Market Insights – 3Q 2018+
Following a volatile October, Cambiar President Brian Barish provides his latest insights on global markets and what it could mean for 2019.
We have a confession to make – our third quarter market commentary became somewhat dated by the time a first draft was completed in mid-October, as a violent global asset sell-off roiled the markets. To make this letter more purposeful, it will be “3Q+” commentary, running through October 31. With this non-standard time frame in mind…
Most developed market indices generated modest single-digit percentage gains in the third quarter, with fairly low volatility. In contrast, emerging market equities and currencies generally fared poorly in the quarter. U.S. short and long-term interest rates rose throughout the quarter, putting incremental pressure on EM currencies and leading to broad selling. Traditionally, U.S. equity markets have declined in the weeks leading up to mid-term elections, and breadth did deteriorate in the quarter; at an industry level, banks, industrial businesses, and “rate plays” such as REITs lost ground – mostly in September. Despite pockets of market weakness, broad U.S. indices did not correct appreciably during the third quarter. That changed approximately 72 hours into October, with most global equity indices falling 10-15% until bottoming in the final week of October.
Based on the above, there have not been a lot of places to make money in the world, with the “FANGMAN” stocks providing most of the gains in the U.S. stock market/global markets this year. These stocks have been a huge part of the market narrative since early 2017, spawning the world’s first $1 trillion + market cap companies in Apple and Amazon (they have not hung onto these levels though), and several others in the > $500 bn market cap club. There is an NYSE “FANG +” Index composed of the FANGMAN names (Facebook, Apple, Netflix, Google, Microsoft, Amazon, Nvidia, plus Tesla and Chinese giant Alibaba and Baidu). Due to its (oddly equal weighted) composition, the index does not precisely correlate to how a portfolio of these names might have performed; that said, sensational gains of 58% in 2017 and 29% in the first half of 2018, or about 3500 bps better annualized than overall market returns, reflect how pronounced this growth trade has been.
Capital Concentration into Dollar Assets Means 2018 is a Tough Year for Globalists
Away from the FANG+ stocks, returns in 2018 have been…abysmal to be precise. Stocks are down around the world, bonds are down, most commodities are down, and REITs/structured finance products are down. Outside of a narrow group of distinctive growth names, there have not been many very productive segments or subsegments. The graphic illustrates this case in rather dramatic fashion, with 2018 as the worst year on record for negative (dollar-based) returns across a variety of asset classes.
A large chunk of the broad-based losses stem from a strong year-over-year comparison; notice how good 2017 was, broadly speaking. We discussed this topic a year ago – i.e., asset prices grinding higher, strong economic data, and broad optimism by economists/technical analysts/strategists…juxtaposed against increasingly poor single-stock liquidity as active stock ownership rates continued to decline. The marketplace as of late 2017 had become uncomfortably comfortable paying very full prices for cyclically elevated earnings and distinctive business models, with gigantic sums flowing into passive investing strategies, subsequently fluffing up valuations and business conditions for a wide swath of industries. It is possible that such market conditions represented an “optimism bubble”, flattered by these highly correlated money flows into various asset classes. If so, 2018 might be a “pessimism bubble”, as earnings have not exactly collapsed in a manner befitting what has become a rolling bear market outside the U.S.
That is one possible explanation. Another is that Central Banks are no longer in the asset-reflation game, and we had better start getting used to it. For years, financial participants (myself included) have wondered about the degree and magnitude by which years of unconventional monetary policies have inflated asset values and masked relative risks. The answer surely lies in the wide space between “some” and “a lot”. The imminent question is whether it is more disruptive to have only one monetary regime (the U.S.) fully re-normalize its monetary policy, or whether this can happen across multiple regimes, as the Eurozone and smaller currencies in its immediate orbit look to re-normalize policies in 2019.
Re-normalization, if there really is such a monetary and economic creature, has not exactly hurt the U.S. economy, as business conditions remain exceptionally good – provided you are not in the market for a lot of new workers, as these are in short supply. It might not exactly hurt in other parts of the developed world either, as and when positive real interest rates are put into place. For the broad group of economies known by the Emerging Market moniker, positive real rates for the dollar have so far been destabilizing.
