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April 2019 Investment Commentary

 

Financial markets rebounded sharply in the first quarter from the weakness during the previous three months.  Client portfolios benefitted from strong returns across asset classes.  Stocks had by far the biggest move, as had been the case on the downside late last year, but bonds and commodities also enjoyed solid gains.  The S&P 500 posted its strongest quarter since 2009, and non-U.S. stocks mostly followed suit.  The strength in stocks largely came in January and February.  Bond strength occurred mainly in March, on tempered economic optimism and buyer demand pushing down rate spreads in most categories.  Municipal bonds enjoyed particularly strong dollar inflows, driving rates lower and producing broad index returns approaching 3% for the quarter.

  First Quarter Last 12 Months  Five Years (ann.)
World Stocks 12.2% 2.6% 6.5%
S&P 500 13.7 9.5 10.9
Emerging Markets 9.9 -7.3 3.9
Developed International Stocks 10.0 -3.7 2.3
Global Bonds 2.3 -0.1 1.2
Global Hedge Funds 2.6 -3.3 -0.3
Commodities 6.3 -5.3 -8.9

To be sure, the Federal Reserve has occupied a lot of investor head space the last six months.  The sharp October sell-off, following a relatively benign nine months, had been triggered by Chair Jerome Powell’s comment on the 3rd that “we’re a long way from neutral, probably”, implying several more federal funds rate hikes, on the heels of a third quarter-point increase for 2018 a week earlier.  Investors, already feeling increased concerns about trade battles and the economy, reacted negatively, pulling stocks down 5.4% over the next seven trading days.  This gloom had only worsened by Powell’s fourth 2018 move in late December, to 2.25-2.50%, and implication of two more quarter point hikes in 2019. 

In a 180-degree pivot from three months earlier, Powell set a new tone on January 4th, expressing a newfound rate policy flexibility, and putting a no-increase 2019 in play.  Market response was immediate, triggering respective U.S. and world stock surges of 13.5% and 12.8% in the year’s first two months.  March then took on a slightly different tone, on further concerns about a cooling economy – with early 2019 data dull in China and other key countries, the International Monetary Fund cut its 2019 global growth forecast from 3.7% to 3.5%.  The 10-year Treasury bond rate dropped from 2.72% to 2.41% in the month.  This downward rate pressure for longer maturities also pushed yield curves briefly into inversion territory (in which longer rates fall below shorter ones -- on March 22nd, the three-month Treasury bill out-yielded the 10-year Treasury, 2.45% to 2.44%).  While short-lived, this rang a few warning bells, as inversions bring recession odds-making into the mix.

Why is this?  Investors flock to longer bonds as a safe haven, pushing rates down, when they expect tougher times.  This can be self-fulfilling: the last three 3-month/10-year Treasury inversions were in 1998, 2000, and 2007.  The first, perhaps more reflecting disquiet around the Asian and Russian currency crises and collapse of hedge fund Long Term Capital Management, did not lead quickly to recession (though one eventually happened).  But the next one did, with a downturn starting in March 2001.  And in the third case, the pain was already upon us, the great recession officially running from December 31st, 2007 through June 30th, 2009.  Arguably, the 2001 and 2008 recessions both were triggered by unique, historic over-extensions that encountered sharp reversals --- sky-high valuations of stocks, particularly internet names, before 2001 and extreme leverage tied to real estate before 2008. 

Fortunately, we don’t appear to have that type of systemic excess in 2019.  And while the GDP appears to be slowing, a recession does not look imminent.  After 2.9% growth in 2018, which was enhanced by lower taxes and other fiscal spending, we should expect closer to 2% in 2019.  But growth is continuing, here and overseas, and recent readings have been mostly encouraging, including in China and Europe.  One exception was first quarter U.S. auto sales, which slid about 4% from a year ago, possibly tied to tax cut timing.  On the other hand, existing home sales jumped 11.8% in February, with 30-year fixed mortgage rates dropping to 4.28% from almost 5% last fall.  Also, our labor markets, after a soft February, rebounded with a March gain of 196,000 jobs, bringing the nine-year total to over 21 million.  This continues to be our engine.

