The Margin of Safety Quarterly Summer 2018
Second Quarter 2018 Key Takeaways
- US stocks rose to the top of asset class performance charts with solid returns in the second quarter and year to date
- Developed international and European stocks declined, as the US dollar rebounded
- Emerging market stocks fared worst and are down over 7% in dollar terms year to date
- US bonds were flat for the quarter and are down under 2% year to date
- With the US economy growing and the labor market tight, the Fed continued its gradual path of raising interest rates
- The global economy remains in pretty good shape, with real GDP growth expected to be above trend again this year
- Recent US dollar strength may continue for a while as currency momentum can take on a life of its own
Second Quarter 2018 Investment Commentary
We celebrated our 242nd birthday as a country on July 4, with traditional fireworks a plenty. Investors are also experiencing “fireworks” of late, with a steady bombardment of “noise” and smoke around trade wars, China, Korea, Russia, etc. US stocks pulled back from the top of their trading range and volatility has increased. As of early July, the $34 billion in tariffs that the US is putting on Chinese goods is a drop in the bucket of a nearly $20 trillion economy. However, a concern is that if the confidence of consumers or business is shaken, spending and capital investment could level off or decline, which could then impact the economic expansion and stock prices.
Larger cap US stocks gained 3.4% for the quarter, but were outdone by smaller-cap stocks, which jumped 7.9%. The smaller cap outperformance was driven by the market narrative du jour (“noise”) that smaller companies are more domestically focused and therefore not as exposed to a strengthening US dollar or potential trade wars, both of which are assumed to be detrimental to larger cap (multinational) company profits.
Non US stocks continue to be in negative territory year to date, down approximately 3-7%, with emerging market equities down the most as recent dollar appreciation continues to impact returns. The global MSCI index which includes US and non US stocks is slightly negative for the year as well.
In addition to the currency effects, emerging market (EM) stocks were buffeted by trade tensions between the United States and nearly all its major trading partners. As we discuss this quarter, we remain confident in our allocation to EM stocks in client portfolios.
The core US bond index had a slightly negative return (bond yields move inversely to bond prices) for the quarter. The benchmark 10-year Treasury yield pierced the 3% level in May, hitting a seven year high. Yields then fell back, ending the quarter at 2.85%, an 11 basis point increase from the prior quarter end.
Once again, floating rate loan funds outperformed core bonds and generated positive returns, as they have every month this year. For the year, the core bond index is down nearly 2% and floating rate loans are up roughly 2%. The Fed raised interest rates again in June, but also forecasted a slightly accelerated path of hikes over the next two years. Whether the economy can withstand that degree of tightening remains to be seen.
Emerging market bonds (local currency) are down just under 7% year to date. Lastly, our multi-strategy alternatives position performed relatively well, essentially flat, out performing core bonds and non US stocks by material amounts.
Except for US large caps and small caps, where we have meaningful exposure for all of our client portfolios, global asset returns year to date continue to be challenged.
As we pause to reflect at the midpoint of the year, it seems so far 2018 has served as yet another reminder to investors that over the short term, markets are driven by innumerable and often random factors that are impossible to consistently predict (i.e. “noise”). In the first quarter, US stocks experienced their first major losses since 2016 and a return to more “normal” market volatility. Many market prognosticators speculated that this could indeed be the end of the nearly decade long US bull market.
Fast forward through three more eventful months and this time around US stocks have been the net beneficiaries, gaining 3.4% on the back of a surging dollar while the rest of the world has slowed. The dollar’s 5% appreciation translated into a meaningful return headwind for dollar based investors in foreign securities and bonds as foreign currencies depreciated against the dollar.
It was a difficult quarter for our equity holdings given the jittery investment climate outside the United States, particularly in the emerging markets. As a reminder, our EM stock manager gained 20% in 2016 and 34% last year. EM stocks then bolted out of the gates in 2018, with our manager gaining an additional 9% return through late January. Our EM bond manger had similar excess returns, gaining just under 11% in 2016, over 15% in 2017 and just under 5% in the month of January 2018. Since then, however, EM stocks and bonds have given back some of the outsized gains since the end of 2015. This is to be expected and is normal.
