One Day at a Time: 2019 Themes and Investment Strategy
January 11th, 2019
“The best thing about the future is that it comes only one day at a time.” —Abraham Lincoln
Each year around this time, the soothsaying inevitably flows from economists and strategists, each attempting to convey a flawlessly precise year-ahead forecast. Of course, projecting anything in the markets over such a short time frame is quite a difficult task. Last year, for example, many of these forecasts called for double-digit gains in stocks, bolstered by synchronized global growth and fiscal stimulus in the U.S. However, after a sub-par year for the markets, the same prognosticators now seem to be setting a far more somber tone.
Perhaps, as Lincoln noted, the future does come “only one day at a time.” Instead of relying too heavily on overly precise annual forecasts, we believe investors should favor a more strategic focus, identifying key themes along with the associated opportunities and risks and positioning portfolios accordingly while remaining nimble to change. At Glenmede, in addition to routinely evaluating and testing our investment strategies throughout the year, once a year we convene to whiteboard our themes and hone in on those that we believe are most important. The result this year is as follows:
#1 Late-Stage Tensions
“Begin at the beginning and go on till you come to the end: then stop.” —the King, “Alice’s Adventures in Wonderland” by Lewis Carol
The first theme is intended to recognize the tensions inherent in a late-stage economic expansion and bull market. Stocks have now experienced their longest bull market on record—the longest period of time without a 20%-or-more peak-to-trough decline (Exhibit 1). This bull market has come on the back of one of the longest economic expansions on record: nine years and counting. Recently, the market has encountered a bout of relatively significant volatility as investors have begun to question the sustainability of this bull market and expansion.
However, while long in duration, this expansion has been relatively moderate, with cumulative economic growth amounting to roughly half of what would occur in a typical nine-year-long expansion. This is important because the economy works to some degree like a rubber band— typically stretching to a point where the tension prohibits further growth and increases the likelihood of a return to normal. The slow growth of this cycle means the rubber band is less stretched than normal at this point in the cycle and, as a result, there is a lower likelihood of a recession.
We are not suggesting there is zero likelihood of a recession. In fact, while we do not yet see the typical levels of over-extension, our analysis does suggest there is some vulnerability. The Glenmede Recession Model is currently forecasting a near-35% chance of recession in the coming year (Exhibit 2). We would characterize this reading as a cautionary yellow light, not a stern red-light warning, given the 65% probability that the expansion continues.
In order to examine the likelihood of recession from a more conceptual perspective, one can divide the key indicators into three categories(Exhibit 3): economic excess; constraining factors, such as inflation and monetary policy; and market signals, such as the Treasury yield curve and high yield corporate bond spreads. Individually and cumulatively, we believe these indicators signal a low or only modest chance of a recession in the next 12 months. Taken together, they provide an overall picture of a moderate risk of recession.
Through the first half of 2018, markets had risen alongside ongoing economic growth and investor confidence had finally been largely restored, driving valuations higher. As is typical in the late stage of an expansion, as valuations had risen, forward return expectations had fallen, leading us to observe that nearly all asset classes were expected to deliver below-normal levels of returns for the next 10 years. This created a quandary for investors. More muted forward returns and modestly higher signals of recession risk were in sharp contrast with the still-reasonable compensation for risk as the value of stocks, and their expected returns remained more attractive than cash and bonds.
Such an environment, however, can create investor anxiety and market volatility, as was the case at the end of 2018. However, the weakness in December has changed this picture rather materially, increasing expectations for stocks as their valuations fell and lowering expectations for bonds as longer-term rates fell as well (Exhibit 4). This creates a more compelling argument for investors to maintain a neutral equity positioning in spite of the signs of fragility in the economy. Having said this, we still prefer a modest defensive stance within portfolios, recognizing the increased risk of recession and the heightened volatility-creating anxiety.
#2 The Not-So-Invisible Hand
“Just because you do not take an interest in politics doesn’t mean politics won’t take an interest in you.” —Pericles (430 B.C.)
Adam Smith1 penned the concept of the “invisible hand,” which accounted for the collective influence that participants acting in their personal interest had upon the economy. Our second theme reflects on the abnormally large influence of the “not-so-invisible hand” government intervention. The table below is a representative list of global government actions taken throughout the nine years of this expansion. While not exhaustive, it highlights the extreme government measures taken to guide the markets and economy throughout this expansion.
In 2019, we expect it will be just as important to watch government involvement. The second wave of the U.S. Tax Cuts and Jobs Act will go into effect in 2019, and is expected to be as impactful as in 2018. The Federal Reserve is expected to continue its balance sheet reduction and will react to the data in determining future rate hikes. The European Central Bank is expected to begin shifting gears as well. Add to this trade policy discussions and the potential for additional tariffs and/or changes to existing ones. Clearly, there are numerous and significant pieces in motion. We believe these policies are, on the whole, slightly positive to neutral for the economy due to the offsetting effects of positive fiscal stimulus and dampening monetary policy and tariffs. The magnitude and impact of tariffs remains a wildcard we continue to monitor closely.
#3 Diversification Fatigue
“Nothing sedates rationality like large doses of effortless money … normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is, continuing to speculate in companies that have gigantic valuations … will eventually bring on pumpkins and mice …” —Warren Buffet, Berkshire Hathaway 2009 Annual Report
While the financial industry often promotes the idea of diversification—by stock, region, strategy, etc.—diversification has not worked all that well this cycle. Instead, investors have been rewarded for concentrating investments in a select few companies.
