· We don’t typically put out commentary recapping what previously happened as our research is forward-looking by design. However, given the increase in volatility in Q1 we have been asked for our interpretation of what’s transpired and what it means for multi-asset investing for the balance of 2018.
· We suggested in several of our previous blogs and reports (see list below) that 2017 was a highly unusual year and would not be repeated in 2018. We expected 2018 to be more volatile primarily driven by a decline in liquidity resulting from:
1) The Federal Reserve continuing to raise interest rates
2) The Federal Reserve faciliting their Quantitative Tightening program
3) The European Central Bank and the Bank of Japan potentially curtailing their Quantitative Easing programs.
· We warned investors about the ramifications of less liquidity back in November 2017. For those interested in viewing our previous pieces, you can find them here:
· Liquidity was a significant driver of asset prices from 2009 to 2017 and our view was that a decline in liquidity in 2018 would negatively impact both stocks and bonds. This thesis has largely played out as we anticipated. This was one of the primary reasons why we rebalanced our portfolios in 2017 to include liquid alternatives, reduced our fixed income bond duration, included more international equities / value-oriented securities, and we began to allocate towards commodities.
· In Q1 2018, we migrated away from market cap weighted ETFs to further extract risk premiums across a variety of factors (https://www.astoriaadvisors.com/blog/we-are-no-longer-bullish-on-market-cap-weighted-etfs)
· 2018 started with an exceptionally strong market. The S&P 500 was up 5.6% in January alone! However, a reduction in liquidity, the Federal Reserve meeting in March, a decline in economic surprise indices (see first chart below), higher inflation, tariffs, and a sell-off in select momentum stocks (see second chart below) resulted in the S&P 500 index declining 11% in a 2-week period starting in late January.
Source: Bloomberg, Citigroup.
Source: Bloomberg, NYSE.
Note: The NYSE FANG+ Index is an equal-dollar weighted index designed to represent a segment of the technology and consumer discretionary sectors consisting of highly-traded growth stocks of technology and tech-enabled companies such as Facebook, Apple, Amazon, Netflix, and Alphabet's Google.
· The US Federal Reserve interest rate hike along with higher short-term funding rates resulted in a tightening in financial conditions (see chart below) in Q1 2018. In our view, this was the primary driver behind the weakness in 2018. We continue to believe a decline in liquidity is a concern for the stock and bond markets.
Source: Bloomberg, Chicago Federal Reserve.
US Federal Reserve
· As widely expected, the US Federal Reserve raised interest rates by 25bps in the March FOMC meeting and forecasted a steeper path of hikes in 2019 and 2020. According to the newly elected Chairman, Jerome Powell “The economic outlook has strengthened in recent months. The job market remains strong, the economy continues to expand, and inflation appears to be moving toward the FOMC’s 2 percent longer running goal”.
· The Federal Reserve has now hiked interest rates six times since December 2015. We believe that the Federal Reserve March meeting presented a more hawkish outlook with the dot plot including more rate hikes in 2018 and 2019. Moreover, the median inflation forecast moved above 2% in both ‘19 and ‘20.
· Trade tariffs were introduced a few weeks ago as President Donald Trump targeted China with proposed tariffs on $50 billion worth of goods. While it is difficult to know how trade tensions will pan out in the end, the good news is that these tariffs are small in the context of the US economy and the bad news has been quickly built into the price of US stocks.
US Earnings & Valuations
· Tariffs along with the other drivers behind the market weakness has made US large cap equities relatively attractive from a valuation standpoint. As of March 29, 2018, the S&P 500 12-month forward earnings ratio has declined to 16x vs. a 10-year average of 15.3.
· Our view is that the upcoming US Earnings season is the catalyst that will bring stability to equity markets. We remain optimistic on global equities but continue to believe the more attractive risk-adjusted opportunity is in emerging and developed ex- US equities which have cheaper valuations and have significantly underperformed US equities over the past decade.
· While the S&P 500 declined 0.76% in Q1 2018, developed international markets did worse as the EuroStoxx 50 (Europe) declined 3.71% (in Euro terms) and the Nikkei 225 (Japan) declined 6.36% (in Japanese Yen terms). A weaker US dollar helped the performance of Emerging Markets as the MSCI Emerging Markets Index increased 1.24% (in USD terms).
· As mentioned, the international expansion is much further behind the US and valuations overseas are more attractive. This is part of the reason why we have been positioned our portfolios to include more International Developed and Emerging Market Equities. Whereas the S&P 500 is up 370% since ’09, European (in EUR terms), Emerging Markets (in USD terms), and Japanese equities (in JPY terms) are up only 170%, 210%, and 255% respectively.
Source: Bloomberg, MSCI.
· US yields continue to rise higher. Over the past quarter, yields on the 10-year US Treasury bond rose to 2.73%, while 30-year government bond yields now stand at 2.97%. In our view, investors should be cautious with traditional interest rate and credit spread products. Historically, traditional fixed income products provided investors with high income, carry, and diversification (i.e. bonds were a hedge to equities). Over $2 trillion dollars has gone into fixed income strategies since 2009. Common sense will tell you that when you deploy that much capital into an asset class, all the historical attributes are long gone.
· There are a few select parts of fixed income that remain attractive; as such we are including them in our ETF Model Portfolios. Short-dated variable preferred securities, senior bank loans, short-dated high yield municipal bonds, and emerging market debt are yielding between 4-6%; we believe these offer value compared to traditional credit spread and interest rate segments.
· Since March 2009, the Bloomberg Commodity Index has underperformed the S&P 500 by 376%. As a result, investors have largely avoided commodities in their portfolios. Historically, commodities have done well during periods of rising inflation.
· Astoria has had an out of consensus bullish view on commodities since Q4 2017 and we continue to believe they remain attractive in a multi-asset portfolio given they are 1) uncorrelated 2) under-owned 3) historically do well as inflation rises and 4) typically perform well during the later stages of the economic cycle. We favor a broad-based allocation toward agriculture, energy, and metals.
Source: Bloomberg, Standard & Poor's.
· We are closely watching the New York Federal Reserve Underlying Inflation Gauge which shows that inflation is slightly above 3% (as of February 2018; latest datapoint available).
· Gold outperformed US equities by nearly 3% in the 1st quarter.
· We believe Gold remains an attractive portfolio hedge due to (1) a weakening U.S. dollar (2) a hedge against a potential North Korea conflict (3) ongoing concerns over central banks debasing their currencies (4) rising inflation (5) they remain uncorrelated to equities. Gold is an asset class that has been time tested for many centuries. Gold remains under-represented in portfolios particularly when compared to investors’ increased appetite towards cryptocurrencies.
· Timing the market top (or bottom) is virtually impossible to do on a systematic, repeatable basis. Investors are more incentivized to enter into hedging programs or consider liquid alternatives which are uncorrelated to stocks and bonds to ensure their portfolios are properly diversified in order to produce attractive risk adjusted returns over varying macro-economic cycles. The key word in the previous statement is varying. Everyone looks like a hero when the market goes straight to the moon as its done over the past 8 years.
· We continue to believe it will be prudent in 2018 to include liquid alternatives given their low correlation to both stock and bond markets.
Best, John Davi
Founder & CIO of Astoria
For full disclosure, please refer to our website: https://www.astoriaadvisors.com/disclaimer