The selloff in EM stocks appears to have been driven by a combination of investor concerns about:
- a potential trade war with China (and possibly other global trade partners such as the European Union, Mexico, and Canada);
- how EM economies will manage a deceleration in global growth outside the United States; and
- a stronger US dollar coinciding with rising US interest rates and tightening Fed monetary policy.
These macro developments, in particular the risk of a US trade war with China and the rest of the world, are indeed risks to EM stocks, at least in the shorter term. However, these are not new risks, nor do we believe they overwhelm the attractive fundamentals, valuations, and potential longer term returns of EM stocks. Based on our analysis, we find that emerging markets are fundamentally better placed today than in past cycles. The sector composition of EM indexes has changed meaningfully over the past decade, from traditional heavy cyclical industries like materials and energy to more growth oriented technology and consumer driven sectors that are less sensitive to shifts in global growth. Evidence also suggests EM stocks do fine when interest rates in the United States are rising as long as global growth is solid (real GDP growth is expected to be above trend again this year). As to the underlying fiscal health of EM economies, emerging markets, in aggregate, have much better debt coverage than in the late 1990s/Asian crisis era. Additionally, most EM countries now have floating rather than dollar pegged currencies, which should help release pressure in these economies and reduce the likelihood of a currency devaluation driven crisis.
On the fixed income side, our portfolios were helped once again by our large allocation to actively managed flexible bond funds and floating rate loan funds (for our most conservative portfolios). In aggregate, these funds contributed positively to quarterly portfolio returns and outperformed the core investment grade bond index materially, as has been the case over the past several years.
Market and Portfolio Outlook
It is understandable that fears of a global trade war are rattling financial markets. Any resolution of the current trade tensions is a meaningful uncertainty (a “known unknown”), with our China relationship being the most fraught with the potential to seriously disrupt the global economy at least over the shorter to medium term (the potential for a positive surprise seems more limited, but also exists). President Trump’s unconventional negotiating approach adds an additional wildcard dimension. The process is likely prone to several more twists and turns before things become any clearer.
The recent dollar strength trend may also continue for a while. But there are reasons to expect the dollar may weaken looking further out: the prospect of a ballooning US federal budget deficit in the coming years, a large trade deficit, and the eventual convergence of central bank monetary policies as other central banks start to raise interest rates, thereby shrinking the yield gap versus the United States.
We remain confident in the positioning of our globally diversified portfolios, which we believe are structured to perform well over the long term while providing resiliency across a range of potential short term scenarios. Should the current trade tensions resolve, and the global economic recovery continue, we expect to generate good overall returns, with outperformance from our European and EM stock/bond positions, active equity managers and flexible bond funds. Alternatively, should a bear market strike, our portfolios have “dry powder” in the form of lower risk fixed income and alternative investments that should hold up much better than equities. We’d expect to put this capital to work more aggressively following a market downturn by, for example, reallocating to US equities at lower prices and higher expected returns sufficient to compensate us for their risks.
Therefore, we file this under the heading: “There are always risks and uncertainties when investing in equities that have the potential to cause significant shorter term price declines.” Whether it is a trade war, a geopolitical event, an unexpected economic shock, a monetary policy mistake, or innumerable other factors, stocks can deliver big losses, at least over shorter term (one- to three-year) periods. Market corrections and bear markets happen. An investor must be able to withstand these drops, stay the course, and stick to their long term plan. This is why we talk with our clients at every meeting about their short term portfolio cash needs and use a “buckets” approach for clients in retirement (whereby we have multiple years of spending needs in cash and fixed income investments). We also spend significant time with new clients making sure we understand their emergency cash levels and portfolio cash needs.
