07.10.18 2018: A FIRST HALF FULL OF “CHARACTER”
While we make no claims of clairvoyance, below were the four key themes we identified in our 2018 Outlook back in December:
- Return of higher / “normal” volatility?
- Investor complacency
- Global growth (especially Europe Ex-UK)
- The Fed (Interest rates & Balance Sheet)
A quick glance at the above list tells much, but not all, of the story of the year’s first half. To varying extents, each of the elements listed contributed to what we would term a first half “full of character.”
Whereas 2017 was a year most noteworthy for its lack of volatility, 2018 quickly turned that trend on its head in late January, as the VIX (the measure of volatility for the S&P 500), traveled from 11.5 to over 50, only to fall back to below 18 in 2 weeks’ time. As the first half concludes, it again sits well below historically normal levels.
Global growth has been more “mixed” than many, including our team, anticipated. Largely driven by political uprisings, labor disputes, and uncertainty surrounding trade and tariffs, this could persist. While the non-US growth construct remains largely in-tact, it may require investors exhibit a bit more patience than initially thought and offer a longer runway to allow the story to fully play out.
In the US, growth, unemployment, and inflation have all slightly outpaced expectations. US companies have largely posted strong earnings, bolstered by benefits from the 2017 tax cuts. However, all eyes remain fixed upon forward guidance. Recent weeks have shown that companies with weak earnings guidance may see their stock price punished by Wall Street.
The Federal Reserve has raised interest rates twice in the first six months and the market anticipates at least one more, with a slightly greater than 50/50 chance for a fourth increase in 2018.
Below are a few other highlights of the year’s first six months:
- Oil prices rebounded >15% after a tough 2017
- 10-Year US Treasury Yields topped 3.1% in mid-May, but slipped back to 2.9% by quarter end (yield was 2.06% in September 2017)
- President Trump met with North Korean leader Kim Jon Un for historic nuclear disarmament discussions
- Trade tensions grew as the US and China staged a very public “game of chicken”
- Jamie Dimon, Jeff Bezos & Warren Buffett began collaboration to address rising healthcare costs in the US
- General Electric (GE), an original member of the Dow, was removed after 122 years
For more than 9 years, simply being “long” equities has been a highly profitable trade. Despite a couple of quickly fading disruptions, the upward trend has persisted. Consider the short list below of what has transpired since the bull market began:
- US Debt downgraded from AAA
- Oil prices fell more than 75% from $108 in mid ’14 to less than $27 in early ‘16
- The UK votes to exit the EU (Brexit)
- The US elects Donald Trump President
- The US enacts largest tax cut in 30 years
- The US national debt doubles
The equity market’s upward momentum has been a seemingly unstoppable force. Nonetheless, investors are wise not to rest with a false sense of security. If the past 20 years have demonstrated anything, it’s that things DO change. Since the 21st century began, the S&P 500 has averaged less than 3.65% per year (ex-dividends)…and that’s inclusive of the second longest Bull market the market has ever posted.
As bond yields have fallen over the past decade, investors have been faced with a gut-wrenching challenge—how to garner the returns needed with an allocation that’s risk appropriate. Nine years has validated owning equities, but for many, disproportionately so.
Risk management isn’t simply about judging the probability of a loss, but also about its magnitude…
Risk management is boring until it’s not. Along with our temporal distance from the pain felt during the Financial Crisis, outsized gains in equities have made it increasingly difficult to stay invested in risk-mitigating strategies.
But the good times can’t last forever! Risk management should be a primary focus given equity valuations, interest rate trends, demographics, and the fact that central bankers continue to remove the stimulus backstop. As we’ve pointed out many times, the math of a big loss is daunting. A 30% loss necessitates a 43% gain to return to even.
Unfortunately, market declines often intersect with investors’ need for distributions. Unchecked and out-of-balance risks should be discussed and can be mitigated. Rather than focus on how much longer the Bull Market may run, we urge clients to remain focused upon the long term—your needs, and your ability to prosper regardless of the storms.
Second Half Outlook: 2018
Halfway thru 2018, perhaps the largest surprise remains the relative dominance of US companies compared with their foreign peers. We wouldn’t be surprised if that trend persists a bit longer. The backdrop for US growth remains strong. Innovation still largely flows through the US.
Don’t be surprised if we see further market volatility, driven by trade policy, upcoming mid-term elections, and global political uncertainties. Couple those factors with OPEC, NAFTA, healthcare and immigration and you have a recipe for volatility.
To properly lay the foundation of our second half outlook, we believe it useful to take a look back at what’s changed during the past 30 years. Asset allocation across US and Non-US, coupled with bonds was a cutting-edge approach that worked! But why? Was it skill or timing?
We would argue that a simple approach could leave an investor short of goals, short on patience, and well short of satisfied. The returns many investors grew to expect, the proverbial 7-8%, reflected a realistic expectation largely because Treasury yields were also much higher.
Today, with yields hovering close to 3%, what blend of asset classes provides an investor that 7-8% many seek? Assuming 3% for the fixed income portion, a 60/40 portfolio would need equities to post more than 11% per annum to aggregate to an 8% blend.
RETURN = SKILL + OPPORTUNITY
After a steady climb for more than 9 years, where is the opportunity set today? Should we ask equities to post another double-digit gain, then another? Should we take more risk in bonds?
We aren’t suggesting an investor eliminate bonds from the portfolio, nor that they overweight stocks without consideration of the risks associated. Instead, we believe that managing bond risk in this environment entails staying predominantly allocated to high-quality and short/moderate duration portfolios. That combination, in our estimation, will likely produce modest returns. When it comes to fixed income, the risk/reward skews us defensive.
With regards to equities, we remain committed to an active approach keenly focused on managing risks. We believe investors are still well served to maintain exposure to both US and non-US equities. There’s no assurance they will post double-digit returns, but we believe they still present the most appealing risk/reward among all liquid asset classes.
Anticipating neither bonds nor equities posting a repeat performance of 2017, what do we do to add value? How do we look to bridge that gap (if in fact there is one)?
We would direct you back to the quote referenced earlier…if opportunity is relatively modest, then skill is at an enormous premium. It is our assertion that such skill must manifest itself in both portfolio construction and expected outcomes.
For our team, we believe complex challenges necessitate multi-faceted solutions.
We believe the answer hinges on the idea of Strategy Diversification. By introducing multiple streams of potential returns, our clients never become overly reliant upon any single discipline. Consider the following:
- When “long equities” is in favor, we have a portfolio that can provide such an exposure.
- When momentum is “king” we have a tactical portfolio that can participate in the trend (and get defensive as the model shifts).
- When alternative asset classes and strategies seem most opportune (and have historically fared best), we have a defined process to overweight them.
- When opportunities are few and raising cash is prudent, we have a signaling process that does just that.
Not only does this approach offer diverse exposures to the markets, but it also creates a discipline whereby our exposure to each market can be reduced.
Determining how to react in a storm is nearly impossible. Unless one has a plan and a discipline, you simply are left with gut feel. As we often say, buy, hold and hope is a lousy investment strategy.
Put simply, as we move through the second half of 2018 and beyond, diversity of strategies is essential. At Head Investment Partners, our “complex” solutions allow us to enter the back half of 2018 with more than just HOPE…with confidence!
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Explore how strategy diversification can enhance your portfolio’s Risk/Reward relationship and help you achieve your financial goals. Contact Head Investment Partners to schedule a strategy overview and portfolio assessment.