2019 Investment Themes: Bear Market Blues

Dear Friends,

We hope you’ve had a restful holiday season with family and a pleasant start to the New Year.

The fourth quarter of 2018 saw steep declines in US stocks, with certain indices entering bear markets (20% below their highs). Amid these moves, the Federal Reserve followed through on broadly held expectations and raised its benchmark Fed Funds rate to 2.5%. Taking a longer view, it’s clear the post 2000 era has been unusual. From 1962 to 2000, the Federal Reserve had never lowered rates below 2.5%. Since 2000, rates have remained below 2.5% for 15 of the last 18 years. Extremely low interest rates were made feasible by the near disappearance of inflationary pressure in the US. Prices for most manufactured goods have been kept low for over two decades as manufacturing was outsourced and large Asian populations were integrated into global industrial production. This multi-decade trend has allowed US and European central banks keep interest rates at historic lows without triggering inflation. Absent a dramatic reversal in global trade policy, we do believe this long-term trend will continue. In the near term, the Fed chairman has signaled two more interest rate hikes are expected in 2019 which would take the benchmark rate to 3%. We believe the Fed is more likely than not to follow through on these hikes, for two reasons:

1. Q4 saw unprecedented pressure from the White House on the Federal Reserve to avoid a rate hike. This included rumors that the president had sought to dismiss chairman Powell in an attempt to influence interest policy. The White House does not have the authority to dismiss the chairman except for cause, and we believe the Fed will be keen to demonstrate its independence by following through on its previously broadcast intentions.
2. Fed governors are well aware that recessionary risks are high in 2019. If the Fed Funds peaked at 3%, the Fed would have more room to respond to a downturn using rate cuts alone. We believe Fed governors would prefer to use interest rates to respond to the next recession, rather than a revival of the unprecedented Quantitative Easing (QE) program put in place in 2008.

Normalized rates, trade disputes, a faltering Chinese economy, and concerns about asset valuations in a long-running US bull market combined to deliver a very volatile stock market in December. Stepping back to get a wider perspective, we are nearly ten years into an exceptionally long bull market. Several risks to economic growth materialized over 2018. Central banks globally have pulled back from the exceptional liquidity programs adopted after the financial crisis. These factors combine to create a less forgiving investment environment and makes a so-called soft-landing less likely. In our view, the underlying risks to the US and global economy advocate for continued caution on the part of investors. As always, long-term opportunities will present themselves in choppy markets and we intend to capitalize on them when they do.

We have enclosed our 2019 investment themes as well as a review of our 2018 themes. We hope to have an opportunity to discuss them with you in the near future.

Regards,

Subir Grewal, CFA, CFP                                                Louis Berger