Emerging market economies and financial assets generally do not perform very well when their underlying currencies become volatile. A surging dollar, brought about by a less accommodating U.S. Federal Reserve, tends to upset the applecart. Emerging market equities entered a bear market in the third quarter, and by late October had declined by 27% from first quarter highs. These issues have not been contained to the emerging world as they continue to compound. Emerging market economic weakness can materially affect global profit levels, as many key industrial and consumer products derive their incremental growth in the emerging world.
Extending back as far as mid-2014 to current, broad U.S. stock indices have roundly trounced international alternatives. The discrepancy had already become extreme entering 2018 (to the tune of almost 50% between the S&P 500 and the MSCI EAFE), only to be compounded by a YTD (through the end of October) return of 3% for the S&P 500 Index vs. -9% return for the EAFE Index. Bull (and bear) markets have generally been positively correlated, but not this one. The performance gap over the last several years represents the widest on record. It has not paid to be a globalist to any great extent this decade.
We see three major factors leading to the wide discrepancy between U.S. and international stocks: 1) better U.S. corporate earnings growth, 2) an out-of-sync global interest rate regime leading to capital concentration in U.S. dollar assets (such as stocks), and 3) financial pressure on Emerging Markets as a consequence of capital concentration into the dollar.
Realistically, we don’t see these primary factors shifting decisively in a different direction between now and year-end. It is possible that U.S. stocks more than fully discount a lot of optimism about the future, or that the increasingly elevated extent of indexation of U.S. stocks has exaggerated all the good. Or perhaps the markets’ capacity to smile past the Trump trade rhetoric suddenly ends, taking U.S. returns lower. International markets have been for sale all year, and at some point, you run out of sellers. With the mid-term elections behind us, maybe the trade talk concludes with a big bro-hug in the coming weeks…
More realistically, abatement may happen in 2019, should the Fed relent from its current rate-hike path. Global investors are essentially playing to be well-positioned into the coming year at this point. For now, not unlike the many occasions in the 1990s and 2000s when the Dow Jones Industrial Average failed to sustain itself over 10,000, the 2,000 level has been a bit of a wall for EAFE stocks.
What Turns This Around?
It’s axiomatic, but bear markets sow the seeds of the next bull markets because valuations compress irrationally. Values abound in the late phases of a bear market as the selling becomes reflexive and unthoughtful, which can lead to diamonds on the street for investors with a modicum of patience and risk tolerance. Today’s international markets are reminiscent of broader global market conditions in late 2011-2012, when valuations were compressed for just about everything, from technology companies to banks to durable goods. The rationales at the time tended to be vague macro negatives – the U.S. had lost its AAA rating from S&P and an unresolved fiscal “cliff”, the Eurozone had a small rogue indebted state on its hands (Greece) and several large undercapitalized banks, and business confidence was poor. If you could wind the clock back to that time, it would have paid to be very aggressive and buy the weakness and daily negative headlines. But the timeframe to resolution would have been uncertain.
As the expression goes, these things end when they end. Today’s catalogue of issues is a bit different from market anxieties of the 2011-12 period. Features of the Eurozone remain unresolved, such as Brexit talks and Italian budgets, and importantly the ECB still has yet to lift off from 0% interest rates. These factors ought to be resolved some time in 2019. Internal demand growth in Europe and Japan remain structurally slow, leaving their companies rather hostage to global growth rates, and EM financial challenges don’t help. Cambiar views the relative earnings-growth superiority of U.S. companies as uniquely benefiting from the end-2017 tax cuts. Statistically, most companies’ earnings growth rate has to come down in 2019 from a nearly 30% growth rate this year, with higher interest charges and relatively poorer foreign exchange translation also crimping growth. Financial flows have followed the growth up to now, whether the Fang+ names or U.S. stocks in general. The math alone suggests further polarization beyond late 2018 levels may be unrealistic.
As the calendar turns into 2019, we see three critical “macro” events that may shape returns.
First, the U.S. Federal Reserve may pause rate hikes beyond the (anticipated) increase slated for December 2018. This would be cathartic for international money flows. The Fed is generally expected to raise interest rates to the 2.50% level in December. Given the behavior of the longer end of the curve, rate increases beyond the 2.5% may exceed “neutral” monetary policy. A move to 3.0% would get dangerously close to inverting the yield curve, particularly as the Fed balance sheet is also shrinking at this time. An inverted yield curve would lessen the global preference for dollar-based financial assets given the ominous financial signal it portends. As would a pause in rate hikes.
