- Few asset classes were positive in 2018 – the one “bright” spot among the asset classes we allocate to was Municipal Bonds, up .50% to 1.25% in 2018 depending on the strategy
- Equity and fixed income markets now offer more attractive valuations – the S&P 500 P/E is now at a reasonable 16.5x (lowest since 2014) after peaking at 23x earlier in 2018; fixed income yields are off the November highs still materially higher than this time last year
- The underlying economy looks OK to good – corporate earnings were up over 20% in 2018, banks are lending and have experienced little impairment or delinquencies, consumer confidence is near its all-time highs
- Macro risks remain elevated around the globe – US (Mueller Report to a divided Congress, Fed independence), Europe (Brexit and Italy), China (how to stimulate)
- Risks to US corporate profit margins are also elevated as virtually every “cost” on a corporate income statement is at or near all-time lows (commodities, labor, financing, taxes)
- Early 2019 Capital Market assumptions show potential for meeting financial goals with a more conservative allocation as spread between expected equity and fixed income returns narrow
2018 in Review
Diversification seemingly helped little in 2018. The S&P 500, including dividends, broke its string of nine straight positive years, returning -4.94% and narrowly missed (for now) a bear market as its maximum peak to trough was -19.78%. Fixed income fared marginally better. At +.01%, 2018 was the third worst year this century for the Barclays Aggregate Index. Depending on your manager and strategy, Municipal bonds returned +.50% to +1.25%. Further afield, international equities, commodities, and alternative strategies also fared poorly. However, I would caution thinking of 2018’s performance as a “reasonable worst case” scenario. For our financial planning, we assume the volatility of a Moderate portfolio is 8.6% and assume a decline for “bad timing” of 2x this number, or ~ 17%. For a Moderate Aggressive portfolio this volatility is 10.3% so a bad timing is ~ “20.5%”. It is reasonable that over a long run we would experience a drawdown approaching these bad timing levels. Even after acknowledging that higher returns require you to take higher levels of risk, if the prospect of being down 2x these volatility figures would cause you to make poor decisions and have sleepless nights, I strongly suggest talking with your Advisor about your risk profile.
Whereas 2017 saw us increase active management within our fixed income allocations, 2018 saw us do so in our equity exposure. We added two active managers this year, a Polen strategy which focuses on domestic growth stocks and a Nuveen/TIAA strategy focused on international equities. Coupled with our legacy active managers, these active equity managers, on the whole, outperformed their passive counterparts this year. Note that many clients have chosen an all passive/ETF equity implementation which would not have these active managers and that the modest transition to active might have too much tax consequence. Looking forward, I would expect us to approve additional managers/strategies in fixed income/credit, in part to optimize for recent tax law changes (e.g., state specific muni funds for high tax states).
The good news after a difficult 2018 is that both equities and fixed income offer more attractive valuations. The Price to Earnings ratio (P/E) of the S&P 500 peaked at over 23x earlier in 2018 and is now down to a more reasonable 16.5x, the lowest since 2014. And while fixed income yields are down versus their November highs, they are still materially higher than this time last year. Further, the underlying economy continues to be sound as we have yet to see any material spillover from the capital markets to America Inc: Consumer Confidence is still near its all-time high (Exhibit A), banks are open for business and have not reported tightening of lending standards (Exhibit B), their charge off (Exhibit C) and delinquency rates (Exhibit D) are still near all-time lows. While not expected to grow at 2018’s 20+%, Wall Street is still predicting 8-9% earnings growth for the S&P 500 in 2019, in line with its historical average.
So green light for risk assets? Not so fast. The macro environment is hinting at several troubling signs: How will the market react to an appearance of the Federal Reserve losing its independence? To a damning Mueller Report with heightened partisan divide? In Europe, how disruptive would a hard Brexit be for the UK and continent? Talk of food and drug shortages, traffic jams at ports of entry and supply chain disruptions does not instill confidence. Will the EU/Italy budget resolution strengthen or weaken the EU’s hand in dealing with its wayward members? How will China address the increasing impact of US tariffs? It seems that international norms of behavior in place for decades are at risk of splintering. Unilateralism has recently replaced multilateralism in many instances, even amongst allies (see US pulling out of the Paris Climate accord, levying sanctions and forcing a renegotiation to NAFTA, Japan pulling out the International Whaling Convention). Russia, China, and Gulf oil exporters have incentives and are taking action to chip away at US dollar hegemony. How does that reconcile with a significant increase of US Treasury bills, notes, and bonds that have to be purchased given the rising deficits? Unlike in the recent past, the USD did not see marked appreciation in a time of market turmoil in Q4 2018, rising only 1.09%.
Even the robustness of Corporate America and its earnings have risks. With profit margins at all-time highs (Exhibit E), might there be higher chance of decreasing than increasing from here? Let’s take a deeper look at an income statement and assume there are four generic costs to subtract from revenues: Cost of Goods Sold (use Commodities as a proxy), Cost of Labor, Cost of Financing, and Taxes. Commodities are back to their lows from the mid-80s and mid-70s (Exhibit F), Labor’s share of economic output continues to fall (Exhibit G), while interest rates have risen, they still are low. Finally, we see the impact of the tax bill of December 2017 – one cannot see a steeper decline of tax receipts from the corporate sector outside of recessions (Exhibit H). It would only take a reversal of one of these to put pressure on margin levels and therefore corporate earnings.
Capital Market Assumptions and Potential Impact on Asset Allocation
As you know, our financial planning tools use capital markets assumptions (CMAs) to drive future return scenarios. This is the time of year when firms update and publish their new CMAs. While we await to see confirmation of this trend, early CMA updates suggest a flattening of the efficient frontier, namely that taking on more risk via increased equity exposure results in less increase in expected returns versus recent past. Said another way, the difference between expected returns of a risky asset like equities and a less risky one like fixed income is the narrowest in years. This may allow clients to accomplish their financial goals with a less risky portfolio. I would especially encourage the client who is on the fence with respect to their appropriate risk tolerance to talk to your Advisor about this.
Exhibit F- Bloomberg Commodity Index
Source: St. Louis Federal Reserve Bank FRED Database