The Point of Know Return?
Membership is now required to use this feature. To learn more:View Membership Benefits
“An Investment in Knowledge Pays the Best Interest”
They say the sea turns so dark that
You know it's time, you see the sign
They say the point that demons guard is
An ocean grave for all the brave
Was it you that said, "How long, how long
How long to the point of know return?"
(From “Point of Know Return”, by Kansas, 1977)
You know I been to the edge
And there I stood and looked down
You know I lost a lot of friends there baby
I got no time to mess around…
Ain't talkin' 'bout love
My love is rotten to the core
Ain't talkin' 'bout love
Just like I told you before, before, before
(From ”Ain’t Talking ‘Bout Love”, by Van Halen, 1978)
Market capitulation, anyone? We’ve been arguing for months (maybe even years) that investors were “over-buying” any good news – driving valuations to unsustainable heights.
Well, now we believe that investors are “over-selling” any bad news (even if it is only potential bad news). The Q4 sell-off has been so significant that it is now probable that most major global asset classes will end the year in negative or only modestly positive territory.
There most certainly are things to be concerned about, but investor sentiment seems to have fallen off a cliff, far below what is warranted given the actual state of affairs.
First, let’s summarize the potential negatives:
- The threat of a US government shutdown and President Trump’s and the Democrats’ squabble over funding for a border wall. This makes for breathless headlines and political brinksmanship but, historically, the markets have shrugged off temporary shutdowns.
- Massive and rapidly growing government debt and deficits. This is a real problem and will almost certainly get worse with a Democrat-controlled House and a President who likes to do deals and declare victory. So far, the markets seem to be ignoring this issue, but it may become more “real” and tangible when arguments over raising the debt ceiling heat up in earnest next March.
- Central Bank Policy. There is a distinct “desynchronization” of global central bank policy, with the US and the ECB tightening (or, at least, reducing the level of easing), while China, Japan, and the UK remain largely accommodative. This has been one driver of current market volatility.
- The US Federal Reserve Bank wants to continue a disciplined rate “normalization” policy and, as expected, raised rates an additional 25 bps in December. But recent signals from the Fed suggest it may back off of its planned 3-4 rate hikes next year, as the economy slows and the markets have free-fallen over the past 6-8 weeks. The consensus opinion now is that the Fed may raise rates 1-2 times next year, but will be increasingly sensitive to economic and market indicators going forward.
- We have argued many times that some of the current market anxiety is natural. We were told for almost a decade that “Quantitative Easing” – flooding the global markets with liquidity – was positive and supportive for the value of risk assets – and it was. So now that the Fed (and, to a lesser degree, the ECB) is pulling liquidity out of the markets, we somehow are supposed to believe that it will not be bad for the value of risk assets? We don’t think it works that way.
- We increasingly are concerned about the state of the public rate & credit markets. The credit quality of the US Investment Grade bond market is deteriorating, with the majority of issuance now rated BBB – the lowest investment grade level. When the next recession eventually comes, if more than even a few of these issuers fall into non-investment grade status, we don’t believe the High Yield market has sufficient liquidity to absorb the volume without significant price disruption. We’ve spoken with multiple fixed income managers over the past few weeks, all of whom are increasing their cash positions in anticipation of this disruption eventually occurring (and positioning themselves accordingly to buy assets at significant discounts).
- Likewise, the Bank (or Leveraged) Loan market has seen a flood of issuance over the past two years, as investors sought shorter duration and / or floating rate exposure in anticipation of higher interest rates. But now both the credit quality and the covenant structures of these largely syndicated loans are deteriorating. This is similar in nature, if not in magnitude, to the state of this space just prior to the 2008 financial crisis, and the collapse of this market was a contributor to the broader market disruption.
In the context of all this potential bad news, it is understandable that investor sentiment has fallen and anxiety increased.