2019 Economic Themes: Return of the Bear

  1. Bear Market Comes out of Hibernation.  2018 saw a major speed bump in the nearly 10 year global bull market run in stocks. We contend this reversal gains steam this year as stocks globally will finish 2019 in firmly negative territory.  Trade wars, rising interest rates, inflated asset valuations, and a general slowdown in economic activity will contribute to  a “risk-off” environment where investors prefer protection over speculation.
  2. Peak Interest Rates.  In December of 2015, after seven years of 0% interest rate policy, the Federal Reserve shifted course and slowly began to raise interest rates in 0.25% increments. At the start of 2019, the effective target rate stands at 2.25%-2.50%. While the Fed has signaled a continuation of rate hikes this year and into 2020, we think rates will peak in 2019 and the Fed will pause before potentially cutting rates if/when a recession materializes.  We do not think the Fed will raise past 3% in this year.
  3. Unemployment Rises.  2018 saw the US unemployment rate reach a 49-year low of 3.7%. The US economy has come a long way since unemployment peaked at 10% in October 2009.  That said, this expansion cycle looks due for a reversal and we expect the unemployment rate will climb back over 4% in 2019.
  4. Investors Want Value.  Since 2009, US growth stocks have outperformed US value stocks in seven of those ten years (including three of the last four). We believe value will outperform growth this year as economic expansion slows and investors shift investment capital into more defensive sectors.
  1. The Unwinnable War.  Despite rhetoric from president Trump that trade wars are “easy to win” and a March 1 deadline to resolve the US/China trade dispute, we see no quick and easy resolution to this fiasco. We see 2019 ending with some measure of tariffs still in place, continued global hostility towards the Trump administration and ongoing damage to the US reputation and economy.
  2. Real Estate Reckoning.   2018 saw residential real estate prices finally eclipse the peak reached before the credit crisis. The S&P/Case-Shiller 20 City Composite Home Price index peaked in April 2006 and didn’t reach a bottom until March 2012.  Since then, it has seen a nearly 7 year uninterrupted run-up of higher prices.  We think this streak comes to an end in 2019 and the index will finish the year lower.
  3. Oil Prices Flounder.  After peaking at $86.07 on 10/4/18, Brent Crude oil prices tanked in Q4, finishing the year at $51.49 per barrel. While there may be a short term bounce in prices to start the year, we believe Brent Crude will dip below $50 per barrel and finish the year under that level as global trade slows and energy consumption slackens.
  4. High Times for the Cannabis Industry. In recent years, marijuana has made a steady push into the mainstream as several US states and a few countries have passed legislation to legalize recreational consumption.  A nascent industry has emerged to service this growing demand.  Many of these companies are small, regional operators, but recently, larger and better-financed corporations have entered the space with many becoming publicly traded entities.  While the road has been rocky and the sector has seen large price swings, we think this is an industry poised for long term growth.  We expect 2019 will bring more legislation to expand the recreational market and more investments from multinational conglomerates (2018 saw Altria and Constellation Brands invest in the space).  We expect publicly traded marijuana stocks will outperform consumer discretionary stocks in 2019.
  5. China Stumbles. Over the course of 2018, we saw several worrying signs that the Chinese economy is slowing. Property prices, which have propped up all other assets for years have slowed, and there are numerous reports that several non-bank lenders have halted redemptions. The trade war with the US has also been a major drag on the economy.  2018 was a terrible year for Chinese stocks — the S&P China Composite index returned -27.82% — and while some investors expect a bounce-back year, we  believe 2019 will continue to be a flat to negative market for Chinese equities. The Shanghai Composite remains around 2,500. This is less than half the 5,178 level reached in 2015, which was lower than its all time high of 5,800 in 2007.
  6. Battery Power.  A long-term trend we are highlighting in our thinking for 2019 is the growth of plug-in electric vehicles. Roughly 2 million four wheel electric vehicles were sold in 2018. US sales of EVs represented over 1% of total vehicle sales. In California, the largest passenger vehicle market, EV were 4% of all vehicles sold spurred by tax incentives and emissions targets. When we include plug-in hybrid electric vehicles, EV sales account for over 7% of all vehicle sales in California. These figures portend a long-term shift in the transportation industry, of the same degree as driverless cars. 10 years from now, we expect 25% of the world’s vehicle fleet to be battery powered. Over the long-term, this implies a very difficult environment for the oil and gas industry. We expect EV sales to continue to grow in 2019, and global liquid fuels growth to be below 1.3%.

Review of 2018 Investment Themes

2018 was an uneven year for our market predictions.   We were right on six calls and wrong on four calls.  While we were right about the general market direction, a few of our sector specific calls were off the mark.

