CAPTRUST Chief Investment Officer
Last year marked a sharp contrast to the steady but anemic growth and low volatility market conditions we’ve become accustomed to over much of the past decade. In contrast to 2017, when every single calendar month showed higher stock prices than its predecessor, the fourth quarter of 2018 concluded with an approximately 20 percent drop for stocks. This decline wiped out the modest gains U.S. stocks had enjoyed through midyear, leaving domestic stocks down almost 5 percent for the year. International stocks fared worse in 2018, declining by nearly 15 percent; an equally blended portfolio of U.S. and international stocks declined by nearly 10 percent.
Even our favorite tool in the investing toolbox—a well-diversified portfolio—could not offer much assistance in 2018. For the first time in 45 years, not a single member of the major asset classes that encompass global stocks, bonds, real estate, and commodities provided a return in excess of 5 percent during the year. It was truly a risk-off market, with few places to hide. We lament that few assets did well this year, but we know that this is as seldom experienced as 2017’s smooth ride. Thankfully, rare events, both positive and negative, are fleeting.
While unusual events grab our attention, the tried and true is what sustains our portfolios. The most basic investment principle is to maintain a long-term investment time horizon. We use time horizons to manage risk in our lives every day, without even realizing it. When driving down the highway at 65 miles per hour, our eyes should just glance at the bumper on the car ahead of us, but be more focused about a quarter mile ahead, to a place that provides time to react, if conditions change. Even while walking down the sidewalk, if you stare at your feet (or your phone!), you’re likely to bump your head on a street sign—or worse.
In investment terms, focusing on market returns of a single bad month, quarter, or even year is akin to walking while staring down. Investing, particularly in stocks and other risky assets, requires time. So before turning to the issues and forces that are shaping our outlook, we wanted to offer some perspective on the importance of time horizons:
- Over the past three years—a period that includes the disappointing results of 2018—an equally weighted portfolio of U.S. and international stocks would have shown a cumulative gain of more than 22 percent, or an annualized return of more than 7.5 percent.
- Over the past 90 years (since 1928), U.S. stocks have posted an average return of 10 percent per year. However, in just four of those years have stocks actually returned between 8 percent and 12 percent. The two most frequent returns for a calendar year have been up 18 percent, and down 8 percent. In other words, the most typical results are far from the average results.
- History shows us that seven in 10 calendar years have shown positive stock market returns. If we increase this horizon from one to three years, eight in 10 periods are profitable. And as you’d expect, historical results only improve with longer horizons, with 10-year investment periods showing profits almost 95 percent of the time, and 15-year periods profitable 100 percent of the time, historically.
On to 2019
Although long-term investors can take some comfort in the historical patterns described above, we’re also clearly very interested in the path of future returns and where relative risk and opportunities lie. CAPTRUST’s Investment Committee focuses on three distinct time horizons—short-term events, intermediate-term (or business cycle) developments, and longer-term macroeconomic trends.
Like the highway driver cited above, we’ve spent most of our time focused on the middle distance—where we are in the business cycle and, specifically, the influence of four types of policy environments: monetary, fiscal, regulatory, and trade policy. We believe that changes within these policy areas have contributed to the increase in market volatility we’ve experienced in the past few months.
Imagine a car with four sets of pedals—four accelerators and four brakes—that can operate independently. If the action of these pedals is not synchronized, the ride could be fitful. We can think about each of the policy areas and their impact on growth and stability in terms of stepping on the gas, coasting (neutral), or tapping the brakes.
Most of the past decade has been marked by exceptionally low volatility and meager growth. During this time, we saw a very heavy foot on the monetary gas pedal through the exceptionally accommodative Federal Reserve policy (also known as quantitative easing) and the regulatory policy brake applied to finance and energy firms. This combination—like a car moving cautiously and slowly through a school zone—provided a stable and fertile environment for stock market returns. However, it provided a less robust environment for the average worker, with slow or nonexistent wage gains for much of the decade. This likely contributed to the growth of political populism.
Sure enough, with a new Federal Reserve chair behind the monetary wheel and a new administration driving fiscal, regulatory, and trade policy following the 2016 elections, the configuration of the pedals (and the driving style) has shifted. Below, we look at each of the four policy areas and how we believe changes have influenced markets.
Monetary policy refers to actions taken by the Federal Reserve to influence the amount of money and credit in the U.S. economy, with the stated goals of maximum employment, stable prices, and moderate long-term interest rates.
The Fed increased its benchmark fed funds rate target four times in 2018, up to 2.5 percent, as shown in Figure One. Meanwhile, beginning in late 2017, it allowed some of the asset purchases made during its quantitative easing program to begin rolling off its balance sheet, initially at a rate of $10 billion per month, increasing gradually to $50 billion per month. All else equal, the reversal of quantitative easing should increase the supply of bonds, thereby reducing their price—which in turn should contribute to higher rates.
Figure One: Federal Funds Target Rate Increases
Taken together, the combination of higher interest rates and quantitative tightening have provided a series of brake taps on the U.S. economy. Home mortgage rates increased to 5 percent in 2018, and the Treasury yield curve (measured by the yield difference between the 10-year U.S. Treasury note and the 2-year note) has flattened. We believe that the market, through the flattening yield curve, has signaled caution to the Fed on the pace of future rate increases. The Fed has listened; in December, the Fed announced a slower expected pace of rate increases over the next year, along with a lower predicted peak in interest rates. Mortgage rates have since declined by half a percentage point, a welcome development for home buyers and builders.