But now let’s examine the other side of the coin – the positive news:
- The US economy is going strong, and is expected to remain so through most of 2019 and potentially into 2020. It probably will not maintain its torrid pace of the past 2-3 quarters, but even though this most recent economic recovery has been historically long (though low and slow), it still seems to have some legs left.
- Inflation remains under control – wage inflation in the US is increasing only slowly, and commodity prices remain repressed by slowing demand and a strong dollar. US inflation remains well within Fed targets and, outside the US, inflation simply is not an issue.
- Interest rates remain low, and also under control. Rates had begun to grind higher earlier in the year as the Fed tightened fairly aggressively and the economy expanded. But with inflation under control and the recent “flight to quality” rally in prices (reduction in yield), the 10-year Treasury once again is trading below the psychological barrier of 3%. This helps equity valuations as well as corporate (and government) debt servicing.
- The non-US global economy remains expansionary, though slowing. Many central banks remain accommodative or plan to become more accommodative during 2019 as their local economies decelerate and inflation remains muted.
- US earnings remain strong, though they, too, are expected to decelerate over the course of 2019 as the impacts of tax reform (e.g., repatriation of offshore profits and heavy stock buyback programs) begin to taper off. But, even after stripping out these transitory events, corporate revenues and earnings should show reasonable positive growth.
- Valuations have returned to earth. It can be argued that the market got ahead of itself through the first three quarters of 2018, raising equity valuations to levels well above historical averages. But the combination of strong earnings, low interest rates, and falling prices have brought down equity P/E ratios to much more “normal” levels, especially outside of the US. At some point, should valuations continue to fall, investor bullishness will return, given the underlying strength of earnings and the economy.
We do not like market disruptions, volatility spikes, or bear markets any more than anyone else but, in our opinion, what we witnessed over the past 2-3 months is a return to normalcy – higher volatility, a return of focus to fundamentals, and more appropriate valuations. History suggests that the current market downturn may continue for a while, but we remain cautiously optimistic over longer and more realistic time horizons.
With that as a backdrop, looking out over the current economic and investment landscapes, here is what we see.
The Current Economic Landscape
The global economy continues to grow, though with signs of deceleration, especially outside of the US:
- The Q3 GDP growth in the US came in at a solid 3.5%, in line with expectations. That growth is expected to decelerate to 2.5% in Q4, as the effects of tax reform, regulatory relief, and fiscal stimulus begin to wear off, bringing overall 2018 GDP expectations to 3.0%; (source: The Wall Street Journal);
- The GDP forecast for 2019 GDP currently sits at 2.3% – a deceleration but still positive (source: The Wall Street Journal). This forecast, of course, remains sensitive to the issues summarized above;
- Both US manufacturing and services remained strong in November, with the PMI (manufacturing index) coming in at 59.3, up from 57.7 in October, while the NMI (non-manufacturing index) increased slightly to 60.7, up from 60.3 in October; any reading above 50 is considered expansionary. The two indexes have now been in expansionary territory for 115 and 106 consecutive months, respectively (source: The Institute for Supply Management);
The Dynasty Economic & Market Outlook:
- The global economy continues to (slowly) expand, though there is a distinct deceleration and “desynchronization” of growth. The US economy shows continued growth, though forecasted to slow in 2019. At the same time, the rest of the world appears to be decidedly decelerating – still expansionary, but slowing down (especially in Europe, Japan, and China);
- US Inflation remains stable and in line with Fed targets, and we maintain our belief that it does not represent a threat to continued economic expansion. Wages in the US are increasing only slowly (though showing signs of acceleration), oil prices have fallen significantly over the past three months, and overall commodity prices remain repressed by slowing demand and the strong dollar. Outside the US, inflation simply is not a problem and, in fact, Europe may soon have to worry once again about entering into a deflationary regime;
In summary then, we believe that investors “overbought” good news through the first three quarters of 2018, and now are “overselling” bad news. There are risks in the marketplace, to be sure, but the US economy is strong, the global economy is slowing but still expansionary, interest rates are low, inflation is low, and corporate earnings are solid.
