The LTWM Insider - Market and Economic Commentary Q3 2019
Any baseball fans out there? As we approach the start of the World Series, it seems baseball talk is happening everywhere, and that includes here at Lake Tahoe Wealth Management. Who will win the series? It has been interesting to listen to the reasons why one team is poised to win, yet an equally compelling argument can be made as to why another team will win. There have been surprises that not even the “experts” could have predicted. That said, the only way we’ll know who will win it all is in the moment it becomes history. Until then, it subject to debate.
Like our prognostications about the World Series, financial planners, investment professionals, economists, and the media have been discussing the likelihood and timing of a recession. While it seems inevitable a recession will happen, the million-dollar debate is about when it will happen. When it does, what will be its severity and duration? As we have covered in our Market and Economic commentary, there are signals that the global economy is slowing. However there have been a few times during this expansion that signs of a slowdown emerged only for the expansion to continue, and there are indications suggesting this current business cycle is poised to continue.
What to do with portfolios? Since no one can time markets or the economy, one must be ready for all market environments in advance and have a plan for whatever market environment emerges. Maintain a diversified portfolio. Rebalance appropriately as markets fluctuate. Focus on what you can control, like spending and savings. Proceed with caution, don’t chase the hot asset class or spend beyond your means. Translated to financial planning and portfolio management terms, ensure cash reserves are adequate, remember markets go up AND down, and find comfort in knowing our policies and procedures are intended to make the most of market volatility and corrections. It is important not to emotionally anchor on portfolio highs and lows, as they are merely a scene out the window on the road to long term goal achievement. That is the focus for successful investors….positioning their lives and finances in a manner that gives them the highest probability of goal achievement based on making good decisions with the information that is available at that time.
Summarizing the latest market activity, during the third quarter of 2019, US and international stock returns were fairly flat. Emerging market stocks pulled back a bit. This is understandable given the economic data points to the rising probability of recession as the trade war with China continues to drag on the global economy. US and globally, real estate led all asset classes. The US economy did achieve the longest economic expansion in our country’s history (beginning in June 2009) in July. The U.S. job market continues its longest growth run in history, with unemployment at 50-year lows. However, we would like to see more wage growth. Interestingly, amidst this backdrop of seemingly positive economic news, the aggregate bond market hit an all-time high (low yield) on September 2nd, and the Federal Reserve is expected to cut rates at least one more time this year. This scenario creates important questions:
Why is there such demand for the safety of bonds and are we in a bond bubble?
Will this global slowdown reach the U.S. economy and end the longest expansion in history in 2020?
Will stocks and bonds near record highs in the U.S. continue to coexist or is one or both of the major asset classes going to correct?
The global economy is in a synchronized slowdown, and central banks are responding by lowering interest rates. Accommodative central bank monetary policy may explain more of the strong bond run than fear of a pending recession, although inflation expectations are still below central bank targets. While the American consumer is doing well (although households are again accruing a high level of debt), business spending and manufacturing are declining in the U.S. Alarmingly, freight and shipping has also ticked down. This is following an established longer manufacturing contraction in the Euro Zone and China. For global stocks to break through to new record highs, we will need a trade deal between the U.S. and China that ends the high tariff cost of trading between the countries. In Europe, a deal between the UK and the EU would be welcome news. These circumstances are creating uncertainty that is keeping global businesses from executing capital spending plans. Further, an increase in wage growth will likely be necessary to maintain consumer spending.
U.S. large cap stocks are above fair value and have been for quite some time, while U.S. small cap stocks, international developed stocks and emerging market stocks are much lower in valuation. During the month of September, value stocks performed much better than growth stocks, which is welcome as growth stocks are very overvalued relative to value stocks.
Just like baseball can’t be predicted (who thought the Dodgers would be knocked out so early), no one can consistently forecast the direction of stocks and bonds over the next quarter. We have taken precaution and have portfolio asset allocations positioned more conservatively with a 5% cash target in order to take advantage of a pullback in an asset class due to elevated valuations or earnings contraction. Our bond allocation is very high quality in order to help protect the portfolio in the event of a bear market. Our cash management process has adjusted to increase cash holdings for recent retirees and liquidity needs to last through a potential recession. We will continue to monitor events to adjust our cash overlay risk management program, while maintaining globally diversified portfolios with bias to factor premiums and active rebalancing. This discipline continues to be the best strategy to achieve long term portfolio management success.
For those who want to dive deeper into our market and economic commentary:
World Asset Class 3rd Quarter 2019 Index Returns
U.S. stocks were slightly positive in the third quarter, mostly due to dividends, while international developed stocks were slightly negative and emerging market stocks were more negative. The Real Estate sector continues to do very well and is near record levels. Third quarter index returns were strong for U.S. Real Estate and Global Bonds. U.S Bonds returned 2.27% and Global Bonds returned 2.83%, which is well above the long-term average return of 1.2%. Both did well due to the drop in the yield curve, which is just above low yields for the year. For the broad U.S. stock market, the third quarter return of 1.16% was below the average of 2% since January 2001. International Developed Stocks returned -0.93%, which was below the long-term average return of 1.4%. Emerging Market Stocks returned -4.25%, below the average return of 2.6%. Global Real Estate stocks returned 5.72%, well above its’s average quarterly return of 2.6%.
A larger sample of asset class returns during the third quarter shows the strong U.S. REIT asset class returns. Small cap stocks, international and emerging market stocks were all red during the quarter.
Taking a closer look at U.S. stocks, we can see that value beat growth in small cap stocks, but not in large cap stocks during the third quarter. Overall, the value factor premium was positive on a market wide basis (including small and large cap stocks):
More insight on the value premium is available if we look at just the month of September. U.S. large cap value (SPYV in purple, up 4%) and U.S. Small Cap value (SLYV in pink, up 6.5%) and compare to U.S. large cap growth (SPYG in blue, up 0.2%) and U.S. small cap growth stocks (SPYG in yellow, up 1.4%), (source: https://finance.yahoo.com/):
For just the most recent full month of September, the U.S. small cap value premium was 5.1% and the large cap value premium was 3.8%. Both are sizeable and ahead of the S&P 500 index, which is the orange line (up 2%). While we may start to see a transition to value out-performance going forward, large growth is still the leading U.S. asset class YTD and out to 10 years (although large value is ahead over the past 1 year):
International developed markets were not as strong as the U.S., mostly due to currency effects, since the dollar strengthened considerably during the quarter. Small cap stocks did out-perform large cap stocks. Additionally, the value premium was positive in small-cap stocks, but negative in large cap stocks.
For International Developed Stocks over longer time periods, the size premium is positive; but the value premium is negative over the past 10 years:
Bond markets around the world were positive due to yields dropping during the third quarter. The yield on the 5-year Treasury note declined by 21 basis points, ending the quarter at a yield of 1.55%. The yield on the 10-year Treasury note decreased by 32 basis points, ending the quarter at a yield of 1.68%. And the 30-year Treasury bond yield fell by 40 bps to 2.12%. Here is the U.S. yield curve, and you can see how yields have dropped during the quarter (current yield curve in green, one quarter ago in blue, and one year ago in grey):
Notice below, the very strong third quarter return for the Bloomberg Barclays US Government Bond Index Long, up 7.83% and 19.61% for 2019 through three quarters, which leads all bond returns for the quarter and year to date (YTD). A direct result of the continued drop in yields at the longer end of the yield curve.
The Federal Reserve will likely continue to support the current record U.S. expansion, since inflation is below their target level. They do have a balancing act, since lowering rates in the U.S. causes other central banks around the globe to lower rates the following day. No one wins with a race to the bottom in rates, especially with many countries already in negative rate territory.
One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). The financial news is usually just a distraction and the markets very rarely react in the manner that the media predicts.
CONCLUSION
The third quarter was another bumpy ride for stocks, with international and U.S. small cap stocks dropping about 8 percent at the end of July and beginning of August. Global stocks did very well during the first two weeks of September, but not well enough to regain July highs. Most of the positive return for U.S. large cap stocks for the third quarter was due to dividends. The Federal Reserve has cut rates once this year and has signaled they will likely cut rates one more time this year. Economic data in the U.S. is more mixed, with strong employment and consumer spending, but contractions in manufacturing. The trade tariffs are causing an international slowdown. While the past 10-year results for growth stocks are better than value, the returns for value have still been strong. We may be in the early stages of a shift to value outperformance, given the strong performance of value during the month of September. We believe our client portfolios are positioned appropriately for both the economic and market environment and relative to their individual life objectives and goals.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
The ICE BofAML Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The ICE BofAML High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).This data represents the ICE BofAML US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index,
ICE BofAML Explains the Construction Methodology of this series as:Index constituents are capitalization-weighted based on their current amount outstanding. With the exception of U.S. mortgage pass-throughs and U.S. structured products (ABS, CMBS and CMOs), accrued interest is calculated assuming next-day settlement. Accrued interest for U.S. mortgage pass-through and U.S. structured products is calculated assuming same-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index.
ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 10, 2019.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities and Exchange Commission.
