A Few Thoughts on December 2018
Astoria Portfolio Advisors was very vocal about the negative implications of Quantitative Tightening (QT), Fed rate hikes, and ECB tapering their balance sheet (i.e. less liquidity and higher volatility). Frankly, we were not surprised by the price action in Q4. This was a key driver behind Astoria’s decision to hedge risk assets, underweight equities, and include alternatives across all of our multi-asset portfolios throughout 2018.
Below is a chart that shows the close relationship between liquidity and the S&P 500 ETF (SPY).
Source: Bloomberg, Morgan Stanley
We expect the relationship between liquidity and stock prices to continue in 2019. If you don’t think liquidity is crucial to the capital markets system, remember that the S&P 500 Index declined 38% in 2008 (liquidity froze across capital markets).
The days of being outright long beta are over. The market sent you a signal in 2018. If you (1) didn't hedge your portfolio (2) weren't tactical (3) didn't lowered your portfolio beta through alternatives, then you were punished. Don't make the same mistake in 2019.
Given the extreme price action and the poor liquidity in the system, Astoria further reduced our underweight in equities in December. This was less about a valuation call and more about managing our risk budget.
We are constantly asked about our investment views in light of the significant correction.
To summarize:
We were not surprised about the Q4 price action as 1) liquidity was poor 2) the Fed has been behind the curve 3) portfolios were not prepared for rising rates 4) YoY earnings decoupled globally - all risk factors that we have warned since December 2017.
We were very vocal saying that the 3 things that made us bullish in 2017 (muted inflation, tremendous liquidity, and great earnings) would all decline on the margin in 2018. In our 2018 outlook, our tagline was 'hedge your risk assets'.
Our view is that stocks will continue to trade poorly until 1) the Fed turns dovish (i.e. announces a more favorable balance sheet unwind along with an outright pause in rate hikes) 2) there is a resolution on trade policy 3) economic trends inflict higher. None of these factors are close to being resolved.
In our Bloomberg TV interview from July 2018 (click here) and our Yahoo! Finance interview from October 2018 (click here), we argued for a more defensive posturing, raising cash, and de-risking portfolios. We also published an article on ETF.com in September 2018 titled, 'Time to De-Risk Your ETF Portfolio' (click here).
US markets appear to be oversold and are due for a bounce. We acknowledge that value is emerging and valuations (single digit PE ratios for EM value stocks) are attractive for long term strategic asset allocators.
We believe US earnings could be a catalyst but that doesn’t kick in until the week of January 14. The US-China trade deadline isn’t until March 1.
A Look Ahead at 2019
2018 saw the return of normal market conditions which was the opposite of 2017 which saw virtually no volatility. We expect volatility to remain high in 2019 until there is a trade policy resolution, a more accommodative Fed, and global economic trends improve.
Liquidity was a big driver behind the increase in financial assets between 2009 and 2017. Hence, it is logical that a reduction in liquidity (if not done properly) would have negative repercussions. The Fed needs to be more accommodative with their interest rate policy and their balance sheet unwind to ensure stability in the financial system.
Value is emerging across the global equity space. Investors' disdain for global equities is quite high. That usually means it is the time to buy. The contrarian in us (we warned about the liquidity imbalance risk in Nov 2017) is attracted to select risk assets which meet our investment criteria.
Astoria will be opportunistic in purchasing risk assets which are systematic, rules based, and multi-factor. We are attracted to US companies with above average ROE and ROA (i.e. high quality stocks). On the international front, we are attracted to value, quality, and low volatility strategies which are dynamically currency hedged. And of course, we will be including alternatives to soften our portfolio volatility. That is, after all, Astoria’s ‘True North’.
There is no doubt in our minds that the days of being outright long beta are long gone. The market sent you several warning signals in 2018. If you (1) didn’t hedge your portfolio (2) weren't tactical (3) didn't include alternatives to lower your portfolio volatility, then you were punished. Don’t make the same mistake in 2019.
A Recap of 2018
Market volatility significantly picked up in Q4 on the back of slower economic growth, ongoing political and trade risks, and a hawkish Fed. The S&P 500 Index declined 9.03% in December which was the worst December since 1931 when the Index fell 14.53%.
For the calendar year of 2018, the S&P 500 Index declined 4.39% which was the worst annual return since 2008 when the Index fell 37.00%.
