10 Jan Q4 2018 Market Commentary
This quarter, we asked Gratus Capital Director of Investments Todd Jones, CAIA®, to summarize the discussions from this quarter’s Investment Committee meeting.
Here’s what Todd is talking about this quarter:
• The fourth quarter was a rough period for investors, bringing most asset classes into negative territory for 2018. While unpleasant, Q4 volatility is emblematic of late-cycle price behavior and should be the expectation for the foreseeable future.
• Higher volatility in the equity markets, while difficult to endure, does not provide any new information about the direction of financial asset prices.
• We continue to closely monitor the investment-grade (IG) and high-yield (HY) bond markets as we believe interest rates are the critical variable in financial asset prices.
• Asset allocation benefits reappeared in the final quarter of 2018. Diversification, which can add non-correlation benefits, continues to be a powerful portfolio management tool.
The fourth quarter was a rough period for investors, bringing most asset classes into negative territory for 2018. While unpleasant, Q4 volatility is emblematic of late-cycle price behavior and should be the expectation for the foreseeable future.
While the fourth quarter ended with a significant decline in US stocks, it’s important to recognize that “bear markets” have occurred in global stock markets since 2008. As the chart below indicates, there have been three peak-to-trough declines of >20% when considering all stock markets as one. The fact that US stocks now find themselves in the company of other equity markets that have had significant declines should not, by itself, set off alarm bells. Instead, I would look at the other side of the coin. The fact that global markets have been able to recover from -20% declines, in both 2012 and 2016, should give US investors some comfort that the recent move lower in equities could be a buying opportunity.
As we indicated in a recent publication, the underlying economic data (which supports financial asset prices) has not changed in a material way. Though global growth is clearly slowing, only a few of the indicators we monitor show a recession on the horizon.
Higher volatility in the equity markets, while difficult to endure, does not provide any new information about the direction of financial asset prices.
As global equity markets have moved lower, the VIX (or volatility index, a.k.a., “Fear Index”) has moved up to a higher-than-average range. While a higher VIX is certainly mirroring a higher level of aggregate price movement within the S&P 500 and MSCI ACWI, it’s difficult to draw conclusions about what this higher volatility level actually means for future returns. The VIX represents a classic coincident indicator, which means changes in the VIX reflect changes occurring at the same time in the S&P 500.
If anything, higher levels of volatility will translate into better opportunities to add to either individual stocks or equity asset classes in the future.
We continue to closely monitor the investment-grade (IG) and high-yield (HY) bond markets as we believe interest rates are the critical variable in financial asset prices.
For the better part of the last ten years, global central banks have depended on interest rates as their policy tool of choice to help stave off a global deflationary episode. Interest rates were specifically selected because most financial asset prices use interest rates as a key input in determining valuation (lower interest rates=a higher valuation, and higher interest rates=a lower valuation). Currently, the US Federal Reserve is actively working to raise short-term interest rates (via the Federal Funds rate and balance sheet adjustments), while both the Bank of Japan (BOJ) and the European Central Bank (ECB) continue to remain stimulative.
In 2019, monitoring the IG and HY bond markets will be important, because global corporations have binged at the trough of cheap debt via low interest rates. In fact, from January 2008 to December 2018, aggregate US corporate debt has grown an eye-popping $2.5tln (or 40%), taking corporate leverage ratios up with the increasing debt level.
All this is to say, the investment grade bond market represents a key funding mechanism for companies looking to raise capital. Recently, investment grade bond yields have been rising as the investment community is beginning to question which companies can ride out financial distress. Relating to our portfolios, we still prefer conservative strategies in fixed income. We expect this approach to provide not only a stable source of income generation, but also portfolio optionality in case equity prices continue to fall.
Asset allocation benefits reappeared in the final quarter of 2018. Diversification, which can add non-correlation benefits, continues to be a powerful portfolio management tool.
While easy to forget when equity markets are strong, short-term, high-quality bonds and cash turned in a respectable 2018 performance. This performance is ironic, given the widespread dismissal of short-term, high-quality bonds last year. We mention this performance because most other fixed income positions (corporate, emerging market, high yield, etc.) all turned in negative performance in the period. In fact, as the heat map chart below indicates, only 3 of 17 asset categories ended 2018 with positive performance (~17%). This is the worst asset class showing since 2008!
While 2018 was a challenging year for index-level investing in many categories, select active strategies in other categories proved beneficial. Differentiation, more importantly, is now starting to become evident in many active equity strategies, and price movement between individual stocks is reaching levels last seen in 2011. Lastly, our investment committee continues to believe that index investing (particularly in fixed income and International equities) will experience more challenges in the years to come. We expect active approaches, which can take advantage of rapidly changing prices in securities, will be one of the few ways to generate adequate returns through the end of the current market cycle.
There is no doubt that 2018 was a challenging year for investors. Yet, with volatility comes opportunity. For example, we would really like to add back to high-yield bond positions … only, at higher starting yield levels. Those investors watching individual companies (and sectors) will notice that the equity markets have experienced bear markets in many places. Positioning portfolios in a conservative manner as we enter 2019 and being ready to take larger amounts of risk when the market conditions are right will remain our priorities. Finally, because cycles are getting shorter, we intend to retain flexibility in our holding periods, with a preference for exiting a holding above fair value and looking for new opportunities.
 The term bear market refers to a peak-to-trough decline of 20% or greater.
Todd Jones, MBA, CAIA®
Gratus Capital is an SEC-registered investment adviser. 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 January 2019 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. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.