As an example, we look no further than the total capitalization of the top five stocks in the S&P 500 (Exhibit 5): Facebook, Amazon, Apple, Microsoft and Google, which all had grown to represent more than 15% of the index at their high. Each has delivered impressive fundamental growth due to the pioneering dominance of its respective business. Each is valued relatively highly for its fundamental success. Each is jockeying for the next growth opportunity to justify the valuations afforded by the market.
These five were not the only companies rewarded for their technology-enabled business growth. A broader picture of this trend can be seen in the performance of growth and value stocks. Growth companies exhibiting above-average growth in recent earnings reports are expected by analysts to provide above-average growth going forward, and awarded premium valuations. Current examples include Facebook and Amazon; two of those top five stocks noted earlier. Value companies, in contrast, are defined by slower growth, more modest growth expectations and discounted valuations that may spell opportunity for investors. Examples include more established companies like JP Morgan and Walmart. Growth stocks have outperformed value stocks by 5% per year for the last five years, an unusually strong deviation (Exhibit 6). It is important to note that in past similar cycles, growth stocks eventually gave way to value, continuing the oscillation between the two.
While investors have become enamored with growth stocks, they have also been captivated by growth regions, with the U.S. as the regional poster child. The U.S. stock market is uniquely concentrated in rapidly growing, technology-related businesses—more than twice the weighting of such companies when compared with developed market peers such as Europe and Japan. Similarly, the U.S. has a smaller allocation of traditionally value-oriented areas, like financials and industrial companies. During a period of outperformance by growth and technology related issues, it shouldn’t be a surprise that the U.S. has seen stronger returns than international markets. However, like the growth value dynamic, this too is subject to oscillations over time. Not long ago, from 2002 through 2007, international stocks roared ahead of their U.S. counterparts (Exhibit 7).
It can be difficult to imagine how these growth companies and regions could ever encounter a period of underperformance. However, should such companies be rewarded so specifically and to such a degree as they have been? Could so many businesses and business models simultaneously succeed in delivering upon such heady growth expectations? We feel we have heard this song before. It might not be the exact same song, but we suspect we may know how it ends, with, as Warren Buffet put it “pumpkins and mice.” In other words, a reversal of predominant trends that is sharp enough to cause anguish for investors chasing recent performance. Such a reversal need not be a market rout; a rebalancing of fortunes between growth and value, both domestic and international, would seem quite appropriate.
#4 Not All International Markets Are the Same
“All generalizations are false, including this one.”—Mark Twain
As a follow up to our third theme, here we recognize that not all international markets are the same. Most international markets trade at a discount to the investor-preferred U.S. markets, but these markets may be too similarly priced. In order to illustrate this concept, we created a rubric (Exhibit 8) that compares our views of key international markets on four attributes: valuation, fundamental growth, business environment and government stimulus.
While each of these markets seems to have a somewhat attractive valuation, key differences are noted in fundamental growth and overall business environment. The contrast between Europe’s dysfunctional politics and Japan’s pro-growth reform efforts is significant. Japan’s government is actively attempting to reassert its position in world markets by outwardly encouraging business efficiency, entrepreneurship and shareholder-friendliness. After a series of government actions, these efforts are showing their effects with rising profit margins, growing profits, increased dividends to shareholders and follow-on effects for the economy. The contrast between emerging markets in Asia and other regions of the world is similarly large. Asia’s emerging markets, no longer just China, but nations like Vietnam and Indonesia, are replicating Western capitalism by encouraging entrepreneurship and business formation and growth. As a result, these countries are developing modern consumer markets, complete with their own middle-class society of consumers. The net effect has led to stronger economic and profit growth. We continue to believe these regional differences are not sufficiently reflected in the valuations of these markets, providing opportunity for investors.
Strategy: Investment Implications of Our 2019 Themes
In summary, investors should utilize a modest level of protection in portfolios since the risks to the expansion and equities are more pronounced at this current stage of the expansion. Our base case remains that the expansion will continue, meaning investors will need to balance between growth and protection. Reducing equity exposure is one way to achieve moderate protection, but employing defensive equity strategies is our preferred method. Such strategies, while partly insulated from the volatility, should participate better than cash or bonds if the expansion continues.
Investors should be mindful of diversification. While the success of certain concentrated stocks has temporarily undermined this approach in recent years, such narrow markets do not tend to persist. Investors should attempt to strike a balance between growth and value, favoring value on the margin. We suggest that investors should look abroad where valuations can be more attractive, paying particular attention to regions such as Japan and emerging markets in Asia where more favorable circumstances are still not fully reflected in their relative valuations.
As we enter 2019, the market’s perception of risks and the resulting volatility is high, a stark contrast to the complacency and strong growth expectations at the end of 2017. Such simple extrapolations of recent events, however, have proven faulty many times before. It is important to reflect on recent history, but it is also important to recognize how expectations can change and stay grounded in a broad understanding of the business environment and market valuations—thus our themes as outlined in this Market Insights. The future still does come just one day at a time, and by understanding this, we will be more capable of adjustment.
You may also be interested in:
A Condensed Overview of our 2019 Outlook
Webinar Replay: 2019 Investment Themes and Portfolio Positioning
1 Adam Smith (June 16, 1723–July 17, 1790) was a Scottish economist, philosopher and author of “The Theory of Moral Sentiments” (1759) and “An Inquiry into the Nature and Causes of the Wealth of Nations” (1776), often abbreviated to “The Wealth of Nations” and considered the first modern work of economics.
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