10 Oct Q3 2019 Market Commentary
Director of Investments Todd Jones, MBA, CAIA®, weighs in on the current financial environment, critical market trends to watch, and what it all means going forward.
Here’s what Todd is talking about this quarter:
Three dynamics setting the stage for a sideways equity market;
Current market opportunity for “value” stocks;
Where bonds now fit into our portfolio.
I Can Feel It Coming In the Air Tonight
Any fan of 1980s rock music would immediately recognize the title to this update as the Phil Collins song bearing the same name with one of the most recognizable drum solos. I’m not sure how this song popped into my head, but I think the essence of the song (with its mystical opening, followed by a melancholy middle, and then a climactic end) aptly describes the sentiment in both the equity and fixed income markets.
Since the ebb of the global financial crisis (GFC), global equity markets have meandered higher, while global bond yields have migrated lower. Global stocks have been pulled higher, primarily, from the contribution of earnings from the US technology sector. The US technology sector has been the beneficiary of a number of tailwinds to include (1) above-market revenue growth, (2) above-market profit margins, and (3) little regulatory interference.
Present-day, however, revenue growth in the technology sector is slowing, profit margins are starting to turn lower, and the drumbeat for regulatory involvement is getting louder. These three dynamics set the stage for a sideways equity market until we reach the next identifiable catalyst (US presidential election), as the main contributors to earnings growth has slowed. We’ve held this view for a number of quarters, and it has largely unfolded as we expected.
In our view, the outlook for equity index investors is somewhat muted for the foreseeable future.
Significant Opportunity In Value Stocks?
Over the years, the way we measure value has evolved, as accounting rules and tax policies have changed. However, a focus on the ability of a company to generate free cash flow has never wavered. Further, we also assess how much of that cash generation is reinvested in the business versus paid out to shareholders.
Why would we care more about this metric versus the past? Look no further than the performance of recent initial public offerings (IPOs), presented in the table below. In our humble opinion, these companies have little hope of generating free cash flow anytime soon, given their substantial reinvestment needs.
To be fair, the above table is a small sample size of recent, high-profile IPOs. Further, there are examples of recently-public companies that have traded above their IPO price (Zoom Technologies, Beyond Meat, Crowdstrike, etc.). However, the point of the table above is to illustrate that the further into the current economic cycle that we get, the more skeptical we become of companies not generating free cash flow.
This leads to our thoughts on the current market opportunity for “value” stocks. First, we find it encouraging that performance has been disparate between the various S&P 500 sectors.
For example, the top-performing S&P 500 sectors over the last 12 months were utilities (+23.28%), real estate (+16.66%), and consumer staples (+13.97%). The bottom-performing S&P sectors over the last 12 months were energy (-22.91%), industrials (-1.85%), and materials (-0.53%). Of particular interest, the difference between the best-performing sector and the worst-performing sector was 46.29%!²
This type of dispersion is a welcome dynamic, as it means there are opportunities in certain segments of the market where potential value can be found by active equity strategies. Further, if our baseline indicates that US growth should remain stable, then valuations for some of the economically-sensitive sectors listed above (energy, industrials, materials) may have overshot to the downside.
As we’ve stated in prior updates, volatility can be our ally. We will wait patiently for the cacophonous drum solo to signal our opportunity has arrived.
Where Do Bonds Fit Into Our Portfolio Now?
If the outlook for index equity is melancholy, then the outlook for fixed income assets is equally muted. Recall that we are looking for two key attributes in fixed income investment:
(1) Income generation
(2) Stability of capital
Does the fixed income asset have a yield that is above inflation?
If not, then your fixed income is losing you money.
For example, on September 30th, the yield on the US 10-year Treasury bonds was 1.54%3 while US inflation was 1.7%4. This means that for someone buying a US 10-year Treasury bond today, they should expect a 0.16% loss in their purchasing power, assuming inflation remains where it is for the next 10 years. If inflation goes up over that 10-year period, further purchasing power is lost.
For our fixed income strategies, we prefer positions that have a starting yield higher than inflation and are relatively short in maturity (so that we can capture any future rises in inflation).
Stability of Capital
The current interest rate environment is very unusual. This is mostly due to the toxic effects of negative interest rates, as applied not only by the central banks in Germany and Japan, but in many other European countries, as well.
While I don’t want to necessarily focus on why yields are negative around the globe, I do want to address how the price of a bond moves once interest rates go to zero (or below).
In simple terms, as the interest payment on a bond goes lower, the sensitivity in the price of the bond to changes in interest rates goes higher. If this is the case, then from an investment perspective, we can no longer look at Japanese (red line), German (blue line), or other negative-yielding bonds, as they no longer fit our need for stability of capital (nor our income generation requirement).
As the opportunity set (described above) continues to shrink, we will adjust along the way. Currently, there are enough investible bonds to justify a fixed income allocation.
In summary, while we cannot predict the future, the feeling of unease is starting to grow as we exit the end of the melancholy section of the song. What awaits us on the other side of melancholy is a change in volume and tempo. When we will reach the bumpy period is difficult to know.
What we do know, however, is that valuations in both equities and bonds would suggest low single-digit returns are in our future (if you are using an index approach). We are clearly investing differently than our benchmark and continue to opportunistically rotate out of index positions. We remain in a conservative position and will be looking for opportunities to add new positions (or trim existing positions), as the index gets more volatile in the months/years to come.
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 April 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. Examples provided are based on current market conditions, and there is no guarantee that any applicable condition will remain in place. Portfolio holdings are subject to change at any time and may differ materially in the future from case studies presented. 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.