MAY 2019

Are You Up to Date on the Latest Market Moves?

Category: Investment Research, Portfolio Management

By Doug Cohen, Managing Director, Portfolio Management

No matter how many years go by, there’s a certain part of me that still gets very nervous this time of year. No, it’s not the NBA playoffs—as a Knicks fan, I can only vaguely remember what the playoffs even are. Nor is it anything related to the just completed National Hoagie Day as I have already sent cards to everyone I know who celebrates. It’s the flashback to college finals that causes me to wake up during the night in a warm, perhaps faintly beer-scented sweat. Of course, as the famous Japanese writer Daisaku Ikeda once said, no one should be left to suffer alone. So, let’s revisit those stressful exam periods via some shared suffering as we work through a quiz that summarizes the first quarter and the near-term market outlook:

Question 1: What do the numbers 4, 6, 3, 4, 7, -1, 3, 8, -14, 14 represent?

A. Peyton Manning’s snap count, excluding multiple mysterious uses of the word Omaha, on the winning touchdown when the Colts beat the Bears in Super Bowl XLI in 2007

B. The total return percentage for the S&P 500 for the last ten quarters through 1Q19

C. The effective temperature range of the average air-conditioned apartment in Boca Raton in July

D. A Fibonacci Sequence that definitively indicated all along who would ascend to the Iron Throne on Game of Thrones.

Answer: B

Those of a certain age may remember that the 1985-86 season of the TV drama Dallas turned out to be nothing more than Bobby Ewing’s bad dream, allowing his TV wife, Victoria Principal, to return to the show after her supposed death. At some level, that “-14” from 4Q18 almost feels fictional in that the prevailing fears were an increasingly hawkish Fed and worsening US-China trade tensions. The 1Q19 narrative was the polar opposite, enabling US equities to post their best first quarter since 1998 and their best single quarter in a decade. Despite a formidable laundry list of potential concerns ranging from a global economic slowdown to an increasingly uncertain Brexit to the inherent financial uncertainty of a world with more than $10 trillion in negative yielding debt, the dominant lesson of the post financial crisis era has been “Don’t fight the Fed.”

On that score, Chairman Powell’s unequivocal retreat from his “we’re a long way from neutral at this point, probably” October bombshell revived hopes for a renewed “Goldilocks” economy. Market bulls believe that such an economy would feature deuces running wild (e.g., GDP of 2%-plus, inflation of 2%-minus, and Treasury rates in the mid 2% range) in a manner that could enable the Fed to stay on hold through the 2020 election. It feels a lot like the Goldilocks of the mid-to-late 1990’s with the aforementioned 2%-ish indicators together with a strong US dollar, a robust domestic stock market, and a lackluster emerging markets environment. The Fed was a key catalyst in turning the tech boom into a bust in early 2000 with a 50-basis point rate increase. At least at this point, it does not appear that history is poised to repeat itself.

Question 2: What does KKR’s Global Macro & Asset Allocation Head Henry McVey’s recent report titled “The Uncomfortable Truth” refer to?

A. Had Ty Jerome been called for a double dribble in the last few seconds of the Virginia-Auburn Final Four game, the Cavaliers would never have gone on to claim the National Championship

B. The 35,000 cookies that the average American will consume in his/her lifetime

C. The global trend of falling interest rates amid rapidly rising deficits and debt loads

D. The severe Ailurophobia (a fear of cats) that afflicted both Alexander the Great and Julius Caesar

Answer: C

First, for anyone who was tempted by A, rest assured that McVey, a fellow Cavalier, would never denigrate the greatest sports redemption story since Rocky knocked out Clubber Lang to atone for Mickey’s death. (And for the record Charles Barkley, Jerome’s arm was blatantly grabbed by the Auburn defender before the ball came loose). Moving to choice C, McVey’s report highlights the challenges faced by yield-oriented investors with heavy fixed income and real asset exposure in a sustained low interest rate environment. His recommendations include an increased focus on cash flowing assets linked to nominal GDP, shortening duration where appropriate, and an overweight to modestly leveraged infrastructure and certain real estate investments with yield—all of which should add ballast to a diversified portfolio, in his view.

Specific examples that McVey highlights include “last-mile” fiber assets, mid-stream energy assets, cell tower assets, renewable energy, and power, water, and utility assets. Athena’s previous Market Overviews have consistently highlighted our view that inflation is unlikely to spike higher in the near term due to several technological, demographic, and monetary considerations. McVey reaches the same conclusion while also emphasizing factors such as price competition linked to Asian excess capacity, structurally slower growth in much of the world (notably China) and, even some 54 years later, the continued profound impact of Moore’s Law.