Market participants were expecting the US Federal Reserve Chairman, Jerome Powell, to be more dovish at the December FOMC meeting. When the Chairman delivered a hawkish speech, the S&P 500 Index sharply declined.
Astoria has been preparing for this increase in volatility as our portfolios have been diversified across geography, region, factor, and asset class since the start of 2018. Moreover, we were underweight equities and included alternatives across all our portfolios.
US Federal Reserve
As widely expected, the Fed raised interest rates by 25bps at the December FOMC meeting. The Federal Funds Effective Rate (a measure of overnight US interest rates) was 2.40% as of Dec 31, 2018.
Powell now forecasts 2 additional interest rate hikes in 2019. Furthermore, the Chairman gave no hint that the FOMC is considering altering its balance sheet reduction program.
Given the recent weakening in global economic indicators, the significant increase in volatility, and the decline in market liquidity, we firmly believe the Fed will need to be more accommodative (i.e. pause their rate hikes and slow down their balance sheet unwind) for markets to stabilize in 2019.
Tariffs
The outcome of the US-China presidential meeting at the G20 conference appeared better than expected. Following the meeting, the US agreed to leave the tariff rate on US$200bn of Chinese products at 10% (as opposed to hiking to 25%) starting on Jan 1, 2019. China agreed to start purchasing more US agriculture goods. If no agreement is reached in 3 months, the US will raise tariffs on US$200bn of Chinese goods to 25%.
We have argued in several of our 2018 notes that nobody stands to win in a trade war. Should there be a positive resolution on trade policy, we believe Emerging Markets will benefit the most as they have suffered the greatest (MSCI EM Index declined 14.49% in 2018). Many stocks in the EM Value space are trading with single digit PE ratios.
Economic Policy
2018 saw elevated economic policy uncertainty in the US. The below chart depicts a measure of US economic policy uncertainty. The Baker, Bloom, and Davis US Economic Policy Uncertainty Index saw multiple days where it spiked above 200.
Source: Baker, Bloom, & Davis, Bloomberg, Astoria Portfolio Advisors
Economic Data, Earnings, and Valuations
Global economic data deteriorated in 2018 which was a key driver behind the dispersion in stock index returns across the world. The JP Morgan Global Manufacturing PMI declined steadily last year (see chart below).
Source: Bloomberg, JP Morgan, Astoria Portfolio Advisors
Compared to International markets, the US economic and earnings data was relatively stronger in 2018. However, by the end of December there was no place to hide as the bear market which started in cryptocurrencies in Q1 eventually found its way towards US stocks in Q4.
There was a clear rotation out of growth/momentum stocks and into more defensive companies in Q4. We expect this rotation to continue until (1) global economic trends improve (2) there is clarity on the Fed’s balance sheet reduction plan (3) trade policy is resolved.
The S&P 500 Index forward PE ratio was 14.5x as of Dec 27, 2018 which is below its average over the past two decades (16x). Broadly speaking, we believe that US Large Cap stocks are attractive at these valuation levels for long-term asset allocation strategies.
International Equities
The global synchronized economic recovery of 2017 collapsed in 2018. Compared to International markets, US earnings and economic data was relatively strong.
The S&P 500 Index declined 4.39% while the MSCI All Country World Index excluding the US (in USD terms) declined 14.20%, the Euro STOXX 50 (Europe) declined 11.78% (in Euro terms), the Nikkei 225 (Japan) declined 10.39% (in Japanese Yen terms), the MSCI Emerging Markets Index declined 14.76% (in USD terms), and the Shanghai Stock Exchange Composite Index declined 22.74% (in CNY terms) in 2018.
The Bloomberg Dollar Spot Index (BBDXY) rose 3.34% in 2018. As we cautioned several times in our 2018 commentaries, a combination of a stronger US dollar and trade policy risks negatively impacted global trade. As mentioned above, International equities will benefit disproportionately if there is a trade policy resolution.
Fixed Income
US fixed income yields rose significantly from Jan 2018 through Nov 2018 but witnessed a sharp descent in the final 7 weeks. With the US yield curve relatively flat, ultra-short duration bond funds are attractive on a per unit of risk basis.
Astoria was cautious in the fixed income marketplace in 2018 as we thought yields and inflation would rise. This was the right call for most of 2018 as the Bloomberg Barclays US Aggregate Bond Index was down 2.65% for the first 10 months of the year. Bonds were on pace for their worst annual return since 1994 (click here). However, as the stock market began to unravel, bonds staged an impressive rally in the final 7 weeks of 2018. For the calendar year of 2018, the Bloomberg Barclays US Aggregate Bond Index was up 0.01%.
