1st Quarter 2019

The stock market is designed to transfer money from the active to the patient – Warren Buffett

The S&P 500’s 13.6% year-to-date gain nearly mirrored its -13.5% fourth quarter 2018 decline. Fears of a US recession faded and the Fed announced a suspension of rate increases. Growth sectors continued to dominate, with Technology returning 19.9% and the Amazon.com-driven Consumer Discretionary sector returning 15.7%. The Energy sector rallied, returning 16.4%. MLPs performed slightly better, returning 16.8%. Healthcare (+6.6%) and Financials (+8.6%) were the worst performing sectors. Small cap stocks modestly outperformed large caps and low quality beat high quality. Outside the US, both developed and emerging markets returned about 10%. Within developed markets, the United Kingdom (+12.5%), Switzerland (+13.1%) and France (+11.1%) were among the top performing major countries. China, which represents just over 30% of the MSCI Emerging Markets Index, drove that benchmark’s performance with its 17.9% return. Russia was the only other country that represented more than 1% of the MSCI Emerging Markets Index that outperformed its overall 9.9% return. Smaller cap companies in emerging markets lagged, with the MSCI Emerging Markets Small Cap Index returning 7.8%.

The brief inversion of the yield curve, where 90-day T-Bills offered a higher yield than 10-Year Treasury bonds for about a week at the end of March, generated speculation in the financial press that this expansion may be ending. While historically, inverted yield curves preceded past recessions by 12-24 months, this brief inversion offers a weak signal. Selling stocks after a curve inversion, despite the signal preceding past recessions, did not offer a path to avoid bear markets. The S&P 500 has performed about as well during 12-month periods following a curve inversion as it did during periods of a normal yield curve.

This year the US economy will likely break the record set in the 1990s for the longest period without a recession. However, the 2.4% annualized real GDP growth since the 2008-2009 Financial Crisis has been the slowest of any post-war expansion. It would take another six years of growth at this rate for the economy to surpass the amount of growth delivered in the ten-year expansion in the 1990s. While this ‘slow and steady’ growth perhaps will allow for several more years of growth, it also poses the risk of stalling and exposing some of the underlying risks that have been building, among which corporate credit appears to be the most serious.

The S&P 500’s gains came in the face of declining earnings expectations. This quarter marks the first year-over-year comparison since Trump’s corporate tax cuts went into effect, and the consensus analyst forecast compiled by Factset expects nearly a 4% decline in S&P 500 earnings. Only Healthcare, Industrials and Utilities will likely show earnings growth over the twelve-month period that ended March 31. Over the past few weeks, a higher than average number of companies provided negative guidance on their first quarter earnings. Most of the expected earnings declines stem from pressure on profit margins as analysts expect overall S&P 500 revenue to increase 4.8%. The index posted a record quarterly profit margin early last year of 11.8%, before the impact of higher interest rates, labor costs and worries about trade wars. During the long economic expansion and bull market of the 1990s, the S&P 500 profit margin never exceeded 8%. It remained below 10% during the mid-2000s period prior to the 2008 Global Financial Crisis. Reverting to more historical normal margins would result in over a 20% decline in earnings, holding revenue constant. The current S&P 500 P/E ratio of approximately 19x would increase to nearly 24x if this occurred.

Falling profit margins pose a greater risk to levered firms. The International Monetary Fund (IMF) identified corporate debt levels as the most significant risk in its April 2019 Global Financial Stability Report, stating The US corporate credit cycle appears to be at its highest point in recent history. BBB-rated corporate bonds – the lowest tier before high yield (or junk) bonds – comprise approximately 50% of the current investment grade universe. The market currently prices approximately 6% of these bonds, totaling over $200 billion, with spreads in line with high yield. Compared to 2007, BBB-rated corporates today possess higher leverage ratios and lower yield spreads. The US high yield market’s current aggregate value stands at approximately $1.2 trillion, less than half the value of outstanding BBB rated bonds. This illiquid market would find it difficult to process $200-400 billion in downgrades of BBB corporates that might occur in a recession. Even greater risks loom in the leveraged loan market. The outstanding value of loans more than doubled in size from 2007 and companies have significantly higher debt ratios and more lenient loan terms.

Energy markets continued to stabilize with the shock of the 2014-15 oil price collapse, now nearly five years past. Midstream, including MLPs, delivered the best performance of any segment of the energy markets this quarter. The emergence of shale as the primary source of US oil and gas created a massive demand for new infrastructure to facilitate its transportation and storage. Midstream companies overextended themselves attempting to meet this demand then had to scramble to shore up financing when prices collapsed in 2014 and capital markets became less facilitating. The majority of 2014’s unfunded growth projects are now coming online and contributing to cash flow. For example, Plains All American Pipeline, which had to cut its distribution by nearly 60%, recently announced a 20% distribution increase this quarter, while retaining a large cushion of cash. Additionally, the industry reformed the old GP/LP arrangement, which involved complex distribution splits that disadvantaged limited partners, in favor of simpler corporate structures.

The market’s increasingly optimistic view of the Chinese economy stems not from improved performance, rather from expectations that announced stimulus programs and some resolution to the trade war would reignite growth later this year. Anecdotal evidence suggests the country remains in a slump despite the official 6.5% GDP growth statistic. Chinese GDP reflects the heavy hand of government directed investment without the correctives that a real market economy places on misallocated capital. The country’s centrally planned economy can rapidly build infrastructure and real estate, which all counts in the GDP calculation, but lacks accountability for the inevitable cost of bad investments. Most investment activity in China is debt-financed and the country’s corporate debt to GDP ratio of 160% – more than double the level of 2007 – far surpasses the US or Europe. These debt statistics reflect the systematic misallocation of capital within the economy and the country continues to run the risk of a financial crisis and/or long period of stagnation without significant reforms. China’s government faces a difficult challenge of reigning in overbuilding and speculative lending while maintaining its goal of facilitating rising living standards and social harmony.

European growth remains linked to China and overall global economic growth. Real GDP growth for the Euro-zone countries declined from 2.5% in 2017, which outperformed the US, to 1.8% in 2018. Growth this year, based on current weak readings, may well fall below 1%. Uncertainty over Brexit and populist movements in Italy and France continues to drive volatility. However, European stocks tend to be more global and less dependent on their home markets than stocks in other regions. The MSCI Europe Index obtains only about half its revenue from its home region, compared to nearly 70% for the S&P 500. Over one quarter of the revenue of the index comes from developing markets. Large part of Europe’s underperformance relative to the S&P comes from the lack of FAANG-type stocks. Technology represents less than 5% of the MSCI Europe Index compared to over 17% for the S&P 500. With the exception of Financials, where European banks performed miserably (and our managers largely avoided them), the individual sector performance between the S&P 500 and MSCI Europe largely tracked each other over the past three years in FAANG-less sectors such as Energy, Consumer Staples and Industrials. If the markets rotate away from technology and toward value stocks, Europe will likely outperform.

While the economy and markets can continue to perform for several more years, current valuations and the possibility of a recession places the balance of risk to the downside. The S&P 500 currently trades at its highest valuations since the late 1990s. Increasing labor and interest costs pressure record profit margins. MLPs and emerging market stocks, out of favor over the past few years, offer some of the best risk /reward prospects but remain satellite investment holdings that should not represent the majority of a portfolio. Maintaining near-term liquidity needs in high quality fixed income of appropriate duration remains paramount to preserving capital if the economy enters a recession.


Stephen C. Browne, CFA
Chief Investment Officer
Chief Compliance Officer


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