Although the Fed has raised rates nine times since the end of 2015, its policy cannot be viewed as restrictive in historical terms. It is simply less stimulative. With a nominal short-term fed funds rate of 2.5 percent, after adjusting for inflation, the real rate is approximately 0.5 percent. Historically, we have not seen economic contraction until the real short-term rate hits 2 percent.
Following the significant economic stimulus efforts after the financial crisis—including the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009—we would characterize fiscal policy as generally neutral over the past five to seven years. Although after-crisis tax cuts for some taxpayers were made permanent in 2013, they were reversed for high income earners.
The last edition of CAPTRUST’s Investment Strategy discussed in depth the potential impact of the significant fiscal stimulus provided by the Tax Cuts and Jobs Act of 2017. U.S. companies responded to the incentives provided by the tax law changes by funding projects and investments with the potential to fuel future growth, productivity gains, profits, and wage increases. They also used the windfall from higher after-tax earnings to repurchase their own stock.
Through tax reform, the fiscal policy gas pedal was pressed to the metal. While putting pressure on the U.S. budget deficit, this significant injection of economic fuel contributed to robust economic conditions, including the strongest growth in wages and gross domestic product (GDP) in 10 years, as you can see in Figures Two and Three.
Figure Two: Average Hourly Wages
Sources: FRED, Federal Reserve Bank of St. Louis, and CAPTRUST Research.
Figure Three: Real GDP Year-over-year Growth
Sources: FRED, Federal Reserve Bank of St. Louis, Fed Atlanta, and CAPTRUST Research. *2018 data is an estimate from Fed Atlanta published on January 8, 2019.
Importantly, we are now seeing other parts of the world respond with their own stimulus packages, most notably in China, as it seeks to manage an economic slowdown that has contributed to global growth concerns troubling markets in recent months.
A stated objective of the Trump administration, alongside tax cuts, has been deregulation. Last fall, the White House estimated that its deregulation agenda would generate $33 billion in cost savings for businesses, by easing regulation in a wide range of areas such as banking, labor, health, education, housing, agriculture, and the environment.
These policy initiatives equate to moving the foot from the brake onto the gas pedal—particularly in the financial and energy sectors. In December, the U.S. exported more crude oil and fuel than it imported for the first time on record, an accomplishment partially attributable to President Obama’s 2015 repeal of an export ban on crude oil that had been in place for 40 years.
Just as the social and long-term impacts of such regulatory actions can be debated, the economic impact of these policies can also be less than clear. The influence of regulatory change can be slow to appear in economic data, such as productivity and employment figures. And the energy sector, cited as one of the largest beneficiaries of deregulation, was whipsawed by plunging oil prices in late 2018, perhaps masking some of the impact of regulatory policy changes.
Over the past year, CAPTRUST’s Investment Committee has been focused on tariff and trade concerns. Last spring, we wrote that this issue would linger for longer than we might prefer, and, unfortunately, we were correct. Trade and tariff negotiations represent a source of uncertainty, and uncertainty depresses business confidence. It can cause corporate executives to delay or cancel projects and hiring, perhaps diluting some of the reinvestment incentives from fiscal stimulus.
An escalation in trade tensions between the world’s two largest economies is a significant headwind. It is a foot on the brake, exacerbated by the on again, off again nature of trade negotiations and news flow—the equivalent of brake tapping. As we know, it doesn’t take many brake tappers to bring a free-flowing freeway to a standstill.
While trade negotiations are unpredictable—and the set of historical examples we can point to is small—we believe the White House will seek a trade deal with China by mid-summer to improve reelection chances in 2020. But almost certainly, some of the negative impacts from trade tensions have already been reflected in the lower prices of both Chinese and U.S. stocks, and the ebb and flow of future trade discussions could continue to inject volatility in market prices.
A Widening Range of Outcomes
Over much of the past decade, the combination of exceptionally low interest rates moderately tempered by tighter regulatory policy promoted a modest but stable economic growth environment. The other policy areas were largely neutral. The result was an era of historically low volatility and a smaller range of outcomes, both positive and negative.
The market environment has changed. In 2019, CAPTRUST believes that the global economy will continue to grow but will do so at a slower pace. We appreciate that, unlike a year ago, stocks today are selling at valuations below historical averages. We expect less braking action by the Fed in the form of rate increases—with an expected increase of 0.5 percent this year (compared to 1 percent in 2018). Trade policy remains as a significant wildcard. If an agreement can be reached by mid-summer (i.e., removing a foot from this brake), the continued stimulus effects of fiscal and regulatory policy may provide enough gas to power through the (gentler) braking effects of monetary policy.
But against a backdrop of slowing global economic growth, these less synchronized policy actions may contribute to a wider range of outcomes and a return to more normal levels of volatility. Although painful at times, market volatility serves to remind us of the critical importance of considering our time horizons as we develop investment strategies and construct diversified portfolios.