  1. Slow But Steady Rate Rise: We expect the Fed to maintain the normalization plan and continue tightening rates in 2018 with the Fed Funds rate ending the year in the 2%-2.5% rangeThe Fed started 2018 with a target interest rate of 1.25%-1.50%, raised rates four times by 0.25% to finish the year with a target rate of 2.25%-2.50%.  This was precisely in the range we expected.
  2. Year of the Donkey: We expect the mid-year election of 2018 to mark a sharp reversal for Republicans, who currently control all three branches of federal governmentThe 2018 midterm elections resulted in a sharp rebuke to the Republican agenda.  Democrats won the House popular vote by a whopping 8.6% and had a net gain of 40 House seats, taking back control of the House of Representatives.  They also had a net gain of seven governorships and six state legislative chambers.
  3. The Bull Runs Out of Steam: We expect 2018 to be a difficult year for equities markets given the extremely high levels attained over the past two yearsAfter a fast start in January, 2018 turned into a down year globally for stocks.  In the US, large caps fared best as the S&P 500 index finished the year at -4.38%.  Mid caps were hit harder as the S&P MidCap 400 index returned -11.08%.  Small Cap value stocks brought up the rear in the US as the S&P 600 Value index returned -12.64%.  International stocks lagged the US as the FTSE All World (Ex-US) index returned -14.13%.
  4. Rise of the Machines: As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks.  While we strongly believe Artificial Intelligence and Automation companies will be integral to the global economy in years to come, 2018 saw stocks in this sector hit a speed bump as investors sold off more speculative technology names.  The Global Robotics and Automation index finished the year at -20.92% while the S&P Global Consumer Discretionary index returned -6.24%.
  5. International Beats Domestic: We expect international stocks, especially European markets, to outperform the US in 2018.  We were flat out wrong on this call.  International stocks fared worse than US stocks in 2018, with European stocks performing particularly poorly.  The S&P 500 index posted a return of -4.38%,  the FTSE All World (Ex-US) index returned -14.13% while the MSCI EMU index returned -16.90%.
  6. Bitcoin Bust: Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018. Bitcoin’s meteroic rise in 2017 saw a sharp reversal in 2018 as speculators fled en masse.  Bitcoin opened 2018 at $13,444.88 per coin, but finished the year at $3,880.15 per coin, a drop of 73.70%.
  7. Renewables Redux:  2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities.  We expect this trend to continue through 2018.  While we strongly believe in the long term prospects of renewable power, YieldCo stocks trailed conventional utilities for a variety of reasons: energy prices fell (because of higher up-front costs, YieldCos tend to be more attractive when energy prices are high) and a flight to safety from investors (conventional utilities are a popular safe haven in times of market volatility).  The INDXX Global YieldCo index finished the year -4.98% while the S&P Global 1200 Utilities Sector index was up 1.69%.
  8. Organics Go Mainstream: We think organic food stocks will outperform conventional food stocks this year.  2018 was a tough year for packaged food stocks across the board.  That said, organic companies performed notably worse than conventional food companies.  The MSCI World Food Products index returned -12.99% while the Solactive Organic Food index returned -26.61%.
  9. New Dawn of Space Race: 2018 will see a number of commercial space ventures mark milestones, including manned-flight into low-earth orbit and potentially a lunar orbital space tourism mission.   2018 saw several space related milestones. The highest profile was a successful test launch for SpaceX’s Falcon Heavy rocket, which placed a car in a helio-centric orbit that takes it past Mars. Virgin Galactic completed testing a craft designed for sub-orbital space tourism flights. The most interesting project is the Japanese Hayabusa2 mission. Hayabusa2 successfully rendezvoused with the asteroid Ryugu and placed multiple rovers on the surface. The spacecraft will return a sample from the asteroid to Earth. This mission provides a viable template for future space based mining endeavors. These technological advances will take a decade or more to reach industrial scale, but once they do we believe they will significantly alter the nature of the mining industry.
  10. Net Neutrality Fallout:  Telecommunications firms have risen in the past month as a result of this ruling, but we believe the medium and longer term prognosis is less rosy, with the prospect of new entrants and even more consumer dissatisfaction.  2018 did see a backlash against the major telecom companies and the net neutrality ruling certainly didn’t help to reverse the cord-cutting trend.  Telecoms underperformed the broader market in 2018 as the S&P 500 Telecom Services Index returned -7.20% while the S&P 500 index returned -4.38%.