THE MARGIN OF SAFETY QUARTERLY SUMMER 2019
Second Quarter 2019
- The first half of 2019 saw robust gains across most asset classes, but it certainly wasn’t a smooth ride.
- The S&P 500 hit a new high near the end of June. Large-cap U.S. stocks shot up 7.0% for the month – their best June since 1955.
- Foreign stocks also notched double digit gains through the first half of the year.
- Fixed income also did well, with the 10 year Treasury yield continuing to decline from its multi-year high of 3.2% last October, dipping below 2% following the Federal Reserve’s June meeting.
- Alternative investments also gained, adding to good first quarter returns and up just under 6% for the first half of the year.
- Looking ahead, we still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the next 12 months (and beyond).
- We believe our portfolios are positioned to both generate attractive returns over the next five to 10 years, and to be resilient across the wide range of potential shorter term risk scenarios.
Second Quarter 2019 Investment Commentary
In our year end 2018 commentary, we emphasized the wide range of plausible macroeconomic scenarios and financial market outcomes for the year ahead with the potential for either a positive or negative shorter term path. Through the first half of 2019 we’ve gotten a little bit of everything — signs of both scenarios, though so far the ups have outpaced the downs. Global stock markets got a jump start on the year thanks to progress in US-China trade negotiations and a newly “patient” Fed, but an abrupt breakdown in the trade talks (announced via Presidential tweet) spurred a sharp market sell off in May. Stock markets subsequently shook off their swoon in June, rebounding on expectations of Fed rate cuts later in the year and (tentative) signs of reengagement on the US-China trade front.
The first half of 2019 saw robust gains across nearly every asset class — including both core bonds and equities — but it certainly wasn’t a smooth ride. Among the primary drivers of the market sell offs and their subsequent rebounds were on-again/off-again U.S.-China trade negotiations and two major shifts in central bank policy.
Large-cap U.S. stocks gained 4.3% for the second quarter, and a remarkable 18.5% for the first six months of the year — largely earning back what was lost in the fourth quarter of 2018. Developed international stocks also experienced a healthy rebound from 2018’s losses, up 3.2% for the second quarter, and 14.2% for the year to date. European stocks have done a bit better, gaining 15.6% on the year so far. In April, the “Brexit can” was kicked down the road at least until October 31, but the risk of a disruptive “no-deal” exit remains.
Emerging market stocks, up just 0.8% for the second quarter, absorbed more of the uncertainty surrounding global trade tensions. But for the year so far, they have gained 12.6%.
In fixed income markets, the 10 year Treasury yield dipped below 2% following the Federal Reserve’s June meeting. This was a near three year low, and among its lowest levels ever, reflecting promises of further easing later this year. These falling yields drove the core bond index to a 3.1% gain for the quarter and an impressive 6.1% return so far this year. Floating rate loans gained 1.7% for the quarter and are up 5.7% for the year. Lastly, our emerging markets bond manager returned just under 7% for the quarter and is up just under 11% for the year through June 30.
Our portfolios saw strong gains in the second quarter with many netting low double-digit returns for the year so far.
Market and Portfolio Outlook
Not surprisingly, we still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the next 12 months (and beyond). But at the margin we think the macro risks have increased. Trade uncertainty has damaged global business confidence in what, by many measures, is an already weak global economy. While this is for now being offset by easier monetary conditions, the inevitable impact of any additional central bank rate easing is certainly muted.
The risk of a geopolitical shock on financial markets is also ever present. Most recently, there is heightened potential for a military conflict with Iran. But there are many other potential geopolitical flashpoints and unknowns: Brexit remains unresolved; the tug of war between democracy, populism, nationalism, and autocracy continues around the globe; the U.S. presidential election next year will likely create additional market uncertainty; China’s rise and challenge of the United States as a global superpower goes well beyond just the current trade conflict; the Middle East (beyond Iran) remains a potential flashpoint, as does North Korea.
To what extent stock markets are already pricing in these fears and risks is also an unknown. On the heels of yet another strong quarter for U.S. stocks, their valuations are looking more stretched than ever. Our analysis of U.S. stock market valuations and expected returns implies the market consensus is discounting an overly optimistic outlook. And it can certainly be said that any investors chasing stocks higher simply because of the tailwind of more monetary stimulus face potential dangers.
Investment professionals we respect have written and discussed—informed by history and applying forward looking judgment—a base case scenario where the expected annualized return from U.S. stocks over the next 5 to 10 years is in the very low single digits. This is well below the upper single digit expected return we require to compensate for the full risk of owning stocks. As such, we remain underweight to U.S. stocks across our portfolios until the risk/reward trade off improves.
On the other hand, we continue to have modestly overweight positions to European and emerging market stocks and bonds. Our analysis indicates their valuations are very attractive relative to the U.S. In our assessment, these markets are implicitly discounting a lot of bad macro news and poor sustained corporate earnings growth. Our research indicates a base case that generates high single digit expected returns for European and emerging market stocks over the medium term horizon. Our emerging market bonds provide an attractive current yield (around 6%) and a hedge against a falling dollar. The bonds will vary more than core bonds quarter to quarter but they also provide diversification for our fixed income positions.
Over the shorter term, if the global economy starts recovering from current depressed levels — with China’s fiscal and monetary stimulus being a key to that outcome — and if the United States avoids recession, we would not be surprised to see strong absolute returns from stocks, with outperformance from foreign stocks versus U.S. stocks. Further, if the growth differential between the United States and the rest of the world narrows, the U.S. dollar will likely depreciate, providing an additional tailwind to foreign stock returns (and emerging market bonds) for dollar based investors.
