Market Overview: Quite a Year! A Pullback or More of the Same in 2020?
2019 was a year for the ages but 2020 will likely be less fruitful. Last year was in about every way possible a great year for financial markets as much of what was worrying investors during late 2018 and early 2019 dissipated as the year progressed. The economy, while slowing from 2.9% GDP growth in 2018 did not fall off a cliff and toward recession as the financial media has cautioned. The Federal Reserve backtracked and provided financial markets with significant insurance by becoming increasingly accommodative into year-end. Finally, the trade situation between the U.S. and China softened significantly as the two sides came to agreement on a Phase One compromise that forgoes additional tariffs and opens the door for potential movement toward a larger, more comprehensive trade deal. All this drove a near-ideal environment for financial markets to thrive and they did as both equities and fixed income delivered strong performance.
Broad diversification and careful portfolio management are required in late cycle
Despite slowing economic growth ahead, equity markets and the economy still have room to run. However, an older expansion and bull market call for a more disciplined approach. It will be even more important for investors to maintain well-diversified portfolios and be willing to make adjustments as late-cycle risks gradually rise.
- JP Morgan Economic & Market Update
Looking to 2020, markets will need to weigh the strong year and more importantly a very strong fourth quarter against the backdrop of elevated valuations, heightened geopolitical uncertainty and increased complacency. A key test for markets will come from Q4 earnings reports and corporate management teams outlook. Revenue growth into 2020 and capital spending sentiment will be crucial determinants for whether equities will advance further given their higher valuation levels that need to be balanced against growth outlooks. Additionally, we believe Europe and a continually improving trend is another test for both equity and debt markets and may well hold the key to unlocking modest performance on the heels of a strong 2019.
In the longer view, we feel complacency likely leads to elevated volatility returning to markets with increased frequency and in a more pronounced way than relative to recent history. Markets need periods of consolidation at times to minimize investor complacency and maintain a healthy balance between risk and return.
A reasonable level of volatility is important as this creates an environment for a disciplined asset allocation policy to work properly. With a multitude of significant issues still in the forefront, including a “return to normal” for domestic and foreign central bank policy, divided U.S. government and debt anxieties, trade and tariff worries and global growth concerns, the ride is likely a bit bumpier. We need to remain mindful of these and other issues as they are likely to impact confidence and deliver heightened volatility to financial markets.
Our allocation to equities continues to remain neutral given diverging points of focus – a solid but slowing macroeconomic environment versus slightly elevated valuation levels coupled with the aforementioned issues likely impacting markets in the forward. With the current bull market in equities maturing, a greater level of discipline with respect to allocation and valuations is warranted. We believe the probability of financial market turbulence continues to increase as we progress through the market cycle which should benefit companies that are well-positioned within their respective industries and good stewards of capital. Accordingly, we must remain cognizant of risk and favor companies with strong balance sheets and disciplined capital allocation strategies. Our fixed income viewpoint is slightly more cautious as opportunities have diminished following the strong result of last year. As always, we believe a properly risk-allocated portfolio is one that is well-diversified across asset classes and mindful of the risk inherent in these underlying assets.
Both domestic and international equities ripped higher throughout 2019, generating returns that most investors would gladly take in total over a two or three-year period. Despite many perceived headwinds (broad slowing of global growth, reversal in Fed policy and U.S.-China trade concerns), foreign and domestic equities provided strong returns proving once again that attempting to time markets is a fool’s errand and that sticking to a disciplined asset allocation strategy provides investors the greatest potential of achieving successful outcomes. Though broad-based gains were realized across domestic equities, large caps outperformed mid and small caps during the year while from a style perspective, a late-year rally helped value edge out growth, reversing trends that have held frequently since the end of the financial crisis in March of 2009. By sector, information technology, communication services and financials performed best while industrials, real estate, consumer discretionary, consumer staples, utilities, materials, healthcare and energy all lagged against broader domestic indices. From a global standpoint, developing markets outperformed emerging markets, though a Q4 reversal favoring emerging markets cut the level of out-performance by roughly half. We continue to believe that the current valuation disparity favors emerging markets especially if global growth strengthens.
Our equity strategies performed well on both an absolute and relative basis (versus the respective benchmarks and peer managers) benefiting from staying invested versus other managers that increased cash in the wake of a difficult Q4 last year. The out-performance was driven by disciplined adherence to investment mandates reminding us once again that trying to time the market is not an investment strategy.