Tuning Out The Noise
We posted on our website in the spring a piece entitled “Tuning Out The Noise”. Given the recent volume of “noise” in the media, we thought it would be good to include the piece in this newsletter:
For investors, it can be easy to feel overwhelmed by the relentless stream of news about markets. Being bombarded with data and headlines presented as impactful to your financial well being can evoke strong emotional responses from even the most experienced investors. We think Peter Lynch, the famous Fidelity Magellan fund manager, said it best when he noted, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Headlines from the ”lost decade” can help illustrate several periods that may have led market participants to question their approach:
- May 1999: Dow Jones Industrial Average Closes Above 11,000 for the first time
- March 2000: Nasdaq Stock Exchange Index Reaches an All Time High of 5,048
- April 2000: In Less Than a Month, Nearly a Trillion Dollars of Stock Value Evaporates
- October 2002: Nasdaq Hits a Bear-Market Low of 1,114
- September 2005: Home Prices Post Record Gains
- September 2008: Lehman Files for Bankruptcy, Merrill Is Sold
While these events are now a decade or more behind us, they can still serve as an important reminder for investors today. For many, feelings of elation or despair can accompany headlines like these. We should remember that markets can be volatile and recognize that, in the moment, doing nothing may feel paralyzing (which reminds us of a quote by the not so famous investor Winnie the Pooh, “Never underestimate the value of doing nothing”, which is appropriate for investors who feel compelled to “do something” during times of negative news flow).
Throughout these ups and downs, however, if one had hypothetically invested $10,000 in US stocks in May 1999 and stayed invested, that investment would be worth approximately $28,000 today.
Hypothetical Growth of Wealth in the S&P 500 Index, May 1999–March 2018
© 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Not representative of an actual investment. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
When faced with short term noise, it is easy to lose sight of the potential long term benefits of staying invested. While no one has a crystal ball, adopting a long term perspective can help change how investors view market volatility and help them look beyond the headlines.
The Value Of A Trusted Advisor
Part of being able to avoid giving in to emotion during periods of uncertainty is having an appropriate asset allocation that is aligned with an investor’s willingness and ability to bear risk. It also helps to remember that if returns were guaranteed, you would not expect to earn a return above what you can earn on CDs (currently around 2-3%). Creating a portfolio investors are comfortable with, understanding that uncertainty is a part of investing, and sticking to a plan may ultimately lead to a better investment experience.
However, as with many aspects of life, we can all benefit from a bit of help in reaching our goals. The best athletes in the world work closely with a coach to increase their odds of winning, and many successful professionals rely on the assistance of a mentor or career coach to help them manage the obstacles that arise during a career. Why? They understand that the wisdom of an experienced professional, combined with the discipline to forge ahead during challenging times, can keep them on the right track.
The right financial advisor can play this vital role for an investor. A financial advisor can provide the expertise, perspective, and encouragement to keep you focused on your destination and in your seat when it matters most. A recent survey conducted by Dimensional Fund Advisors found that, along with progress towards their goals, investors place a high value on the sense of security they receive from their relationship with a financial advisor.
How Do You Primarily Measure the Value Received from Your Advisor?
Source: Dimensional Fund Advisors. The firm surveyed almost 19,000 investors globally to help advisors who work with Dimensional better understand what is important to their clients.
Having a strong relationship with an advisor can help you be better prepared to live your life through the ups and downs of the market. That’s the value of discipline, perspective, and calm. That’s the difference the right financial advisor, like River Capital Advisors, makes.
River Capital Advisor News
We are pleased with the positive feedback from our clients as to their new investment performance reports and related client portal. Clients like the new look, graphs, as well as the convenience to access their client information when it is convenient to them via the portal. The next step in our process of improving client access to information is the finalization of our investment app! Clients will receive an email shortly on how to access, download and configure the app.
We would like to thank all of our clients that participated in our recent client survey. The survey touched on a number of service and client experience items, as well as potential seminars that we are thinking about. It is important to us that we receive feedback so that we can improve what we do for clients. Based on the feedback, we are considering a seminar on the non-financial aspects of retirement, which is as important as the financial aspects. We will update clients soon on this matter, once we finalize our thinking and due diligence work.
Lastly, we thank our clients for their referrals to others that are considering working with or need a trusted advisor. River Capital Advisors, along with Smoak, Davis & Nixon (our affiliated CPA firm) are the exception and not the norm in the financial services industry – we are independent, objective, financial fiduciaries who do not sell any financial products and do not take any commissions. We have fully embraced being a financial fiduciary to our clients for our entire twenty plus year history. We are fee only, with the sole source of compensation coming from our clients. We are honored to work for our clients and their families, to help them achieve their financial goals.
Enjoy the rest of the summer and stay cool!