What we are witnessing in Q4 is a return to more normal market conditions – a renewed focus on fundamentals and higher volatility – than we experienced in almost 10 years of global central bank accommodation.
It can be painful to endure, but discipline and continued alignment of your investment plan time horizon with your long-term financial objectives remains the appropriate course of action.
We wish you a blessed and peaceful Holiday season, and a healthy and prosperous 2019.
Scott Welch, CIMA®
Chief Investment Officer
Dynasty Financial Partners
Source: Bloomberg, Data Analysis, 1/2017-Present
Source: Zephyr, Data Analysis, 1/2017 – Present
Source: Morningstar, Data Analysis, 1/2017 – Present
Past performance shown is model performance shown is no guarantee of future results. The model portfolio performance does not reflect actual trading or any advisory, management, or transaction fees, all of which could result in substantially lower results. This does not reflect the impact that material economic and market factors have had on decision making. You cannot invest directly in an index.
General Disclosures: Dynasty Financial Partners is a U.S. registered trademark of Dynasty Financial Partners LLC ("Dynasty"). Dynasty is a brand name and functions through Dynasty's wholly owned subsidiary Dynasty Wealth Management, LLC, (“Dynasty Wealth”) a registered investment adviser with the Securities and Exchange Commission when providing investment services. A copy of Dynasty Wealth's current written disclosure statement discussing our advisory services and fees is available for your review upon request. This message is intended for the exclusive use of members or prospective members considering joining the Dynasty Network of registered investment advisors for educational purposes. It is not intended for any other persons, clients or other entities. It should not be construed as an attempt to sell or solicit any products or services of Dynasty, Dynasty Wealth or any investment strategy, nor should it be construed as legal, accounting, tax or other professional advice. Information contained herein is based on sources believed to be reliable, but there are no representations or warranties as to the accuracy of such information.
This presentation is for illustrative purposes only. Past performance is not indicative of future results. The information contained in this presentation has been gathered from sources we believe to be reliable, but we do not guarantee the accuracy or completeness of such information, and we assume no liability for damages resulting from or arising out of the use of such information.
The performance numbers displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. The index is unmanaged and does not incur management fees, transaction costs or other expenses associated with investable products. It is not possible to directly invest in an index. All returns reflect the reinvestment of dividends and other income.
Historical performance results for investment indices and/or product benchmarks have been provided for general comparison purposes only, and do not include the charges that might be incurred in an actual portfolio, such as transaction and/or custodial charges, investment management fees, or the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices.
The views expressed in the referenced materials are subject to change based on market and other conditions. This document may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. The information provided herein does not constitute investment advice and is not a solicitation to buy or sell securities.
This content may not be modified, distributed or otherwise provided in whole or in part to a prospective investor or someone considering investing in the portfolio models without the express authorization of the party delivering the presentation. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be direct investment, accounting, tax or legal advice to any one investor. Consult with an accountant or attorney regarding individual accounting, tax or legal advice. No advice may be rendered, unless a client service agreement is in place.
This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Dynasty Financial Partners, who reserve the right at any time and without notice to change, amend, or cease publication of the information contained herein. This material has been prepared solely for informative purposes. The information contained herein includes information that has been obtained from third-party sources and has not been independently verified. It is made available on an "as is" basis without warranty. Strategies and investment programs described in this presentation are provided for educational purposes only and are not necessarily indicative of securities offered for sale or private placement offerings available to any investor
DWM is a registered investment advisor with the Securities and Exchange Commission. DWM serves as a sub-advisor to Dynasty Strategist Portfolios (“the Portfolios”), however DWM does not directly manage client assets within the Portfolios. Any reference to the term “registered investment adviser” or “registered” does not imply that Dynasty or any person associated with Dynasty has achieved a certain level of skill or training.
Membership is now required to use this feature. To learn more:View Membership Benefits