A solid global economy would also be beneficial for our flexible fixed income and floating rate loan investments relative to core investment grade bonds, which have much lower yields and would be hurt by rising interest rates.
On the other hand, if the global economy continues to weaken and the United States falls into a recession and bear market, our balanced (stock/bond) portfolios have “ballast” in the form of core bonds as well as lower risk fixed income and alternative strategies that should hold up much better than stocks on the downside. These lower risk, alternative positions have been a drag on our overall returns over the past several years as U.S. stocks have been in a raging bull market. But we’ve seen their benefits during the occasional market corrections, including in last year’s fourth quarter.
We are not making any changes to our portfolios at this time. However, we have been updating our research on a number of existing and potentially new managers for both stocks and bonds.
A House approved bipartisan retirement savings bill, which includes changes to the so called “kiddie tax,” has stalled in the Senate. You have to love the names that our politicians come up with for legislation and in this case, SECURE is short for Setting Every Community Up for Retirement Enhancement (SECURE). The bill cleared the House on May 23 by a 417-to-3 vote. Although we do not know if the legislation will become law, it does give us a sense of the political winds, as the bill addresses retirement savings and a repeal of an unintended controversial hike on the kiddie tax by the Tax Cuts and Jobs Act’s (TCJA). This is a proposal worth watching.
The SECURE bill closely resembles the Senate’s bipartisan Retirement Enhancement and Savings Bill, known as RESA. Previously, it was anticipated on Capitol Hill that the Senate would quickly take up and approve the House’s SECURE Bill “as is.” That did not happen.
Notably, some of the sweeping changes to retirement savings under SECURE would be:
- repeal the maximum age for traditional IRA contributions, which is currently 70 1/2;
- increase the minimum age for taking required minimum distributions from 70 ½ to 72;
- change the “stretch” IRA law from over an heirs life expectancy to a requirement that assets be withdrawn within 10 years (with certain exceptions);
- allow certain part-time workers to participate in 401(k) plans;
- allow up to a $5,000 penalty free withdrawal from retirement accounts within a year of birth or adoption for qualified expenses;
- expand 529 plan benefits to include homeschooling and certain elementary and secondary expenses and;
- allow up to a $10,000 withdrawal from 529 plans to repay student loans.
Kiddie Tax Hike
The Senate on May 21 unanimously approved the bipartisan Gold Star Family Tax Relief Bill (Sen. 1370), which aims to retroactively fix certain unintended TCJA related hikes to the kiddie tax. Generally, children’s unearned income over $2,100 prior to the TCJA was taxed at their parents’ marginal rates. However, under the TCJA, children’s unearned income above this threshold is now inadvertently taxed as a trust, thus significantly raising taxes up to five times over on benefits received by children of deceased members of the military, among others. It appears this legislation is now tied up with retirement savings legislation.
Early Financial And Tax Planning Thoughts Related to SECURE
Although not law and changes will probably occur, the legislation as presented provides planning opportunities. For example, removing the age limit for IRA contributions would open the door to more back door ROTH strategies. Older individuals could fund an IRA and then execute a ROTH conversion. As a reminder, when executing a ROTH conversion, all IRA account values need to be considered to determine taxation. Another welcome benefit would be moving the required minimum distribution (RMD) date to age 72, allowing a little more time for values to compound before RMDs begin.
A big negative for planning, however, would be the loss of the ability to stretch an inherited IRA over the life expectancy of the heir. This is a big financial benefit today, including a big benefit for passing wealth to the next generation. However, under the proposed legislation, the IRA beneficiary would wind up with a 10 year rule.
We will continue to monitor the legislation and provide updates.
As we experienced this past quarter, uncertainty is a constant presence and volatility can return to markets at the drop of a pin (or a tweet, it seems, these days). Regardless of our tactical and global diversification efforts, those of us who own stocks need to be prepared to ride through the inevitable down periods. It’s the shorter term price we pay to earn their higher expected returns over the longer term.
Below are a couple of quotes that we hope you like:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him (or her) with an opportunity to buy wisely when prices fall sharply, and to sell wisely when they advance a great deal. At other times, he (or she) will do better if he (or she) forgets about the stock market….Ben Graham
I think it is essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future….Howard Marks, from his book, The Most Important Thing
If someone offered you a stock trading at 28.9 times the last 12 months’ earnings, 4.5 times revenue and 17.0 times EBITDA (earnings before interest, taxes, depreciation and amortization), that has averaged less than 3% sales growth over the past decade, and with the prospects of even lower growth in the near term, you’d run for the hills. Yet that is the asset (S&P 500) that people can’t get enough of today…from Fiduciary Management Inc. (“FMI”) June 2019 shareholder letter; valuations are FMI’s weighted average estimates for the iShares Core S&P 500 ETF (a proxy for the S&P 500).
River Capital Advisor News
We will be monitoring the tax legislation touched on in this letter and provide updates when (or if) the legislation becomes law. We would like to see more incentives in place to help individuals save as much as they can, for as long as they can. For the reasons noted in our newsletters, we think that equity returns over the next 5-10 years will be lower than historically. That will have an impact on an individuals financial plan. We have been generating more plans, to help clients set out a road map for their lifestyle, when their working years end or are reduced. Some of the most important work that we do for clients is to help them identify their unique financial goals and objectives. Once this is accomplished, the investment plan is updated based on the goals, objectives and cash flow needs identified in the financial plan.
Our main source of new clients are referrals from existing clients. Although RCA is not right for everyone, we make sure that we spend time up front getting to know a referral, to learn about their financial concerns, as well as their goals and cash flow needs. We are happy to provide a no cost, second opinion on an investment or financial plan for someone looking for the right financial advisor. Please do not hesitate to contact anyone on the RCA team.
Enjoy the summer!