After nearly 10 years of economic expansion and a bull market, the sheer length of this latest cycle was always going to be a concern. We all knew this couldn’t continue forever, so the question became, “How will it end?” With investors across the globe attempting to divine the tipping point, market sentiment became increasingly important to market performance, with each new headline being digested as the tell-tale sign of what’s to come. In this environment over the past few years, we likened market sentiment to investors gripping to the top of the towering cliff that they had climbed over the past decade, waiting for the slightest breeze to push them over the edge into the abyss. At the same time, however, no one wanted to miss out should the climb continue to even greater heights…
It was for this reason that, back in the inaugural September 2018 paper of this series “The Good, The Bad, and The Ugly” as well as a follow-up note in October, we advocated for deleveraging client balance sheets and de-risking portfolios that had inadvertently or intentionally become overweight risk. In our opinion, continuing to overweight portions of the market that are driven by momentum or those which carry greater sensitivity to investor sentiment was akin to stepping in front of a bulldozer to pick up a few extra nickels. Our view, at the time, was concerned primarily with the potential of far greater downside risk then upside opportunity.
We do not like market disruptions, volatility spikes, or bear markets any more than anyone else but, in our opinion, what we have witnessed over the past 2-3 months is a return to a more normal market environment – high volatility, a welcomed return of focus on fundamentals, and more reasonable valuations. History suggests that the current market downturn may continue for a while, but we view this as an opportunity to reallocate client portfolios at more realistic valuation levels. An additional benefit of reallocating portfolios during such a period is that it allows for the prudent harvesting of tax losses. As such, we have sought to capitalize on this benefit in order to potentially reduce the unrealized tax burden that accumulates during a long bull market. While we are still cognizant of many of the risks which we discussed in September and see now, in some cases we believe the recent sell-off has provided attractive entry points for a disciplined and pragmatic investor.
With market sentiment appearing to be a predominant driver of performance over the past few years, it was only a matter of time before the euphoria and “over-buying” any good news gave way to doom-and-gloom. We now believe that investors are “over-selling” any bad news (even if it is only potential bad news). The Q4 sell-off has been so significant that most major global asset classes ended 2018 in negative or only modestly positive territory, despite a strong start to the year and positive economic data.
There most certainly are risks to be concerned about, but investor sentiment seems to have fallen off a cliff, far below what is warranted given the actual state of affairs.
First, let’s summarize the potential negatives:
In the context of all this potential bad news, along with other real risks, it is understandable that investor sentiment has fallen and anxiety increased.
But now let’s examine the other side of the coin – the positive news:
As we stated in the introduction, we do not relish periods of market disruption, spikes in volatility, or large sell-offs. But it is imperative for one to keep in mind that the experience of Q4 2018 represents a return to normalcy. We welcome the return of a market that focuses on fundamentals and values investments based on such. In addition, we view this environment as an opportunistic one. With a dedicated eye on underlying realities instead of broad (often irrational, in our opinion) sentiment, we believe the current environment may provide some attractive long-term entry points for several asset classes.
With the above as a backdrop, surveying the current economic and investment landscapes, we now turn to what we see moving forward.
The global economy continues to (slowly) expand, though there is a distinct deceleration and “desynchronization” of growth. The U.S. economy shows continued growth, though forecasted to slow in 2019. At the same time, the rest of the world appears to be decidedly decelerating – still expansionary, but slowing down – especially in Europe, Japan, and China.
U.S. Inflation remains stable and in line with Fed targets, and we maintain our belief that it does not represent a threat to continued economic expansion. Wages in the U.S. are increasing only slowly (though showing signs of acceleration), oil prices have fallen significantly over the past three months, and overall commodity prices remain repressed by slowing demand and the strong dollar. Outside the U.S., inflation simply is not a problem, and, in fact, Europe may soon have to worry once again about entering a deflationary regime.
The positive impacts of fiscal stimulus, tax reform, and regulatory relief remain in place, but should begin to taper as we head into 2019. The Fed previously had laid out a fairly aggressive tightening program over the next 12-15 months, but there is now some belief it may “back-off” of that plan in the face of the recent market correction and expectations for a slowing economy in the latter half of 2019.
