Q1 2019: Observations on Investment Markets
The long, painful market decline in the last month of 2018 seemed to promise more of the same for the new year of 2019, but at the end of the first quarter, the results couldn’t have been more different.
The Federal Reserve was subjected to some very loud and pointed criticism over its actions in the second half of 2018. And in December, the Fed made a somewhat startling reversal and began to talk down future rate hikes. Then, during the first quarter of this year, went further, with the Fed suggesting no more imminent rate hikes. Just about every investment asset rebounded in the early months of 2019.
Whether the Fed changed course due to outside pressure or due to new data is hard to know for certain. In a speech on January 10th, Vice-Chair Richard Clarida did state that, “financial conditions tightened materially and recent developments (globally)…represent crosswinds to the U.S. economy.”
If a global slowdown is the reason for the Fed’s sudden new interest rate stance, markets seem unconcerned as equities continue to climb back toward all-time highs.
The bond markets were less optimistic about the future of economic growth as coupon rates on 10-year Treasury bonds dropped to 2.39%, while 6-month bond yields rose to 2.46%. This inversion in the yield curve has historically been a cautionary warning signal of future recessionary risks.
Will the party continue? Who knows? The next few months will see many companies post their first quarter earnings per share, and negative growth (which is expected for many) could chill the surprisingly hot market. Nevertheless, slower profit growth is still growth, and this suggests that a recession is not on the immediate horizon. Economists remain reluctant to predict an economic downturn when unemployment is at record lows, but it may be worrisome that the World Trade Organization’s leading indicator of global merchandise trade dropped to its lowest level in nine years. Many are watching the new round of U.S.-China trade negotiations, hoping for a breakthrough that would re-integrate disrupted corporate supply chains around the world.
It is worth pointing out that some of the steepest rises in market indices come right before a bear market, when investors become over-enthusiastic despite declining fundamentals and high valuations. We do not seem to be in that territory yet. It’s always best to be cautious when the markets are rising fast, and optimistic when stocks go on sale. Actually, doing these things is counterintuitive and very difficult emotionally, but for the intrepid, it has historically been a winning investment strategy.
The Birth of a New Asset Class
According to Investopedia, an asset class is defined as “a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.” The three primary asset classes are equities (stocks), fixed income (bonds) and cash (including money markets and equivalents). Real estate and commodities are also asset classes. And then there is a class of investments collectively known as alternative assets. These latter include stamps, art, jewelry and collectibles.
And now a new asset class is being born. It has all the “early days” characteristics that other assets have experienced. Some of these characteristics include slow or limited transactions, cumbersome in nature, lacking regulation, and without a mechanism to hedge or arbitrage. All were true of stocks until technology and regulatory frameworks made stock transactions much easier, faster, less expensive, trustworthy and available to anyone.
We are in the early days of this new asset class. And while there are several descriptions of it, my preference is the term “digital assets.” Some prefer the term “crypto assets” referring to the world of crypto coins. Many use the term “cryptocurrencies,” which, for the purposes of our investment discussions, can be eliminated from our vocabulary since the U.S. government has specifically said these coins are not currencies. Nor are they securities according to the Securities & Exchange Commission (SEC).
Readers may be wondering why an investment commentary would be discussing assets that are not regulated securities. The reason is quite simple – we think you need to know about this new asset class. That we all need at least a base level of understanding. Even if many of the early stage digital assets are not currently securities or available for purchase within a custodial investment account, the asset class will evolve. Early stage adopters, institutional investors, regulators and governments will again bring technology and regulation to the asset class, making adoption more widespread, easier, faster, cheaper, and trustworthy.
Speaking of trustworthy, the basis for the digital asset class can be summed up as seeking to move from an era of trust (via “middlemen”) to an era of authentication (via immutable digitized records). Our personal information – whether medical, financial or banking – is today held on servers and in centralized databases, which makes it extremely convenient to access and verify information. The stored data exists to prove ownership and to provide history. However, central storage has proven to be costly and vulnerable to hacking. Theft of property and personal identification has made cyber security one of the fastest growing industries.
Even in today’s technologically modern world, there are transactions, processes and structures which are cumbersome, costly, slow, dangerous and inefficient. A real estate transaction occurs via an escrow process that typically takes 30-60 days. During escrow, information is verified, money held, a title report is created, appraisals are completed. They are all part of an authentication process involving record searches. A process designed to provide peace of mind and security for the buyer. But this process also involves significant time and money costs.
Digital assets and the underlying technology platform, seek to remove these barriers. Assets in this space are still being developed. Technologies and transaction structures are being created. The underlying technology is known as Blockchain. Simply put, blockchain is a decentralized, permanent, unalterable storage technology that seeks to eliminate hacking and theft and improve transaction processes by reducing time and costs. Blockchain is a viable, high growth technology and is currently the best and easiest way to invest into the entire digital asset class.
While digital coins currently make up most of the digital asset class, in the future, it is likely that other “tokens” become the equivalent of shares or units. This could create the ability for all investors to own a small fraction in a private real estate project or private company through digital tokens. Why are huge public corporations available for everyone to own via shares or units, but not a real estate development project? And perhaps just to be a little provocative, why wouldn’t the future lifetime potential of a prodigy be an investment choice?
JP Morgan launched their own coin in the 4th quarter of 2018 and is using it in limited transactions. Citizens in countries with high inflation and disruptions are fleeing fiat (paper) currencies and moving to digital assets (which are inherently immune to inflation, and is a topic for a whole other discourse). The IRS is positive on the idea of digital transactions as they reduce black market transactions and increase tax collection efficiency.
The new digital assets class requires significant thought and research. As with any possible investment, analysis is performed, recommendations are made and then investment decisions are executed. The investment committee is working on this theme and will provide more details and recommendations in the coming quarters. But for now, we wanted to outline the new asset class at the highest level to provide some initial context into the topic.
Comments on Key Themes in Today’s Markets
The following is a list of key characteristics within investment markets that the investment committee is using as inputs on portfolio construction:
1. Rate outlook moved from rising to stable. Move from being underweight bonds in general and owning mostly short-term bonds to seeking a broader set of opportunities, add to bond allocations opportunistically.
2. Fed states that it sees crosswinds to the U.S. economy. Allocate within high quality bonds, underweight “junk” bond allocations, not a time to reach for more yield from low quality issuers.
3. U.S. equity market valuations (in aggregate) are at the 95th percentile of history. Future returns tend to be lower over a multi-year period when valuations reach extremes. Extreme readings can persist for a long time, so caution is warranted, including a tactical underweight to offset deteriorating risk/reward trade-offs.
4. Stable interest rates, low tax rates, moderate inflation and high employment are a constructive backdrop for equities. Bullish set of macro data in the near term mitigates some of the long-term overvaluation extremes.
5. Potential for a China “trade” deal settlement. Equities have traded higher in anticipation of a deal and may already be priced into stocks, but a trade deal and/or infrastructure spending bill would be positive for equities.
These key themes can be characterized as “cross currents” and bear close monitoring. For several years during the current economic expansion, there was nothing but tailwinds. We now see crosswinds and need to be mindful of any change in direction, needing portfolio allocations to be ready for headwinds, when they arrive.