Question 3: The recent inversion of the three-month and 10-year Treasury yields is an indication that:

A. A recession is underway

B. A recession is imminent

C. A recession is highly improbable

D. A recession may well be 12-18 months away

Answer: D

Truth be told, one could probably make a case for any of the above, but history most closely supports D. The simple reality is that the curve has inverted before each of the last seven US recessions. On average, recessions occur 12-18 months after an inversion, while stocks have peaked about six months before an inversion (ominously, the last inversion was in 2007). The not so simple realities are that there is considerable variation from cycle to cycle in terms of both the timing of a recession and the market reaction. Moreover, it is not clear whether the recent short-lived inversion (a few days in March and a few in May) should truly count. Some market watchers believe that an inversion needs to persist for at least a month. For example, the 1-year and 10-year curves inverted for just a few days in 1998 and no recession followed until 2001. There is also a “this time is different” argument that an inversion may not be a reliable indicator given the historical anomaly of super-low global interest rates. Each US recession since the 1960’s has begun in a 5%+ interest rate environment and the inversion curve predictor was not prescient in those low interest rate environments either here or overseas. The historical record is crystal clear on one thing though—history indicates that the Fed should avoid increasing rates in the aftermath of an inversion. We suspect that the equity market’s relative indifference to the inversion is indicative of its current confidence that the Fed is effectively on hold for the foreseeable future.

Question 4: Like a proverbial stopped clock, those who have been calling for a peak in US corporate profit margins for the better part of the last eight years will be right—eventually. When is eventually most likely to occur?

A. It has already occurred

B. Within the next 12-18 months

C. In another eight years or so

D. Impossible to determine given that the current post-Enron version of Corporate America has rediscovered the wonders of recording revenue when future services remain to be provided, selling to affiliated parties, ignoring equity-based compensation, etc.

Answer: B

With S&P 500 net margins having reached 10.7% in 4Q18, the highest level since FactSet began tracking the data in 1999, this is a key issue if the decade-long bull market is to continue. Truth be told, we might grant partial credit for answer D, not so much because of any increased accounting shenanigans (even as earnings adjustments divided by reported earnings hit 17% last year, easily the highest since the immediate aftermath of the financial crisis). Rather it is because peak margins have been a long-standing fear that simply hasn’t materialized—yet. Answer B is our best guess as at long last it does appear that several of the key sources of previous margin expansions are losing momentum. As Bridgewater’s Ray Dalio has recently highlighted, those key drivers have included increased globalization, falling labor bargaining power, lower corporate taxes, and lower tariffs.

We have long noted that the market has tended to treat most political issues, particularly during the current administration, as little more than a distraction. Of course, that could change at any time, as underscored by the recent re-escalation in China-trade tensions. Either way, it is impossible to believe that the aforementioned key drivers will not be impacted by the policy positions of the eventual 2020 presidential nominees.

In the shorter term, the recent modest downshift in global growth seems likely to pressure overall revenue growth at a time when the so-called Amazon effect is limiting pricing power across broad swathes of the economy. Meanwhile, oil prices are coming off their largest quarterly gain since 2009. That leaves wage costs as the key wildcard. Wage growth typically tends to accelerate as the economic cycle matures. Indeed, after a multi-year lull, wage growth has recently exceeded 3% as unemployment numbers have fallen toward generational lows and more companies embrace “living wages” at or above $15/hour. Still, to the extent wage inflation remains somewhat elevated by recent standards, productivity growth is finally increasing at an even faster rate. That productivity growth—a cornerstone of most previous economic recoveries—has generally been missing since the Financial Crisis and its potential revival could be the key to sustained or even higher profit margins.

Question 5: Athena’s current high conviction market calls include:

A. Retain a slight overweight to cash and enhanced cash as the yield curve remains historically flat and there is little incentive to take maturity risk

B. Remain tactically underweight fixed income as credit spreads are at or near fair value while leverage is high and interest rates remain a risk

C. Within equities, favor “quality” businesses with healthy balance sheets, strong cash generation and generally lower economic sensitivity

D. All of the above

Answer: D

All of the above are indeed spelled out in Athena’s recently published Athena Market Overview and Outlook. Taking them individually, the case for cash over fixed income in the US rests not just on the flattish yield curve, but also on the level of government debt (including entitlement obligations) and the potential increased politicization of the Federal Reserve. Within fixed income, we have recommended that clients reduce exposure to bank loans where aggressive issuance has recently been combined with weaker covenants.

Within US equities, Athena recommended buying into weakness at the end of 2018, specifically via a reduction in high yield bond exposure. Given the robust YTD rally, our inclination is now to rebalance equity positions back toward strategic targets. Our bias within equities toward quality businesses is tilted toward active managers with a demonstrated ability to emphasize strong businesses, rather than passive strategies that, at least in the short-term, tend to re-rate businesses due simply to fund flows. We remain mindful that the correlation between US and overseas equities has been increasing over the past two decades, even as the US has generally outperformed—particularly in the most recent decade. On a tactical basis, China remains the key swing factor, with a reversal to their currently accommodative monetary and fiscal policies as probably the greatest threat to global growth.

We conclude with a couple of last big picture observations from the alternative investment world. First, within the context of our neutral stance on hedge funds, Athena continues to favor funds with truly uncorrelated strategies rather than “closet” long-only exposure. Finally, within private equity, we remain concerned that the combination of rich valuations and active fundraising makes for an uninspiring general backdrop. Rather, we continue to look for attractive secular themes and differentiated managers within the context of good vintage year diversification.