Portfolio & Market Review: Q3 2018
A strong US economy drove US stocks and bond yields higher over the third quarter of 2018. Investor optimism thrived as Q2 earnings came in strong and positive economic and sentiment data rolled in during the summer months. Consumer confidence hit its highest level since 2000 while unemployment metrics reached lows not seen since the late 60’s. According to the National Federation of US Business’s survey, small US businesses, benefiting from rising wages and lower taxes, were the most optimistic they have been since 1974. Interest rates continued to drift higher as the US Federal Reserve (Fed) continued down its path of normalization raising its discount interest rate for the third time this year by ¼ of a percent to a target range of 2.00%-2.25%.
While the quarter was kind to the US markets, the same cannot be said about international markets. Over the course of 2018, we have continued to see a decline in the “global growth synchronization” we experienced in 2017 and has given way to “global growth divergence” with the US leading the pack. Data over the third quarter continued to suggest that US growth continues to accelerate, while growth in the rest of the world has started to slow. The dual effect of higher interest rates and stronger growth prospects in the US have resulted in a flight to the dollar and dollar denominated assets, creating a wide dispersion in investment returns.
US stocks had their best quarter in 2018 as they increased 7.4%. The rally in US stocks was broad- based as all 10 major sectors were positive with Healthcare (+14.5%) and Industrials (+10%) having the strongest performance. Growth stocks continued to surge (+9.2%) versus their value counterparts (+5.7%). The divergence between growth and value stocks, now up 17% and 4% respectively on the year, has been a clear underpinning to the markets this year (more on this below).
Developed international markets returned 1.4% over the quarter as the Eurozone continues to deal with tariff threats from the US and political uncertainty in Turkey and Italy. European banks, in particular, had a difficult August in response to investor concern about financial exposure to Turkish debt. Although trade tensions continued to escalate during the quarter, Japanese equities were a bright spot, up 5.9%, as the highly export-driven economy benefited from an increase in business sentiment and a weaker yen.
Emerging markets continue to struggle in 2018 and finished the third quarter down 0.9% bringing year to date returns to a disappointing - 7.4%. Regional returns were mixed as both Latin America (+4.7%) and Eastern Europe (+2.3%) rebounded from a very difficult second quarter, while the Asia region fell 1.9% led by China (-7.7%). As has been the case over the year, emerging economies that are most reliant on external sources of capital are having trouble dealing with a rising dollar and rising interest rates in the US. Most of these countries have large amounts of dollar-denominated debt and run current account deficits (e.g. value of exports is less than value of imports). This situation has caused their currencies to depreciate, thereby forcing their central banks to raise interest rates to defend their currencies and control inflation, leading to a drag on growth. As we have discussed in previous letters, we expect that a strong dollar, higher US interest rates, and trade tensions will continue to be a headwind for the emerging world.
Overall, global growth remains positive with the US as the clear-cut leader. The most obvious near-term risk to the global markets is the potential for a further escalation of trade tariffs from the US. While some headway has been made with agreements between Mexico and Canada, the most important issue weighing on the markets is China. To date, the US is imposing tariffs on $250 billion of Chinese imports, and China has retaliated with tariffs of $110 billion of US imports. Tariff rates are scheduled to increase in January, and if a deal cannot be reached, they could become an increasing drag on global growth while at the same time push prices higher. While these tariffs are marginal in comparison to national GDP’s, the extent to which the US and the rest of the world can withstand the impact of higher tariffs and any further escalation will be key going forward. At this point, growth remains healthy, but the risks are gradually increasing.
Model Portfolio Update
Our investment approach at New Capital is maximize investor returns through efficient management of risks and implementation costs. As markets have become more globally integrated, we have constructed portfolios that are well-diversified across the world. Additionally, we have made a conscious effort to tilt our portfolios to risk premiums (value, which means low stock price to book value, and smaller companies) that we believe will provide superior long-term risk-adjusted returns. These approaches are very well supported by academic research and historical performance.
This year has proven challenging to our approach. While our portfolios include substantial growth components, the strong robust global economy last year, where value, small-cap, and international stocks outperformed, gave way to a very narrow market where US growth and small-cap stocks have far outpaced other categories. To make matters worse, bonds (designed to provide stability and income) have had a negative year, down almost 2%.
In short, 2018 has been a tough year for diversification. Although fundamentals remain strong across the globe, economic data abroad, especially in the Eurozone and Japan, has cooled somewhat from a very hot 2017. On the positive side, earnings data has begun to improve in these regions with anticipated earnings growth to be on pace with the US in 2019.
In the US, strong earnings driven by tax cuts, low unemployment, rising wages, and trade tensions have created a growth differential versus the rest of the world and subsequently very strong domestic equity returns. However, the effects of the tax cuts are not expected to last into next year and low unemployment and rising wages are likely to be a headwind to earnings going forward. Moreover, US equity prices reflect these developments.
Investors typically flock back to value companies in the later stages of an economic cycle. On August 22, the current 9-year bull market became the longest on record, so it is very likely we are in the later stages of this cycle. Coincidentally, industrial and healthcare stocks, which are traditional value sectors, had the strongest returns in the third quarter indicating that investor preferences may be changing.
As long-term investors we understand that markets move in cycles and certain asset classes, investment styles, or regions can fall in and out of favor. During such times, the investment experience can feel challenging, however, history has shown that markets tend to “mean revert” and it is best to stick with a long-term plan designed to meet your financial goals.
There were no changes to our model portfolios during the month of September.