As we look ahead into 2020, we believe that risks are amplified with respect to elevated valuations on top of a settling macro backdrop. However, this is offset by an increasingly accommodative central bank environment which is trending towards further easing of monetary policy. While this likely lifts most markets in unison at inception, this strategy will need to generate stronger macroeconomic growth or it will be met with skepticism, pressuring both earnings and valuations. As a result, we are keenly focused on upcoming Q4 earnings, both in terms of results as well as management’s commentary regarding revenue growth and willingness to spend on capital investments which we view as necessary to extending the business cycle still further. Quality stock selection should become of greater importance and is likely to be rewarded going forward. From an allocation perspective we continue to remain neutral towards equities pairing an accommodative Fed with elevated valuation, settling macroeconomic growth and potentially negative headwinds from broader trade disputes coupled with mounting political friction as we head towards the 2020 U.S. Presidential election. We see opportunity in emerging market equities (relative valuation and a weaker U.S. dollar), value stocks (style rotation) and large cap financials (money center banks such as JP Morgan (JPM) and Citigroup (C)) benefiting from scale and continued capital flexibility.
Debt markets held serve in the back half of the year after posting strong gains through the summer. For the full year, the broader fixed income asset class benefited from the significant decline in prevailing interest rates driving price appreciation and most of the broader category’s year-to-date return. Within domestic markets the high yield increased by roughly 15% in 2019 while the leveraged loan category saw a full year increase of approximately 10%, benefiting from the lower rates which expand the gap between offered yield and the prevailing market rates along with the rise in equities which is often buoyant for high yield bonds. The corporate investment grade category performed well during the year returning low-double digit percentage gains, while the commercial mortgage backed securities space provided positive high-single digit percentage returns. Finally, municipal bonds produced respectable high-single digit percentage gains during 2019 with the taxable municipal sub-category performing even better with greater than 10% gains. On the international front, developed markets realized gains in the mid-single digit percentage range while the emerging markets outperformed achieving low-double digit percentage gains and benefiting measurable from a softening dollar.
Moving to 2020, expectations are muted given the solid returns realized last year and the likelihood of less deviation in rates given the Federal Reserve Board’s current neutral bias. Sustained economic growth coupled with accommodative global central banks and manageable inflation all point to continued favorable outlook for the broader asset class but with returns likely below what was experienced in 2019. Collectively our predisposition on the margin is toward modestly higher exposure in high yield and floating rate categories married with exposure to low duration and high quality fixed income and CD instruments.
KbC Equity and Allocation Strategy Model Portfolios
KbC equity strategies performed well during 2019 with three of the five strategies outperforming in a strong up and to the right market. Stock selection proved to be paramount in outperforming versus respective benchmarks as our “core” portfolios benefited from positions that skew growth but also from perceived value positions that performed equally well on a relative basis. The Dividend strategies led the out-performance charge benefiting from the lower interest rate environment as the gap between the average holding’s dividend yield and the 10-year U.S. Treasury yield widened. This along with strong stock selection drove out-performance versus its respective benchmark. Additionally, the Market strategies experienced alpha generation during the period, benefiting from strong stock selection. Finally, from an out-performance perspective our Strategic Asset Allocation strategies experienced solid returns benefiting from near fully invested exposure (versus a significant number of competing managers that were negatively impacted from cash positions built in response to the Q4 2018 downturn). Alpha Leaders and Alpha Tax/Qualified were two strategies that lagged during 2019 with stock selection impacting Alpha Leaders and the equal weighting approach of Alpha Tax/Qualified impacting performance. As we continue to expect elevated levels of volatility (though recent levels have fallen off some), we feel the risk/reward trade-off of equal weighting and the tax sensitivity of the strategy position it well in the current environment and should equities sell-off meaningfully at some point in the future.
