01 Aug Q2 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.
September would mark the 10-year anniversary of the Lehman Brothers collapse. Any updates on risks that are being overlooked by investors?
Interesting topic. Bloomberg just ran an article that speaks to this very subject which, I think, would be useful to review. In the article, the author identified four “big risks,” described below with my comments:
Post financial crisis, total global debt levels (which includes both sovereign and corporate) have risen a total of $63tln to $237tln according to estimates by the World Economic Forum. The article also notes that the number of countries with a AAA credit rating (the highest according to S&P) now stands at only 11 of a possible 193. Similar dynamics exist at the municipal level where the number of AAA states in the United States is only 14 out of 50 (28%). Clearly, accumulating debt for consumption is problematic at the personal level. This is because, at some point down the road, the debt service costs overwhelm one’s ability to pay, which is the case for individuals, states, and corporations. Sovereign nations, however, have the dual benefits of both a central bank and the ability to create currency. These unique features of a sovereign nation allows countries to put off the day of reckoning well into the future (e.g., Japan). However, if a nation accumulates too much debt (and subsequently issues new currency to cover interest payments) then the currency would decline in value relative to other currencies. Recent examples of this rapid decline include the Argentine Peso, Turkish Lira, and Zimbabwe Dollar. This decline in currency creates rapid inflation.
Our thought on the post Great Financial Crisis debt accumulation is that investors should be very thoughtful around making bond investments. We believe investments in asset categories such as high yield bonds, emerging market bonds, and long maturity bonds should be viewed skeptically given the risks. Our preferred destination in the bond market for the past few years has been short-term corporate/municipal bonds, floating rate bonds, and asset backed securities. These bond categories have been selected as a way to mitigate the impact of rising interest rates and inflation.
The final two points of the article relate to the fraying of international institutions (like the G-7, G-20, and World Trade Organization) as well as the hollowing out of the global political middle. The recent trend of the frailty of international institutions seems unlikely to dissipate with the election of self-proclaimed protectionists in places like the United States, United Kingdom, Austria, and Italy. In our opinion, these two issues are political and interrelated. It is difficult to say exactly how increasing trade tensions and a more polarized political system will impact financial markets directly, but we take comfort in the idea that stock prices are moved primarily by company earnings, not politics.
To date, global trade has not collapsed (unlike the 1920’s), therefore we are not making significant adjustments to our portfolios….. yet. That is not to say we have been sitting idle. Over the last 18 months we have been taking profits in select positions, raising cash levels back to target ranges, and revisiting client asset allocation. 
With the S&P 500 having recovered all the losses of the first quarter, how do equity markets look heading into the back half of the year?
First off, we don’t pretend to have a crystal ball. Anyone proclaiming to know what will happen in the future with any significant degree of confidence is kidding themselves. At Gratus Capital, we look at markets through the lens of probabilities.
Currently, our highest probability scenario for equity markets is one where global indices continue to grind marginally higher, ending the year with a mid to high single-digit return. Key assumptions we make in this assessment are that earnings will remain supportive in the US (thanks to the Tax Cut bill of 2017), interest rates will remain range-bound, and commodity prices will float higher (due to reduced capital expenditures on exploration). Within that framework, we continue to believe that large US companies are the preferred allocation for equities. Though small capitalization companies have had a nice run over the recent months, valuations are looking unattractive.
The passage of a large infrastructure spending bill could add additional upside to our base case scenario. Any infrastructure bill similar to what is being contemplated in Washington D.C. right now would add immediate spending to the economy.
Emerging markets have been in the news on a regular basis. Is this asset class approaching an attractive entry point?
We’ve been very vocal about avoiding emerging market assets in our portfolios. We initiated this “underweight” in the weeks following the first European financial crisis, circa 2011. Ever since that time, we’ve looked at various emerging market strategies but have not been able to get comfortable with the risks they would involve. One of the primary risks is currency risk. The example in Argentina in recent months typifies how currency dynamics can play an outsized role in returns. Year to date through 6/30/2018, Argentina’s largest telecommunications company, Telecom Argentina, is down -26.22% in local currency terms, while in US dollar terms the loss is -53.81%! In other words, a US investor’s return was affected an additional 27.59% just due to currency moves! We prefer investments where potential outcomes are easier to model.
Also, we continue to hear the valuation argument as a reason to consider emerging market stocks. Based in part on data sets like the one below, our analysis suggests that emerging markets equities are not presenting a very intriguing risk/reward as valuations for EM stocks are in line with their long term averages.
Any final thoughts you’d like to share?
If I had to sum up our thoughts into a couple of words it would be capital preservation. While our comments above would suggest there are opportunities to uncover in financial markets, we think a bigger opportunity (with equity markets at all-time highs) is in risk management. Positioning portfolios to be able to take advantage of lower equity prices is a priority for our Investment Committee (IC).
Finally, the valuation argument we hear that considers emerging market stocks as cheap relative to developed-market stocks makes a false comparison. There are reasons emerging market stocks should trade at discounts to developed markets. Some reasons include rule of law risks, established property rights, chronic nepotism, corruption, commodity sensitivity, and political volatility. There are a few countries where investment dynamics are improving, but, compared to equity markets like the US, there’s not a compelling reason to change at the moment.
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 July 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.
 https://www.bloomberg.com/view/articles/2018-07-03/lehman-collapse-10-years-later-four-major-risks Overall, this means making sure clients are taking the appropriate amount of equity risk relative to their long-term objectives.