Key Investment Perspectives
A December to remember — a year the bull ran out of gas.
We live in the age of hyperboles and short-termism. It is therefore justified to dismiss commentators when they use or invent superlatives to contextualize the vagaries of the stock market over very short timeframes. Should we really care if any given market swoon is the worst since a few months prior? Or should we hit the panic button each time our CNBC screen flashes the now ubiquitous red “Markets in Turmoil” alerts, warning of an implosion that is almost always ephemeral?
After all, investing is about the long game, and to borrow Nobel Laureate Paul Samuelson’s metaphor, “should be more like watching paint dry.” Then came December 2018 — a month that may have rightfully earned every hyperbolic moniker commentators could conjure.
We had the worst Christmas Eve ever, with the S&P 500 dropping almost 3%, and the month shaping up to be the worst December on record (down nearly 15% at that point). To put the selloff in context, there were 16 trading days in December up to Christmas Eve last year. Going back to 1928, the probability of experiencing any rolling 16-trading-day window where the S&P 500 had a worse performance is less than 1%. It was truly uncharted territory. Even worse, most of the periods that underperformed coincided with deep recessions, a high unemployment rate, and very weak consumer confidence. None of that is true today. While global growth has visibly slowed and certain sectors within the U.S. are increasingly showing signs of strain, we remain of the view that the likelihood of a U.S. recession during the next 12 months, barring a major policy-induced error, is unlikely.
So, it was not too surprising that the S&P 500 had its best post-Christmas Day return ever and clawed back some of the losses, before ending the month down 9%. Although this was the worst December since 1931, it was an ironically fitting bookend to a year that began with so much promise, rocketing out of the gates with the best start in over three decades. Just like the euphoria of those early days in January 2018 was excessive (at least in hindsight), today’s doom and gloom appear to be inversely excessive. Regardless, 2018 will go down as the year the bull ran out of gas. And that’s okay; even healthy. Corrections are an essential mechanism for properly functioning capital markets and should provide patient, rational investors with opportunities to earn above-average prospective returns.
For the full year, the S&P 500, including dividends, was down 4.4%, while the broader Russell 3000 Index was down 5.2%. Growth (-2.1%) outperformed value (-8.6%), while large cap (-4.8%) outperformed small cap (-11.0%). Low volatility (0.0%) was the best performing investment factor, substantially outperforming high volatility (-10.2%). Looking forward, history suggests that after a 12-month decline of 4% or more in the U.S. stock market, there is an increased probability of an outsized return in the subsequent 12 months.
Specifically, the probability of a 20% return or more in one year hence jumps from 28% to 42% after such a decline. We will however caution that history is an imperfect guide, and the data also suggests there is a higher-than-normal likelihood (but lower than what the bull case suggests) of a large negative return after such a decline.
Today, while our tactical asset allocation models have seen marginal declines in investor psychology and macroeconomic signals, they are seeing improved corporate fundamentals, driven largely by attractive valuations and still-healthy corporate profitability.
While the U.S. was the epicenter of December’s turmoil, developed international equity markets (-5.4%) fared better. Hong Kong (-0.6%) was again the best performing major market while Japan (-7.0%) was the worst despite a 3.5% rise in the yen relative to the U.S. dollar. For the year, the yen (2.7%) was the only major currency that strengthened against the dollar, living up to its safe haven status. This was not particularly beneficial to Japanese equities though, with the market slumping 13.3% in 2018. Domestic-focused sectors outperformed as a result of lower oil prices while more cyclical sectors declined, reflecting concerns about slowing global growth. On the bright side, vacancy rates for office space in central Tokyo dropped to 1.98% (5% is viewed as the equilibrium) in November, the lowest level in 27 years.
Elsewhere, although UK Prime Minister Theresa May survived a no-confidence vote, she just suffered a humiliating defeat to her Brexit deal with the EU by a very skeptical UK Parliament. Scheduled to leave the EU this March, this defeat has now thrown the UK into further turmoil. Amid this backdrop, UK stocks were down 4.6% in December and 16.6% for the full year, with the pound falling by almost 6% against the U.S. dollar.
Germany was the worst performing developed equity market in 2018, cratering 22.5% amidst slowing global growth as almost 40% of its economy is exports-driven. France endured a slowdown in the auto sector, anti-government protests, and a first contraction below 50 in the Purchasing Manager’s Index (PMI) (a measure of economic health) since 2016, but stocks there recorded a relatively benign -13.6% return in 2018. Lastly, Italy (-17.4% in 2018) finally succumbed to pressure, agreeing to a 2019 budget with the EU in a move greeted favorably by the market.
We reiterate our modest underweight to developed equities ex-U.S.
