Q4 2018 Market Analysis
Clients of the Firm,
The fourth quarter of 2018 has begun with a more pronounced rise in longer term interest rates and strong economic data in advance of quarterly earnings reports from our equity investments. Yields for the 10-year Treasury bond rose to 3.22% this morning. This move was precipitated by the most recent Fed rate hike, perceived hawkish comments by Fed Chairman Powell, China trade tensions and strong employment. While the absolute level of interest rates remains low, policy has become less accommodative and the Fed and markets are signaling a new rate regime is underway. This rate transition has been our base case positioning for the past many months. Our expectations for the impact on various asset classes are outlined in this letter.
Long-term, stock values are driven by the expectations of what future profits will be, discounted using the risk-free rate plus an equity risk premium. The change in the risk-free rate (as measured by the 10-year Treasury yield) impacts what price we should pay for a stock. The lower the risk -free rate, the higher the expected value of equities. Conversely, the higher the risk-free rate, the lower the valuation estimate of a stock.
This inverse correlation exists due to the opportunity cost or competitive characteristics of bonds versus stocks. Bonds offer principal priority payment by the issuer and a steady stream of interest payments that are fixed, which is why the asset class is often referred to as “fixed income”.
A stock’s expected inverse P/E ratio (annual profits/share price), which includes risk forecasted estimates, should be compared to a bond return. For many years, we have seen expected inverse P/E values on many companies greatly exceed bond returns and therefore making equities a very compelling alternative to bonds. The inverse P/E ratio or earnings yield for the S&P 500 stands at 6.02% as of this letter whereas the risk-free rate is 3.20%. The difference between the two represents the earnings yield premium for stocks, which is currently 2.82%. This is the risk premium in the market for stocks versus bonds.
Recent months have seen a significant increase in short-term interest rates, making this equation less compelling than before. Recent days have seen longer-term rates rise as well. This change has still not made the case that bonds are a better value than equities, but the risk premium has decreased.
Volatility has been quite muted, especially given headline risk over the past year. Our expectation is that this will not persist, especially if there is a change of control in the U.S. House and Senate or if interest rates spike quickly and higher than expected. Capital will move around portfolios as investors look to find companies that will benefit from higher rates (i.e. Banks) or avoid exposure to interest rate sensitive sectors or junk bonds.
Clients who hedge using derivatives as short positions would likely benefit from this volatility spike or a sudden downdraft in prices. Other clients, whose portfolios are balanced with short-term Treasuries or equivalent funds, would likely see little impact to that portion of their portfolio while the equity portion of their portfolio experiences more pronounced ups and downs.
Indeed, we are at a moment where long-term bonds and equities could be volatile simultaneously as the market adjusts to a normative equity risk premium between the two asset classes. Equity volatility can be muted with derivatives or short positions and bond volatility can be reduced by remaining in short-term maturity bonds.
With yields rising, the short end of the bond curve has continued to behave largely in-line with our expectations, modeling the Fed rate hikes, as expected. Interest rates at the long-end of the curve have now reached above 3.20% on the 10-year Treasury, a key technical level.
We continue to like the short-end of the Treasury curve as a place for bond and stable value invested capital. Investing in this area will help avoid downside risk, should rates normalize, while achieving similar returns to long-dated bonds with far less risk. This approach can be achieved through Treasury money market funds or individual bonds depending on the client portfolio size, liquidity needs and risk appetite.
As we have indicated for several years, there remains substantial price risk in long-dated bonds and especially in junk bonds (bonds below investment grade). While most bond prices have declined this year, the total return for junk bonds has been positive. We feel this return profile is not warranted and represents a blow-off top in terms of junk bond prices. Junk bonds have high default rate characteristics and should become more distressed in terms of repayment risk as interest rates rise. Therefore, we expect a double negative of default and interest rate risk to weigh on junk bond prices longer term and would avoid this segment of the bond market.
