Quarterly Updates - January 2019

2018: A challenging year for financial markets

In our last quarterly letter, we highlighted how well the US stock market held up through the first nine months of 2018, while many global markets were in or approaching bear market territory (i.e., down 20% or more from their highs). During the fourth quarter, the S&P500 which is the bellwether index for the US stock market, finally succumbed and had one of its worst fourth quarters in history. At one point, the S&P500 was down nearly 15% in the month of December alone, making it the most challenging December since 1931 and one of the worst months in history for the US stock market.

All major global stock indexes finished 2018 well into negative territory, including in Canada where the TSX declined almost 9%. What made 2018 uniquely difficult was that many asset classes which have historically provided a counterweight to weakness in stock markets, such as bonds and gold, also declined in value. In many respects, this made 2018 as challenging and in certain ways even more challenging than 2008. In fact, in 2008 even though total equity losses were larger than in 2018, strength in bond prices and gold helped offset part of the equity market weakness. In contrast, 2018 saw all asset classes with the exception of cash decline in value, making 2018 one of the most challenging years on record since 1921 when similar trends were experienced.

Figure 1 above, although somewhat US-centric, encapsulates what made 2018 so special – out of 15 asset classes ranging from stocks to bonds to REITs to Gold and Commodities, only one finished higher: US cash.

Quant strategies and rising interest rates huge factors in 2018 decline

In the brief market update we sent at the end of December, we hinted at what made the latter half of 2018 so volatile.

In addition to general overvaluation across global stock markets (and the US market in particular), markets over the last 10 years were increasingly being driven by quantitative or “quant” strategies – computerized trading strategies that use algorithms to determine when to buy and when to sell. Vast amounts of investment dollars now are being dedicated to quant strategies, particularly by hedge funds. We have always been concerned about what would happen to markets when several quants decided to sell at the same time – it seems we were shown the answer in the last quarter.

Over the past three months, untold numbers of these quant strategies, some of which use significant amounts of leverage (or debt) to enhance returns, were forced to liquidate their positions quickly (i.e., before year end and regardless of price). The price of oil in particular seemed to have suffered from this hedge fund liquidation, but the damage spread outwards as the quarter progressed. As an aside, this is not the first time we have seen this – a similar episode took place in the summer of 2007.

Unfortunately, the violent action in markets caused by these shorter-term trading-oriented quants also began to impact the sentiment of all investors, including those with longer investment horizons. Seeing the carnage in markets caused even traditional investors to sell into the weakness, which culminated in the selling panic in the month of December. Figure 2 below shows how equity related mutual fund outflows in the fourth quarter rivaled only those seen during the worst of the Global Financial Crisis in 2008.

Another factor that loomed large over markets in 2018 was the interest rates set by the US Federal Reserve (the Fed). In order to guard against the inflationary effects of a strong US economy, the Fed has been slowly raising interest rates. In addition, the Fed has also been shrinking its balance sheet, which reverses the accommodative liquidity measure put in place in the aftermath of the Global Financial Crisis. After the fourth rate hike last December, the market sold off heavily. This was likely a signal by the market that investors thought the Fed was tightening too much, thereby pushing the economy into a recession.

Our view is that 2018 was a year that saw the global economy slowing, but not collapsing. The US economy which has outperformed all others, is cooling down after several quarters of above trend growth driven by the Trump tax cuts. Yet despite fears of an imminent recession by many market pundits, the US economy, for the time being, continues to chug along. Unlike 2008, the US consumer is in relatively good shape. Our worries are more centred around corporate balance sheets.

Corporate America has taken on significant amounts of debt over the past 10 years to make acquisitions and buy back their shares. As interest rates inch higher and growth slows, we believe the debt that some companies have taken on will prove to be unsustainable. It is at that point that we will see the downside of the credit cycle. We are not sounding the alarm today, but it is a development that bears watching and we will be updating you in the quarters ahead.

Emerging markets could provide greater opportunity to capitalize compared to US markets

It is well documented that US equity markets outperformed non-US markets during the recovery from the Global Financial Crisis in 2008. However, the magnitude of this outperformance may not be fully appreciated. As can be seen in Figure 3 above, when the US market has experienced extended periods of outperformance vis-à-vis the rest of the world, this is also often followed by long periods of underperformance. Over the last 10 years, US markets experienced a strong upcycle of outperformance. Now with cheap valuations in emerging markets, we believe this trend is set to reverse.

One of the main tenets in the investment world is “reversion to the mean,” which simply means that asset prices eventually return to their long-term average. In 2019, we suspect that non-US stock market returns could start a multi-year cycle of outperformance relative to the US. A number of variables could cause this shift, and at the top of the list is the fact that the US is now running twin deficits (current account and fiscal deficits). These deficits are likely unsustainable over the longer-term and as such, we think it makes sense to have portfolio exposure to the more dynamic regions and economies in the emerging markets. Interestingly, during the most recent stock market weakness, emerging markets actually performed much better than markets in developed regions – an encouraging sign in our opinion.

Closing thoughts: Proceeding defensively, but ready to capitalize on further volatility

2018 was one of the most difficult years in recent memory as almost all asset classes generated negative returns. In short, there was nowhere to hide except cash. The encouraging news is that historically, these challenging years have generally produced attractive investment opportunities through improved valuations and favourable investment returns in subsequent years as negative investor sentiment improves.

While we are less cautious now that markets have corrected, we are by no means suggesting that we are currently in an exceptionally bullish investment environment as the recent correction was relatively mild by historical standards. There are indeed several economic and market related challenges in the world that we will continue to monitor. Among them are record levels of debt and continuing trade tensions between China and the US. Furthermore, the recent tightening of US and Canadian interest rates may cause problems as it works its way through those economies. Another concern is that the positive effects of US tax cuts on corporate earnings growth will dissipate in 2019, leading to more muted gains in corporate profits. Despite these conditions, one offsetting factor that leads to our slightly more constructive view on markets versus a year ago, is that the recent correction in stocks is now better reflected in valuations.

Our relatively conservative asset mix has provided us with the required flexibility to add to our existing positions and buy new stocks for the portfolio during the recent market correction. Overall our asset mix is still somewhat defensive and will allow us to continue to take advantage of any further volatility in 2019.

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