Our conviction to stick with our modest emerging markets (EM) overweight was rewarded in the last three months. Countries like Brazil, India, Indonesia, Hungary, and even Turkey posted positive returns during this period, helping EM (-7.3%) outperform the U.S. (-14.3%) and Developed ex-U.S. (-13.3%). For the full year, however, EM (-14.9%) underperformed the U.S. (-5.2%) and was essentially in line with Developed ex-U.S. (-14.6%). China remains the 800-pound gorilla. Resolving its trade hostilities with the U.S., implementing additional monetary and fiscal stimuli, and the success of its planned shift away from fixed asset investments to becoming a high-tech behemoth will be important.
Like we stated last month, we continue to maintain a slight overweight to emerging markets as we believe many of these economies are better prepared to withstand a global economic crisis than the last time and are trading at attractive valuations.
A safe haven does its job amid ballooning credit spreads.
The Barclays U.S. Treasury Index was up 24 basis points (bps) in December and 1.4% for the year. Acting as a safe haven, it was one of the few asset classes to post a positive return in 2018—doing so despite four rate hikes by the Federal Reserve (Fed). The intermediate (1–10 years) index was responsible for all the 2018 performance, up 1.7%, while the long (10+ years) index was down 33 bps. Although the yield curve (spread between the 10-year and 2-year treasury notes) ended the year at 21 bps (the same level as November), 2018 saw a yield curve that flattened by 30 bps (it was at 51 bps at the end of 2017). We continue to monitor this metric given its efficacy in predicting prior recessions, although as we have noted on many occasions, an inverted yield curve does not suggest a recession is imminent.
In December, spreads on U.S. investment grade and U.S. high yield credit rose to 153 bps and 523 bps, respectively. These spreads are the highest in two and a half years and are now above their long-term averages going back to 1994. While this would suggest that both are now fairly valued, we are of the view that equities still provide greater upside, especially considering the December selloff.
For the full year, both U.S. investment grade (-2.5%) and U.S. high yield (-2.1%) declined. From a sector perspective, the biggest detractors for investment grade were utilities (-3.8%) and consumer non-cyclicals (-3.3%). For high yield, energy (-6.7%) and consumer cyclicals (-3.3%) led the decline.
Best relative performance in a decade for hedge funds. REITs follow secular trends and Commodities offer no diversification.
In December, hedge funds (-68 bps) posted their best performance relative to equities since February 2009, with 93% of the hedge funds in the Hedge Fund Research Index (HFRI) outperforming. Large macro and credit multi-strategy funds were the best performers. Even better, 2018 marked the strongest outperformance for hedge funds (-84 bps) over equities in a calendar year since 2008.
We believe hedge funds could play a role in well-constructed portfolios owing to their downside protection and diversification attributes. We however strongly believe that manager selection is very critical in this space, as hedge funds are not created equally.
U.S. Real Estate Investment Trusts (REITs) were down 4.2% in 2018, better than the broad equity market. The best performing segments were those riding the coattails of secular trends like millennials’ preference for apartment rentals and the yawning gap in affordable housing. These include manufactured homes (+12.2%), residential (+3.4%), and apartments (+2.3%). The worst performers were in segments dealing with oversupply and disruption like office (-12.6%; disruption by WeWork) and hotels (-12.5%; disruption by Airbnb) and those most susceptible to the rise of e-commerce like strip centers (-14.6%; disruption by Amazon). Mall REITs (-6.1%) held up relatively well.
Commodities were down 7.8% in December and 13.8% for the full year, providing no diversification benefits. All major sectors from industrial metals (-18.0%), energy (-17.1%), and agriculture (-8.1%) to precious metals (-3.6%) declined in 2018. Even gold (-2.8%), a hitherto reliable safe haven, was down last year.
Tactical Asset Allocation
Maintaining our modest overweight to equities
Key Private Bank’s tactical asset allocation recommendations are based on three pillars – corporate fundamentals, macroeconomic insights, and investor psychology. Corporate fundamentals capture the long-term impact of valuation and profitability across various asset classes. Macroeconomic insights capture the impact of leading and coincident economic indicators as well as broad market variables like currency, inflation, and interest rates. Investor psychology attempts to capture aspects of investor behavior that are not necessarily driven by fundamentals, as well as the views of informed market participants like hedge funds, equity analysts, and credit analysts. Based on these factors, we currently recommend an overweight to equities and an underweight to bonds. Within equities, we maintain a modest overweight to emerging markets and a corresponding modest underweight to developed ex-U.S. We continue to maintain a neutral stance to the broad U.S. equity market and are similarly neutral across all size and style buckets within the U.S.
About Bola Olusanya
Bola Olusanya has more than 20 years experience in investment management as both an executive and thought leader. As Managing Director of Asset Allocation and Portfolio Strategy with Key Private Bank, Bola applies his expertise to direct Key Private Bank’s third-party manager research efforts, oversee the group’s portfolio construction efforts, and design an asset allocation methodology applicable to all stakeholders.
Bola received an MBA with a concentration in finance from Emory University and an MS in computer science from the University of Lagos. He is known for his quantitative expertise, his extensive knowledge of the full spectrum of asset classes, and his ability to mentor and manage high-performing investment teams.