Market Perspective for September 25th 2018
The Fed and Interest Rates
Interest rates are probably going up by 25 basis points later today. The market and I believe it’s a done deal. The interesting part will be the Fed comments regarding future policy action. Any sign that the expected December hike has become less certain or that next year’s rate hikes are “wait-and-see” are likely to be taken as market friendly, especially for the international stock markets. There is already a sense that the performance gap between U.S. and non-U.S. equities had reached historic proportions, and this helped fuel the international stock rally last week. The rally in international stocks will probably continue only insofar as the dollar correction lasts. A hawkish Fed on Wednesday means higher rates, a stronger dollar, and more international stock pain.
It’s has been a difficult environment for asset managers who are philosophically committed to diversification. With domestic stocks ahead around 10% (all figures YTD through September 16th), any money allocated to foreign stocks (-4%), domestic bonds (-1.5%) or foreign bonds (-3%) is negatively impacting your returns relative to the U.S. domestic market which is most people’s market performance reference point. For example, a 60/40 portfolio invested 40/20/30/10 (domestic stock, foreign stock, domestic bonds, foreign bonds, respectfully) has returned 2.45% before fees. If you were a skilled tactician and over-weighted U.S. stocks while underweighting foreign stocks and bonds (50/15/30/5), you could have improved your return to 3.80% pre-fee. The point is, no diversified 60/40 investor should have any reasonable expectation of having earned even half of the S&P’s 10% return.
Some might respond to this by saying that they don’t care about diversification – “just give me the best return, I don’t care where it comes from”. The problem with this statement is that it assumes one can know where the best returns are going to come from. In retrospect, it has paid off handsomely to have investment in U.S. stocks over the past 9 years. Nothing else is even comparable. That said, it is in no way guaranteed that U.S. stocks will remain the best performers over the next 9 years (or even the next nine weeks). Below is an asset class return graph from J.P. Morgan. Each color corresponds to a different asset class. The white boxes represent a balanced portfolio. I include the chart to illustrate that year-to-year performance volatility of individual asset classes is high. Trying to pick the ‘winning’ asset class one year may lead to large underperformance the next year.
Source: JP Morgan 3Q18 Guide to the Market
It has been pointed out several times over the past few years (by myself and others) that valuations for most U.S. stocks are stretched; at some point that rubber band is going to snap. The reason advisors should care about this is that it isn’t the three or four percent that you have in emerging market debt that is going to destroy a client’s portfolio. That asset class is already off more than 10%; if it loses another 15% from here, that is only another 0.6% in a diversified portfolio. If, on the other hand, U.S. stocks finally come back to earth – say 25%, your 50% exposure is going to cause a -12.5% wealth reduction.
China and Tariffs
China would like to make a deal with the U.S. and is prepared to make modest concessions. The Trump administration wants major concessions, so that it can announce that the Chinese “caved”. The U.S. stock market has been betting on the former scenario. I do not believe that the latter scenario, that a deal isn’t reached and things escalate, is reflected in current market prices. Semiconductor chip stocks might be the exception to that last statement. They are off 7% since the first tariffs were implemented back in June.
The Long Bond
Watch the 3.22% yield level on the 30-year bond. That level provided support during past bond sell-offs. If it doesn’t hold, the yield on the 30 year could quickly move to 3.5%. more importantly, it could more decisively confirm that the great bond bull market ended in 2016 and the era of reflation is underway. This could also eventually light a fire under gold.
I am reading about a lot of concern regarding corporate debt levels. Issuing debt (to buy back equity) has been a very attractive way to boost earnings and stock prices over the past seven years because interest rates have been low. Rising interest rates will make that harder to service. Think about it this way: If a company had a $5 billion market cap three years ago with $2 billion in debt, it had an enterprise value of $7 billion and a leverage ratio of 40% ($2 billion/$5 billion). Let’s say the company aggressively borrowed to buy back its stock and was rewarded with a big P/E multiple increase. It now has a market cap of $10 billion with $6 billion in debt. The leverage ratio is now 60%, but we don’t care because we believe the company is a skillful manager of its balance sheet. Eventually, the economic cycle peaks and the stock price begins to fall. As the stock price falls, the leverage ratio increases, which makes the company look riskier. Soon we have a $7.5 billion company with an 80% leverage ratio ($6 billion/$7.5 billion). The company would like to pay down some of that debt because credit conditions are tougher now , but it isn’t exactly flush at this point, so all it can do is lobby the Fed to lower rates to help it out. The lesson is that high interest rates serve a purpose. When rates are high, companies are very careful about taking on debt. In an environment of permanently low rates, debt is taken on and rolled over, but never retired. Eventually it chokes the company (and by extension, the economy itself).
- Value is performing better than growth this month but I’m not ready to shift my portfolio just yet. I would scale back my overweight to momentum growth (if I had one)
- International equity is cheaper that domestic equity and had a good week but I’m not changing my portfolio yet. Small cap developed international stocks and emerging market stocks are oh-so-cheap, but that is probably a 2019 story.
- Large caps are outperforming small caps. I absolutely would reduce or eliminate small cap over-weights. From a Fed and a political standpoint, uncertainty is high. That favors bigger and more defensive stocks. The “small-is-better-shielded-from-trade-concerns” argument is played out.
- The bull continues. Investors have responded to any and all bad news over the last six months not by exiting the stock market but by redeploying assets within the stock market. As long as that continues, side with the bulls.
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