued future earnings gains.

That being said, we have always been proponents of global diversification and this year is no exception, where we see international markets, both developed and emerging, as well as other asset classes like international real estate, commodities, and certain hedge fund type strategies, as being a complement to our existing portfolios.

As for bonds, while the siren call for a bond bear market continues, the Fed’s recent move to raise interest rates, and the flattening of the yield curve, all are signals to us to position our portfolios in a conservative risk posture, maintaining a focus on short maturities, as well as investments in rising interest rate vehicles like floating rate bonds.

As always, we think that a well-diversified portfolio in line with your long term goals should allow you to participate in upside potential as well as serve as a ballast for any short term volatility that may arise in the coming months.

In 2017, we were again reminded of the importance of following an investment approach based on discipline and diversification vs. prediction and timing. In fact, last year provided several interesting, and unexpected, examples on how best to achieve the long-term return the capital markets offer. For example: What do you get when you combine a tumultuous year for a new US president and divisive political trends in many global markets? Answer: A new record for the US stock market.

For the first time since 1897, the total return for the US stock market was positive in every single month of the year. As you may recall, a great deal of media coverage was focused on markets at all-time highs, and some investors braced themselves for a sharp drop in stock prices. Not only did the much anticipated “correction” never occur, financial markets remained remarkably calm. Out of 254 trading days in 2017, the total return of the S&P 500 Index rose or fell over 1% only eight times. By comparison, in a more rambunctious year such as 1999, it did so 92 times.

North Korea issued threats of a nuclear missile strike throughout the year and boasted that even mainland US cities were vulnerable to its newest warheads. Next-door neighbor South Korea would seem to have the most to lose if such a catastrophe occurred, but Korean stocks were among the top performers in 2017, with a total return of 29.5% in local currency and 46.0% in US dollar terms.

To many experienced analysts, Chinese stocks appeared alarmingly vulnerable as well. A gloomy November 2016 article warned that “China’s debt addiction could lead to a financial crisis.” In the article, a prominent Wall Street strategist observed: “It’s scary that China seems to be continuing its debt binge to achieve its unrealistic growth targets.” How did these dire predictions turn out? China was the third best-performing stock market in 2017 with a total return of 51.6% in local currency and 50.7% in US dollar terms.

These “surprises” from 2017 reinforce the challenge of drawing a direct link between positive or negative events in the world and positive or negative returns in the stock market.

However, it is really nothing new that financial markets surprised many investors in 2017, as they have a long history of surprising investors. For example, from 1926–2017, the annualized return for the S&P 500 Index was 10.2%, but returns in any single year were seldom close to this figure. In fact, returns for the S&P 500 Index for this time period were anywhere between 8% and 12% only six times, but experienced gains or losses greater than 20%,40 times (34 gains, six losses).

Clearly, attempting to pick only winning markets in any given period is a challenging proposition. By pursuing a globally diversified approach to investing, one doesn’t have to attempt to pick winners every time to achieve a rewarding investment experience.

Some Commentary provided by Weston Wellington, V.P. of Dimensional Fund Advisors

The third quarter of 2017 again posted positive returns for domestic, European and emerging market equities. Global growth is back for the first time in a decade, with 45 economies monitored by the Organization for Economic Cooperation and Development (OECD) in economic expansion. As Jim Paulsen, Chief Investment Strategist of the Leuthold Group, has stated we are in a sweet spot with low inflation, low interest rates, and higher earnings all resulting in higher valuations and rising stock markets around the world. In addition, for the first time in eight years we have a President who is pro-business and whose agenda includes increased fiscal spending, less regulation and lower corporate taxes which if enacted could result in even higher earnings.

However, we are watching the Federal Reserve’s actions as they have started to slowly normalize monetary policy by gradually lifting interest rates. If inflation increases and the Federal Reserve takes on a more aggressive role in raising rates, it could provide a problem for U.S. equities.

We have currently positioned our portfolios to reflect a slight over-weight in both the international and emerging markets versus the U.S. domestic market. As for bonds, we are positioning the portfolios for a gradual rise in interest rates thus, we remain with shorter maturities on the yield curve.