November 2018 Market Commentary
Eugene provides a fresh update on the investment backdrop, including the current equity market, trends in corporate earnings, and broader economic fundamentals.
Market Overview: At the end of the day, we believe corporate earnings drive long-term returns, and earnings look as healthy as ever. Stay positive and keep long-term prospective!
US Economics: Prior to 2018, low and stable interest rates provided support to equities, as the Federal Reserve boosted the economy with affordable money. Because of strong GDP growth and higher inflation, interest rates are advancing, as yields on 10-year Treasury notes recently hit a seven-year high. Markets reacted in a negative way. However, the business expansion appears sustainable even with modestly rising interest rates. The latest consumer pricing data suggests inflation will not jump sharply anytime soon. More importantly, rising corporate profits look rock solid. We don’t believe rising interest rates, the uncertain outlook for oil prices, and the worsening trade rift with China are likely to upset the long-term upward trajectory in the economy. We believe U.S. economic growth remains solid. That being sad, we are expecting and prepared for periodic, temporary corrections in the marketplace. As a matter of fact, they may occur a bit more often than in the recent past. Because we are long-term investors, we look at pullbacks as opportunity to increase long-term returns by buying good investments at more attractive prices.
Global Economy: The global expansion is following a traditional business cycle dynamic. Accommodative policies helped deliver above trend global growth. This growth, in turn, is now promoting tightening labor markets, higher wage and price inflation, and rising interest rates. These late cycle dynamics can slow future growth. Despite increased risks as we approach late cycle, JP Morgan has not backed away from their positive growth view for 2019. Economic data remains supportive, which points to above trend global growth, while regional divergences look likely to fade. However, the US-China trade dispute could disrupt supply chains and derail the rise in global business sentiment. Also, China faces considerable challenges to sustain growth as it deals with nagging internal imbalances and increasing external drags. It is common for an emerging market economy to face significant idiosyncratic pressure, but China’s size (17% of global GDP) and its growing geopolitical importance raise the stakes. Nevertheless, JP Morgan takes comfort from signals that the US trade conflict will not broaden to autos or NAFTA and that a turn toward Chinese policy stimulus is underway.
George Costanza Equity Portfolio: We published a white paper on our multi-factor investment approach back in September, which reinforced our faith in our investment framework and philosophy. We were glad to see a prominent institutional manager (AQR) of $226 billion publishing similar results in a similar paper at the end of October. Their conclusions are largely in line with ours: stay the course of a multi-factor approach. Please, see the full paper at https://www.aqr.com/Insights/Perspectives/The-George-Costanza-Portfolio
As Cliff Asness of AQR writes: “As a blunt example, in general we believe in choosing individual stocks with good value, good momentum (both price and fundamental), low risk, high quality (e.g., profitability, margins), and positive views from those we think are “informed investors.” When it doesn't work, or even hurts a lot for a while, we don't suddenly prefer expensive stocks with bad momentum, high risk, low quality, and negative views from informed investors. What I'm saying is, admittedly, our base case is to rely on the (in our humble opinion) overwhelming evidence we started with.”
Cliff’s George Costanza portfolio paper shows that if you apply what has been working this year to the last twenty years, you would see good results in a few periods, specifically in 1998-1999 (IT bubble), 2007, 2016 and 2018. The rest of the time, representing 80% of that period, you would be disappointed. Overall, at the end of 20 years, you would have produced deeply negative results. Since no one can effectively time the shifts into or out of a multi-factor approach, it makes sense to stay the course as the odds are on our side in the long-run.