On other fronts, the Brexit slugfest has moved into overtime, with no clear resolution yet in focus.  Meanwhile, crucial U.S.-China trade and broader economic policy talks continue.  Stakes are particularly high in the technology sector, where turf wars are being fought, with occasional bouts of conciliation.  China reportedly is offering the U.S. and other countries better access to its burgeoning cloud computing market, opening internal access while also assuring greater protection of foreign intellectual property.  So far this is just talk.  By comparison, relative lack of conciliation may characterize the rollout of new high speed “5G” (fifth generation) cellular mobile communications, given their wide-ranging importance for years to come.  The U.S. will try to limit the foothold of Chinese 5G equipment makers while China will inevitably defend its own as it invests heavily in its ambitious Belt and Road infrastructure campaign. 

A U.S.-China technology impasse is not good news for investors, according to a recent piece by Ian Bremmer of the Eurasia group.  It could in fact lead to what he calls an “innovation winter”, due to closing or shifting supply chains and tightened U.S. visa terms restricting the flow of creative talent.  (Since last summer, the State Department has begun to restrict visas for Chinese STEM students from five years to one year, fearing espionage and other threats to intellectual property.  There is a total of 350,000 Chinese students here, many of them innovation drivers.)  While the U.S.-China relationship is the nexus, higher barriers are really a worldwide phenomenon, what Bremmer calls a “tech-lash” of digital regulation to protect against privacy breaches and social media aggression.  All of this hinders collaboration, which in turn holds back innovation.   

Meanwhile, the biotech sector in late March suffered a big setback in Alzheimer’s therapy research, affecting a patient population of 5.7 million people in the U.S., and tens of millions worldwide.  Cambridge-based Biogen and its joint venture partner, Japan-based Eisai, discontinued phase three trials for their experimental drug aducanumab, based on an independent futility analysis.  This may be viewed as final confirmation (following earlier retreats by Merck, Pfizer and others) that the central thesis behind much of the last 20-25 years of Alzheimer’s research is irretrievably flawed.  The thesis --- that preventing the build-up in the brain of beta-amyloid, a protein fragment, and/or BACE1, an enzyme key to its production, could improve cognitive function --- had been widely accepted.  But at this point, lack of results may force a shift toward alternate paths, tempering growth expectations as well as optimism within the patient community.

More broadly, this year will present challenging earnings comparisons after last year’s 20% gains.  The corporate tax cut benefit accrued mostly in 2018, and margins may begin to show effects of wage growth that has exceeded 3% on a year to year basis since last fall.  Higher commodity costs, including a 40% rebound in the oil price in 2019, could affect bottom lines as well.  Overall, we may see relatively little earnings growth in 2019.  The key will be the health of operating conditions late in 2019 and heading into 2020.  A fairly brief earnings pause could be taken in stride, but if corporate guidance beyond the next couple of quarters deteriorates, returns could be challenged, whether we’re feeling better about the Fed or not. 

On this backdrop, we are maintaining modest under-weights to equities.  We still have medium to long term confidence in both U.S. and non-U.S. stocks.  Following their V-shaped recovery, U.S. stocks no longer offer the thrifty valuations we noted three months ago, having returned to September multiples of around 16.8 times forward earnings, in line with historical averages.  Outside of the U.S., the valuation prospect is more compelling – developed international and emerging market forward multiples are 20-25% cheaper than the U.S., and overseas stocks are half the U.S. on a price/book value basis. 

We also are keeping other weightings in place.  Bond exposure is being held at roughly an equal weight, having been beefed up last year.  Bond valuations are now a bit more elevated following the big March move, and arguably more vulnerable to any upward GDP surprises.  Our managers, however, have shown an ability to add value during that type of repricing.  Finally, hedged and absolute return strategies continue to be moderately over-weighted, a posture we typically favor as this has shown a smoothing effect on volatility, which helps asset growth over time.

We hope the early spring is treating you well.  Always, we value the trust you place in us and our firm.  Please reach out if we can help with anything.

 

David S. Beckwith, CFA

Managing Director & Chief Investment Officer

 

This letter may include forward-looking statements.  All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”).  Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct.  Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.