Commodities
Our allocation towards commodities was mistimed. A stronger dollar, a decline in inflation, and trade policy uncertainty proved to be the worst-case scenario for most commodity markets in 2018. The New York Federal Reserve Underlying Inflation Gauge peaked in June 2018 and has since declined (see chart below).
Source: Federal Reserve Bank of NY, Bloomberg, Astoria Portfolio Advisors
We thought gold was attractive in a multi-asset portfolio as it historically has served as a portfolio diversifier against (1) policy uncertainty (2) exogenous shocks and (3) is uncorrelated to stocks. Our allocation towards gold lowered our portfolio volatility in Q4 as gold rose 7.53% while the S&P 500 Index declined 13.52%.
For the calendar year 2018, the Bloomberg Commodity Index declined 12.99% although there were notable divergences across the complex. The SPDR Gold ETF (GLD) was down 1.94%, the Invesco DB Agriculture ETF (DBA) was down 8.74%, the Invesco DB Base Metals ETF (DBB) was down 19.47%, and the United States Oil ETF (USO) was down 19.57%.
Alternatives
Our view was that liquidity would decline in 2018 due to higher US interest rates and the Fed implementing their QT program. We repeatedly wrote that a continuation of trade protectionism polices could further increase the probability of a full-blown trade war, leading to a decline in stocks. For these reasons, we were vocal about including alternatives in our multi-asset portfolios.
Appendix
Below are the portfolio characteristics across all our portfolios as of Dec 2018.
Asset Allocation Bands
Our total equity exposure ranges from 14% in our Dynamic Income Model to 44% in our Dynamic Aggressive Model.
Our total bond exposure ranges from 43% in our Dynamic Aggressive Model to 59% in our Dynamic Income Model.
Source: Bloomberg, Portfolio Visualizer, Astoria Portfolio Advisors
Credit Quality Breakdown
Our AAA exposure ranges from 45% in our MARS Model to 59% in our Dynamic Growth & Income Model.
Our AA exposure ranges from 23% in our Dynamic Aggressive Model to 29% in our Dynamic Conservative Model.
Our BBB exposure ranges from 10% in our Dynamic Growth & Income Model to 14% in our MARS Model, Dynamic Aggressive Model, and Dynamic Income Model.
Source: Bloomberg, Portfolio Visualizer, Astoria Portfolio Advisors
Interest Rate Risk Breakdown
Our average effective maturity ranges from 2.86 in our Dynamic Income Model to 4.65 in our Dynamic Aggressive Model.
Our average effective duration ranges from 1.96 in our Dynamic Income Model to 3.05 in our MARS Model.
Our average weighted coupon ranges from 3.34% in our Dynamic Growth & Income Model to 3.57% in our Dynamic Income Model.
Source: Bloomberg, Portfolio Visualizer, Astoria Portfolio Advisors
Effective Maturity Breakdown
Our 1-3 year maturity exposure ranges from 43% in our Dynamic Conservative Model to 57% in our Dynamic Growth & Income Model.
Our 3-5 year exposure ranges from 10% in our Dynamic Growth Model to 23% in our Dynamic Income Model.
Our 10-15 year exposure ranges from 2% in our Dynamic Growth & Income Model to 7% in our MARS Model and Dynamic Growth Model.
Our 20-30 year exposure ranges from 11% in our Dynamic Growth & Income Model to 19% in our Dynamic Conservative Model.
Source: Bloomberg, Portfolio Visualizer, Astoria Portfolio Advisors
Fixed Income Sector Exposures
Our government bond exposure ranges from 11% in our Dynamic Income Model to 36% in our Dynamic Growth & Income Model.
Our municipal bond exposure ranges from 22% in our Dynamic Aggressive Model and Dynamic Income Model to 27% in our MARS Model.
Our corporate bond exposure ranges from 21% in our Dynamic Growth & Income Model to 35% in our Dynamic Income Model.
Our securitized credit exposure ranges from 7% in our MARS Model to 18% in our Dynamic Income Model.
Our cash and equivalents exposure ranges from 8% in our MARS Model to 16% in our Dynamic Conservative Model.
Source: Bloomberg, Portfolio Visualizer, Astoria Portfolio Advisors
Best, John Davi
Founder & CIO of Astoria
For full disclosure, please refer to our website: