Market Insights: Fourth Quarter Wrap-up

Market Update

2018 turned out to be a very difficult year for investors. We not only have most equity markets hitting bear market or near bear market territory at one point, but we also have most asset classes ending with negative returns for the year. In fact, according to data from Deutsche Bank, 90% of the 70 asset classes tracked posted negative returns, which is the most in over a hundred years (see chart below). This is a stark contrast to last year when only 1% of asset classes were in the red.

However, as the following chart demonstrates, if anything in markets can be described as “abnormal”, it was the minuscule 2.8% maximum drawdown we saw in 2017, which was the second lowest on record. This past year was actually only a bit more than average. This year felt worse due to the calendar year effect, in that the largest portion of the drawdown occurred right before the end of the year. This is in contrast to the last 20%+ correction in 2011 when it occurred in the two middle quarters with the calendar year return ending up positive in the U.S. 

One bit of silver lining is that in all of the four prior occurrences since 1940, when over 60% of assets classes were down over a calendar year (1949, 1982, 2008, and 2015), the following year was very strong for equity markets with an average increase of well over  20%. 

Volatility and corrections are features in markets, not abnormalities, for without risk there would be no reward. Thankfully, investors with long-term vision who don't panic can benefit from this relationship. This is exemplified by record outflows of US equity funds from retail investors, while pension funds, endowments, and foundations continue to invest aggressively in credit, providing massive amounts of capital to companies for shareholder enhancement activities (i.e. buybacks and M&A) providing further fuel to an already strong corporate earnings backdrop. Our investment process will continue to operate in this light with a long-term mindset. 

Our S&P/TSX Composite ended the year down 11.6% while the S&P 500 declined 6.2%. Small and mid-caps in North America were down in the 12-20% range. In a backdrop of rising interest rates since 2016, fixed income markets have also had a tough time generating returns for investors. The FTSE TMX Canadian Bond Universe finished 2018 up 1.4% on a total return basis while the Bloomberg Barclays U.S. Aggregate Bond Index ended up almost exactly flat on the year. However, high yield bonds as tracked by the Merrill Lynch U.S. High Yield Index fell 2.3% and the S&P/TSX North American Preferred Share Index dropped almost 7%.  

Most commodity prices declined in 2018, with oil and gold prices down 21% and 2% respectively. Natural gas prices were roughly flat. One area that provided some shelter last year, at least in Canada, were REITs, with the S&P/TSX Capped REIT Index returning over 6%. Lastly, in currencies, our Loonie fell 7.8% to the Greenback and 3.4% to the Euro, which aided as a bit of a cushion for clients holding unhedged U.S. or international positions. 

With no clear sign of impending recession for the U.S. by our measures, extremely negative sentiment, positive fundamental factors still in play in the current secular bull market, now reasonable equity valuations, and a U.S. Fed that has recently eased off on its tightening policy, forward-looking returns are certainly looking more attractive at this point. There are many factors in play that could alter how this story plays out in 2019, so we will comment on some of them and provide an update to our Milestone Recession Risk (MRR) composite. We will finish this quarter's comments with some specific thoughts on U.S. debt and the resurfacing negative headlines surrounding it.

Milestone strategy and outlook

To illustrate further how equity markets can diverge from the economy, we entered 2018 with general bullishness among investors, historically low volatility, a ramping economy, a global synchronized recover and the potential for greater than 20% earnings growth for the S&P 500. While that played out for at least the first three quarters of the year, including over 20% earnings growth, the U.S. stock market fell over the calendar year for the first time since 2008 on a total return basis, and only the seventh time in the last 40 years. The exact opposite is in play as we start 2019, with slowing but still positive U.S. earnings growth, a synchronized global slowdown, a technically broken stock market on a short to intermediate-term, high volatility, and historically extreme bearishness. 

Yet, we believe the recent correction/crash has more than discounted the slowing economic growth profile. Outside of a U.S. recession, as we are right now, there have only been three prior occurrences of a 20% or greater decline from a peak since 1950; this marks the fourth. After these moves, forward returns have been very healthy. As opposed to fundamentals-based or credit-driven (i.e. 2008), we believe the current correction is more of a market-event brought on by a Fed policy mistake in mid-December and chaos in Washington. The recent reflex rally we have seen with softening of the Fed's tone, as per Powell's very recent speech on January 4th at the American Economic Association, certainly shows evidence of this thesis. The three prior occurrences have shown consistent post-crash behavior, and therefore, we have a fairly reliable roadmap to help guide us in the near-term. Unless our longer-term indicators change, we would be want to move to a more offensive position upon a re-test of the December low. 

Speaking of indicators, although we have seen deterioration in some, we still see many leading indicators as positive, and therefore, the incredible amount of negativity in the marketplace could well be a good contrarian indicator. High yield credit spreads have widened of late but remain much tighter than they have been prior to past recessions. The Conference Board’s Leading Economic Indicator (LEI) has always peaked many months in advance of past recessions and it is still rising. In addition, their Present Situations Index, which has telegraphed every recession, is also still rising. Personal incomes are rising and household debt-to-disposable income has declined. Corporate balance sheets are strong and public pensions continue to invest significant amounts of capital into credit markets. 

With that being said, the recent market meltdown has forced us to reexamine our positive fundamental core thesis, however, in doing so we see evidence that it is still constructive. The U.S Treasury yield curve, whether one looks at the 2yr-10yr, the 91day-10yr, or the 91day-30yr is still positive. We prefer the latter, although we are very aware that many in the markets focus on the former, thus we need to be weary of that. The outlook on inflation remains subdued, especially with the recent collapse in commodity prices and 5-year inflation break-evens. Small business confidence remains historically high and consumer spending, the bulk of the US economy, has been strong. And although corporate earnings growth has slowed significantly recently from an extremely high level post-Trump corporate tax cuts, they are still positive and we expect them to grow at a 5+% clip this year. As such, economic activity, although experiencing a sharp slowdown in the first half of this year, is also still positive and likely to stay that way.  

The extreme decline on equities and the resulting pressure on credit certainly give the appearance of a very negative fundamental backdrop to the economy; however, we do not see that to be the case yet. We have seen the current picture before in varying degrees, as painful as a decline can be like back in 2015/16 and certainly in 2011, and all of these were resolved strongly to the upside. We do not believe we have a credit crisis on our hands (it has been equities pressuring credit as opposed to the opposite which is far worse), and thus we view U.S. recession risk as moderately low at this point. However, if we continue to see policy and communication mistakes from the U.S. Fed, by maintaining their projected path of rate hikes while ignoring waning inflation data, or if we do not get any resolution to trade conflicts with China, or if the yield curve turns negative, then we could envision the situation worsening. As evidenced on the following chart, the high yield credit market appears similar to the 2011 and 2015-16 credit issues vs. acting as a leading indicator ahead of recession. The high yield spread is still well below the two prior major corrections this cycle and thus showing no significant signs of stress yet to warrant a very negative economic view.  

We will continue to objectively rely on our MRR Composite which finished the year at 5.5/10, declining from a level of 9.5/10 at the start of 2017, to guide our longer-term view and resulting asset allocations. Within our discretionary platform, we have been able to raise varying degrees of cash since July in advance of some the current weakness allowing us to have the ability to move it back into the market once we get all-clear signals. As the back half of this secular bull market progresses, higher volatility will likely become the norm and thus cash as an active asset allocation tool becomes more important. Although recession risk has certainly risen globally, the risk of a recession for the U.S. over the next six to twelve months still remains only moderate by our Composite’s measure. 

From a technical perspective, we have been watching the breadth of markets as they attempt to recover and we are seeing some positive signs recently. Unlike the two prior recovery attempts in mid-November and early December, the most recent bounce has had much stronger breadth. This likely tells us that pensions and the equity desks of companies are starting to put in bids. This should support the market and we believe we have probably seen the low of this correction or close to it. As the chart below demonstrates, you can see the recent push higher has had two major 95% thrusts versus none in the prior two. The thrust level is when 95% of the NYSE volume is up in a given day. Having two such days in close proximity is a strong sign.

To summarize, we believe the risk of U.S. recession is not as high as current perceptions exhibited by the recent market rout, outside of further policy mistakes by the U.S. Fed and the Whitehouse. The Fed's recent softening tone and positive market reaction are encouraging signs on that front. As we have highlighted in past commentaries, our positive core fundamental thesis is driven by a positive credit environment, which we still view to be in play today. The stock market is most closely correlated to earnings growth and economic activity which, although they have slowed from last year from global trade issues, higher interest rates and a lesser impact from the 2017 corporate tax cut, both remain positive.

Economic activity in turn is driven primarily by the availability of credit and the steepness of the yield curve, which again, still remain positive. In fact, although the Q4 equity market collapse has resulted in some pressure on credit, the overall picture on credit remains robust in our view as evidenced by continued very positive credit capital flow from public pension funds and endowments. Until we see a significant yield curve inversion that shuts down credit, we expect the positive trend for the economy to continue. 

And lastly, the availability of credit and the yield curve is driven by Fed policy based on core inflation which remains subdued, especially of late, and well in the range of the past 20 years. This positively driven cycle will remain positive, in our view, absent a Fed policy mistake which should remain neutral looking at the Real Fed Funds rate. It is critical that they follow these inflation indicators and ease off their original projected rate high path.

As always, we continue to monitor our long-term leading indicators for recession risk, as well as some of the near-term risks like escalating trade wars, accelerating inflation and Fed policy mistakes. However, we remain positive in our longer-term outlook based on the core drivers that we still see in place today.

Some thoughts on U.S. debt 

With the U.S. government shutdown, debt again is the news de jour with pessimistic prognostications that record U.S. debt levels will spell the end. We are certainly not downplaying the current government shutdown and that it will likely affect Q1 economic growth to some extent, however, we do see some flaws in the endless fret over debt. Debt has been rising for decades, if not centuries, so we can certainly venture to say with certainty that debt itself doesn’t cause recessions even though debt tends to be at record highs when a recession starts. On the other hand it doesn’t cause growth either. We believe it is likely that high debt levels have not been the cause of faster growth in recent years, but that growth has likely improved due to a combination of better fiscal policies and entrepreneurship.

What we should focus more on than the level of debt is the underlying reasons for the debt and the sustainability of that debt relative to asset and income levels. So although U.S. household debt levels are currently at or near a record level of close to $16 trillion, even higher than the previous $14.7 trillion record set back in 2008, one must look at that in context of asset and income levels. At the last peak, total household debts were 19% of assets, now they’re 12.7% of assets. This is the lowest debt to asset level since the mid-1980s. In addition, household’s debt service is the lowest level of after-tax income since at least the 1980s. On the corporate side, although debt is also high, it is low relative to assets based on historical comparisons and the interest costs as a percentage of profits are within the normal range of the past.

 

Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through December 31st, 2018: (click image for PDF version)