17 May Q1 2018 Market Commentary
This quarter, we asked Gratus Capital Director of Investments Todd Jones, MBA, CAIA, to weigh in on the current financial environment and critical market trends.
Here’s what Todd is talking about this quarter.
What are the biggest risks you see in the stock market right now?
There are four important risks to keep an eye on.
#1 – Rapidly rising interest rates due to an increase in short-term inflation. Recently, interest rates have been rising back to more normalized ranges, especially on the short end of the yield curve. This situation has the potential to make bonds competitive with equities at some point.
Clearly, we’re quite a ways off from that point. The long-term average for the 10-year bond yield is about 4.5%. Currently, the 10-year bond yield is 3%. Another half percent could cause bonds to become competitive with equities.
#2 – A central bank policy error. The Fed and other central banks are getting too aggressive with their interest rate tightening programs. Whether they’re raising interest rates on the short end via the discount window or running off their asset purchase programs at a faster rate than expected, a policy error would be problematic for financial markets.
Signaling the intent to raise interest rates and actually following through, with the slow wind-down of policies that were enacted years ago, will be critical to keeping stocks at their current levels.
#3 – Overconfidence of political figures and individual investors. On the government side, the tax bill (The Tax Cuts and Jobs Act of 2017) was just passed, and it may be followed by an infrastructure bill. While growth initiatives aren’t a bad thing, it’s very late in the cycle to be putting growth initiatives in place.
These initiatives would have been much better suited seven or eight years ago, but now that the economy is at full employment, the job market is going to become very competitive, which has the unsavory side effect of potentially creating inflation.
On the corporate side, share buybacks are set to hit their highest level ever. Typically, corporations have very poor timing for buying back shares. Usually, they buy the most at the peaks and don’t buy anything at the troughs. Corporations seem to be buying back a lot of stock—or probably too much—at prices that are not attractive.
#4 – Continued strengthening of the US dollar. A strengthening dollar has the effect of sucking liquidity out of the global financial system. If asset prices are built on increasing liquidity, then reducing liquidity should have the opposite effect. That’s what we saw in 2015 and ’16, when the US dollar rose dramatically, tanking oil prices and collapsing overseas dollar funding, which brought emerging market currencies down dramatically.
How is Gratus addressing these concerns on behalf of clients?
Generally, we are de-risking portfolios. Step one was trimming back our equity exposure to target over-weightings. We conducted a rebalance of many of our accounts in late January, reducing equity exposure and raising cash positions.
The second piece is that this is a great time to consider cash as an investment with a lot of optionality, especially now that interest rates have risen. Generally speaking, cash is rarely thought of as an investment. But now, investors are actually getting a decent rate of return in the money market. Holding cash isn’t necessarily as bad as it used to be, where the money market had an almost 0% expected return.
The third piece is, we’re adding more to what we consider to be our alternative bucket in our accounts. Typically, most of our portfolios are divided into equity, fixed income, alternative and cash buckets. We’re adding to the alternative bucket primarily, because we’re finding good opportunities.
Usually, alternative assets don’t depend on equity or fixed income markets to generate a return. Instead, a typical investment in alternative assets is more focused on differentials. If we’re using a market-neutral strategy, buying good companies and shorting overvalued companies doesn’t require a high multiple or a low multiple to be successful. Additionally, in private markets we’ve been adding exposure to certain strategies that have an appropriate risk/reward.
Some investors fall into a trap, thinking that they have to make dramatic portfolio decisions when in fact the small ones are what can really pay off over time.
Are earnings likely to continue to grow this year?
The short answer is yes. According to FactSet, analysts estimate earnings growth in 2018 of 18% to 19%. Those estimates are showing up in company earnings reports.
We’re right in the middle of earnings announcements season for Q1, and most companies are exceeding estimates by a small margin. That’s part of the reason we’ve seen a bit of a snapback recently off the lows of February and March.
Most of these gains in earnings are coming from a one-time change in the tax rate, so we shouldn’t necessarily depend on this type of growth rate in the future. Migrating down to a much more stable growth rate from a combination of revenue growth plus productivity gains would get about 6% to 7%.
Can the stock market continue to rise if interest rates keep going up?
The short answer is yes, but the caveat is that it’s only a “yes” if the adjustments are gradual. If the 10-year goes from where it is now to right around 4% in a couple of months, that would be toxic for equities. Not only would that rate of interest be competitive with equities, but also, funding markets such as corporate bond markets would be down dramatically — in the neighborhood of 10% to 15%.
A gradual re-rating of bonds allows equities to stay static and gives the P/E multiple time to decline as earnings growth accelerates.
What is Gratus’ approach to investing in international stocks?
We would need a compelling reason to deviate from our US bias. At Gratus, we fully recognize that investor biases come through in several different ways, one of them being home bias, and we’re certainly cognizant that we have a more US-focused portfolio.
That being said, there needs to be a reason to look outside the US, and non-US developed country indexes don’t currently present a compelling opportunity to invest internationally. As you might expect, we’re looking at active strategies in international companies.
We keep hearing an argument in the press about how international stocks are undervalued compared to US equities. On an absolute basis, international stocks are less expensive, but relative to historical ranges they are trading about where they should. If we can’t find anything outside the US that’s not uniquely cheap or attractive relative to our US positions, then we’ll just maintain our US positions. We are a value-oriented firm across all asset classes, whether it be fixed income or alternative or equity, and if there’s no demonstrative value proposition, then it’s probably something we shouldn’t pursue.
Gratus Capital is an SEC registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of May 2018, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.