Second, the ECB should begin the process of exiting from QE and normalizing its own interest rate regime. Success on this front would bolster the value of the currency and business confidence, along with ending (or at least mitigating) the capital concentration in dollar assets. On a trade-weighted basis, the Euro (about $1.13 as of October-end) is generally viewed as an undervalued currency, with fair value closer to the $1.25-1.30 level. Yet given the interest rate differentials and a difficult to quash “what-if” question about bond yields and fiscal sustainability in weaker European countries, the Euro probably continues to trade cheap. The Fed messaged “gradualism” and “data dependency” as it exited QE and ZIRP in 2015-17 to assuage market psychology with good effect. The ECB needs to similarly communicate its new rules of the road as it stops buying sovereign bonds in massive quantities. We can only speculate what the exit plan may be – credit rating-based yield spread caps on weaker sovereigns vs. the strongest countries seems like a good idea to us – but maybe they have a different plan. ECB President Mario Draghi will step down in late 2019 after a heroic stint, and legacy at this juncture matters. A better Euro as an alternative reserve currency to the dollar matters a great deal.
A stronger Euro would partially neutralize the strong dollar tourniquet that afflicts EM financial conditions. The dollar’s status as the dominant global reserve currency is amplified by current conditions, where it is the only major reserve currency with a positive short-term interest rate. With most industrial products and commodities priced in dollars, a higher dollar on the back of higher U.S. rates creates double pressure on emerging economies in terms of import costs and financing. It is worth pointing out that U.S. interest rates have not been “normal” until 2018, having remained below 1% up to the latter part of 2017.
Last, China Finds Ways to Grow – World demand depends little on Argentina or Turkey, but depends considerably on China. To date, China cut individual tax rates and has let its currency slip a little versus the dollar, while tightening up the exits by which dollars can leak out of the country. In 2009, China enacted aggressive fiscal and monetary stimulus plans to offset the GFC-induced global recession. These measures worked in aggregate, although much of the spending was widely acknowledged as having questionable merit. We anticipate a more targeted approach to stimulus, with higher value-added industries getting priority. China’s growth has slowed from the early 2010s to today, and we expect it will continue to slow. However, the country’s move up the value-added curve to greater prosperity is clear on a broad basis. While we would not underestimate China’s growth, the challenge of sustaining growth off of a higher economic base should not be underestimated either.
Where Do These Musings Lead?
After a sustained bull market of tremendous magnitude in the U.S., it is easy to lose sight of the basic notion that return potential is far superior when assets are properly risked. At the beginning of 2018, asset prices globally reflected lower risks. Assets prices reflect a good deal more risk now. Whether they reflect enough risk, or whether financial markets can sustainably tolerate a very different set of Central Bank objectives – these remain open questions. Since the 2009 market lows, there have been two distinct ~25% bear market declines in non-U.S. equities – the 2011-12 time period (Euro Crisis), and the 2014-15 period (more due to dollar strength). The current decline stands at 19%, or the threshold of a bear market. These things have tended to exhaust themselves after about a year (we are currently at ten months). There is a basis for optimism and for the capital concentration in U.S. dollar assets (and U.S. stocks are dollar assets, to be clear) to evaporate off. The U.S. markets have been on their own island to an incredible degree. While we would not be surprised to see a reversal in the current domestic-over-international trade in the coming year, at a minimum we anticipate non-U.S. stocks to begin trading in more synchronous fashion with U.S. markets.
Thank you for your continued confidence in Cambiar Investors.
Brian Barish – President
Certain information contained in this communication constitute “forward-looking statements”. Due to market risk and uncertainties, actual events or results, or the actual performance may differ materially from that reflected or contemplated in such forward-looking statements. Securities highlighted or discussed in this letter have been selected to illustrate Cambiar’s investment approach and/or market outlook and are not intended to represent the performance or be an indicator for how the accounts have performed or may perform in the future. Each security discussed in this letter has been selected solely for this purpose. The portfolios are actively managed and securities discussed in this letter may or may not be held in client portfolios at any given time. Nothing in this letter shall constitute a recommendation or endorsement to buy or sell any security or other financial instrument referenced in this letter.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended by Cambiar and the reader should not assume that investments in the securities identified and discussed were or will be profitable. Characteristics are included for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics are based upon third-party sources that are deemed to be reliable, however, Cambiar does not guarantee its accuracy or completeness.
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