Solid U.S. GDP growth, as well as respectable earnings and revenue growth, make for a generally positive market environment and, despite the recent sell-off, we maintain a generally optimistic outlook for U.S. stocks over medium- and longer-term time horizons (though the current correction and disruption may continue over the short-term).
Ongoing trade tensions between the U.S. and China, European tensions over Italy’s fiscal state and the U.K.’s struggles with “Brexit”, and decelerating non-U.S. economic growth seem to be the largest potential threats to the current economic and market regimes.
Emerging Market and EAFE (Developed International) markets continue to be hurt by a generally strong U.S. dollar, slowing economies, trade tensions, and a corresponding “risk-off” mentality driving investment outflows. That said, due to relatively attractive valuations following the steep price declines earlier in the year, investors are beginning to reconsider these markets from a longer-term perspective. These markets posted strongly negative performances in 2018, in both local and U.S. terms, and will continue to exhibit higher volatility, but we still like them as longer-term positions and opportunistic entry points, from both a valuation and economic growth perspective. In addition, we believe the U.S. dollar strengthening cycle which has plagued these markets recently will begin to wane in severity.
At current interest rates and credit spreads, the public credit markets continue to look very expensive to us, and our return expectations are muted accordingly. We are nearing the end of the current credit cycle and risks are increasing, especially in the high yield space, which is often a harbinger of an impending market correction.
The leveraged loan market (i.e., floating rate bank loans) has seen a decided deterioration in both the credit quality of borrowers and in loan covenant structures – both distinct warning signals.
Likewise, the traditional investment grade bond market has seen a downturn in the average credit rating of borrowers. This could have dramatic implications if / when the next recession hits and corporate revenues decline. Many investors are turning to shorter-duration bond strategies and even cash solutions, which finally have a positive real yield again due to the Fed rate hikes. The yield curve is so flat that investors simply are not being sufficiently compensated to take on term or duration risk, despite the recent “flight to quality” rally. For investors who can access the private markets and handle some degree of illiquidity, we believe there are better opportunities in the private versus public credit markets.
Given the current uncertain state of the public equity and credit markets, many investors are revisiting the use of alternative investments within their portfolios, both for diversification purposes and as a means of accessing lower-correlated sources of potential return. We continue to believe that certain alternative investments may deliver superior performance than their liquid alternative brethren, because of less liquidity and leverage constraints.
We previously muted our short-term expectations for real assets and the overall commodity complex, due to lower than expected global inflation, slowing demand, falling oil prices, and the strong U.S. dollar. However, we are beginning to believe that these markets have been over-sold and may be poised for a comeback as we head into 2019.
While we generally are constructive on the global economy and overall market performance, the public markets are “rationalizing”, and the market volatility we long expected has materialized. We still believe that the market can move higher over the next 6-12 months, but we do not expect it will be the smooth ride that investors have become accustomed to over the past 10 years.
In summary, we believe the tide of market sentiment has turned, but irrationally so. That investors “over-bought” good news in the first three quarters of 2018 and very quickly shifted to “over-selling” bad news at the end of the year, signals to us that market sentiment had become an overwhelming and irrational driver of returns. In our opinion, this overreaction will correct itself, and from the trough of this sell-off, a renewed focus on fundamental determinants of investment valuation can send markets higher again. Along the way, we will look for those opportunities that provide attractive entry points for client portfolios, while remaining cognizant of risks on the horizon.
To be sure, there are risks across the globe, be they economic, market, or geopolitical risks. But the U.S. economy is strong, the global economy is slowing but still expansionary, interest rates are low by historical standards, inflation is muted, and corporate earnings continue to stand on solid footing. We do not expect that the market leading performers of the past decade will be the same leaders moving forward, and, in fact, an increase in volatility and dispersion may change the market landscape significantly. For this reason, we continue to favor positioning portfolios in a more defensive stance, with the goal of potentially limiting our downside risk exposure. From this stance, we can wait patiently – with some dry powder on hand – for attractive opportunities as they arise.
While the increased market volatility can be difficult to endure for some, we believe focusing on a disciplined and pragmatic investment process and continued alignment with long-term financial objectives remains the appropriate course of action.
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*This report is a publication of Aaron Wealth Advisors LLC. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.
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