The political landscape as we mentioned in our last letter has become increasingly polarized, but is not unprecedented in market history. Indeed, political unrest has existed throughout US history. Examples include: the Whiskey Rebellion in 1791 under Washington, the Alien and Sedition Acts in 1798 under Adams, the Civil War in the 1860s under Lincoln, Labor strikes and violence in the early 20th century, tent cities under Hoover, Vietnam and Civil rights protests under LBJ and Nixon. Today’s political movements, while an important part of constitutionally guaranteed freedoms under the 1st and 14th amendments, are part of the continuing story of America and should not form the basis of an investment thesis in our view.
We continue to see the potential that mid-term elections could result in a change in the balance of power in the US. Most polls have indicated this is now likely in the House and less likely in the Senate. We continue to see this prediction in recent polling. That said, the reliability of traditional political polling has been drawn into question given unexpected outcomes both in the U.S. and abroad.
Wall of Worry
In our last letter, we indicated there was a substantial “Wall of Worry” to climb regarding trade tariffs, mid-term elections and interest rate hike uncertainty. A small portion of this worry matrix has been tentatively resolved with the USMCA agreement. If ratified, this agreement will replace NAFTA with Canada and Mexico and generally provides for a more beneficial trade relationship with both countries. Whatever one’s politics, this agreement has not been widely panned by those opposing the current administration and has a strong chance of being ratified in all three countries.
It is widely believed that the Fed will hike rates at least three more times over the next 12 months. This would bring the Fed funds to between 3.00-3.25% by the end of 2019. The key impact to markets will be the extent to which this rate hike sequence damps economic growth or causes unforeseen impacts to credit markets. To be clear, the absolute level of rates is expected to remain low by historical standards, but not at the crisis level lows maintained for the past decade. This new normal for rates will take some adjustment and it remains to be seen what impact that will take.
Trade tensions with China have now been put on the front burner with the USMCA agreement agreed to in principle. It is likely that rhetoric and tariffs will continue to escalate in the absence of an agreement with the Chinese. It is more likely that a strategic framework will be the first step in China/US trade negotiations as there is no existing trade agreement to revise as there was with NAFTA.
Our view is that peak escalation will result in increased tensions for a time between the U.S. and China. These conflicts will likely run the spectrum of economic, military and political confrontations. How long this will last will likely depend on internal politics of both countries and the willingess of the two principals to sit down to establish a framework as a starting point for real negotiations.
Tariffs are being used as a tool by the Trump Administration to combat Chinese import duties and government subsidized rebate programs for industrial production in China. In particular, the Chinese rebate policy enables producers of goods to sell them below actual cost in the global market, including the U.S., and then obtain a rebate for the difference from the Chinese government. This makes Chinese manufacturers much more cost competitive. Moreover, this action puts U.S. and other developed world companies at an economic disadvantage. In addition, the U.S. is seeking reforms regarding Intellectual property access in China. This issue represents a huge competitive and economic cost to U.S. companies seeking to do business in China and is at the forefront of U.S. political demands.
Quick resolution of this matter is not likely and we continue to monitor developments and the impacts of Tariffs and other trade barriers on our holdings.
The remainder of 2018 will likely be dominated by political and trade headlines and the market adjustment to higher interest rates. Earnings on the other hand are expected to be 20% higher on average for the S&P 500 in Q3 2018 according to Factset. While the aforementioned worries will capture headlines, ultimately earnings will drive stock market performance long-term. The headwinds to earnings created by trade disruption and higher interest rates will likely weigh on some firm earnings and be used as a competitive advantage by others to gain market share. For our equity investments, we remain focused on trying to identify to companies that will rise to the top from a strength, price and competitive perspective. At the same time, we remain cautious on long-term bonds, preferring instead to focus fixed-income exposure on the shorter end of the maturity curve or in principal protected assets. For clients that hedge, we continue to favor derivatives over direct shorting for short exposure and have generally looked to damp equity price risk, while staying long companies we feel are trading at a discount to their fair value.
In closing, we would like to take this opportunity to thank you for your confidence in us in the endeavor to manage your funds. We recognize clients have individual unique needs and try to offer our best advice on an individual basis whenever needed. In addition, we offer our general outlook in these investor letters as a strategic framework for capital allocation as the investment environment evolves. We hope you enjoy your holiday season and look forward to sharing our 2019 outlook as the year winds down.
Peter C. Wernau
Wernau Asset Management
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