KbC Dividend Strategies displayed strong performance throughout 2019, besting their respective benchmarks by significant levels. Portfolio exposure as near-core with a slight bend towards value did not hold the strategy back and staying committed to a few positions which lagged at the end of 2018 paid off handsomely with Ameriprise Financial (AMP), Blackstone (BX) and Lockheed Martin (LMT) all driving significant out-performance relative to the broader market. We continue to view the strategy as well positioned, especially from a risk/reward perspective as markets move into what looks to be increasingly volatile times benefiting from ownership of both offensive (growth) and defensive (value) positions. Our philosophy towards income producing strategies employs a barbell approach, holding both consistent dividend payers and companies increasing their dividend at enhanced rates versus the broader market. During 2019, exposure in this regard paid off as both out sized dividend growers, companies with mostly higher growth profiles and consistent dividend payers, companies exhibiting value features performed well. Strong performers during 2019 in addition to those mentioned above include AT&T (T), Allergan (AGN), JP Morgan Chase (JPM), Microsoft (MSFT) and United Technologies (UTX), all outperforming the broader market. Laggards such as Energy Select Sector SPDR (XLE) and JM Smucker (SJM) impacted performance as well Altria (MO) and Walgreens Boots Alliance (WBA) which were both exited during 2019.
KbC’s Market Strategies significantly outperformed their respective benchmarks during 2019. Performance from the strategies financial services positions drove approximately half of the alpha with Ameriprise Financial (AMP), Citigroup (C), JP Morgan Chase (JPM) and RenaissanceRe Holdings (RNR) all realizing gains at levels significantly above the broader market. Additionally, AT&T (T), Ball (BLL) and Microsoft (MSFT) all drove alpha for the strategy while posting gains of 50%+ during 2019. Conversely, positions in Altria (MO), Constellation Brands (STZ), Energy Select Sector SPDR (XLE) and JM Smucker (SJM) dragged on performance slightly though not enough to offset strong performance elsewhere. This strategy seems well positioned moving into 2020 with its natural mix of offense and defense acting appropriately and playing off each other.
Mid Cap Strategies
KbC’s Mid Cap Strategies slightly under-performed their respective benchmark during 2019 as back half performance tailed off. After solid first half performance, stock selection negatively impacted the strategy late in the year. This portfolio bends the most growth of the core strategies and benefited modestly from the significant growth-to-value divergence during the first nine months, and disproportionately during the reversion in the final three months. Examples of this can be seen with Ball (BLL) which after advancing ~70% through early September gave back ~1/4 of that performance through year-end; as well as with Axis Capital Holdings (AXS), Dollar Tree (DLTR) and Spirit AeroSystems (SPR) which exhibited similar reaction. Conversely, strong performance was realized in several positions including ACADIA Pharmaceuticals (ACAD), Ameriprise Financial (AMP), Conagra Brands (CAG) and Jacobs Engineering (JEC) all significantly outperforming the broader market (at better than 2:1).
Alpha Leaders lagged its respective benchmark, the S&P 500 in 2019 despite outperforming during the fourth quarter. This strategy is focused on companies identified as incumbent or emerging leaders in their respective sectors and tends to be concentrated in a relatively small number of positions. Given the concentrated nature of the portfolio it can and will perform more divergently from its benchmark at times as evidenced by outperformance of 4% during its inaugural year and underperformance of approximately 1.5% in 2019. Taking a longer view, total outperformance since inception has been in excess of 2.5%. The sole portfolio modification was the elimination of Altria (MO) where the fundamental investment thesis broke down as legal and regulatory headwinds from JUUL lowered the growth algorithm. Berkshire Hathaway (BRK.B), Biogen (BIIB), Boeing (BA), Simon Property Group (SPG) and Exxon Mobil (XOM) also trailed the benchmark while positions in Danaher (DHR), JP Morgan (JPM), Lockheed Martin (LMT), Microsoft (MSFT), NextEra Energy (NEE), Netflix (NFLX), NVIDIA (NVDA), Sherwin Williams (SHW) and Visa (V) all significantly outperformed the S&P 500 and point to the strategy’s well diversified holdings base.
Alpha Tax/Qualified performed as expected given the broader equity market’s run higher in 2019 but as a result lagged S&P 100 benchmark, which is market capitalization-weighted as opposed to the Alpha Tax/Qualified strategy where components are equal weighted. The rationale for the equal-weighting is to limit downside from mega-cap stocks that become outsize after years of out-performance when trends inevitably reverse and participate in the upside from those positions which have become relatively smaller weightings and have built to a favorable risk/reward relationship.. 2019’s performance is directly a result of design, giving us confidence in the overall strategy and its valuation-sensitive attributes.
Strategic Asset Allocation strategies displayed strong performance during 2019 benefiting from robust performance of both the equity and fixed income markets along with its fully invested exposure (versus a significant number of competing strategies that built cash in response to the Q4 2018 volatility resulting in performance drag). The strategies exposure to total stock market (SPDR Portfolio Total Stock Market ETF-SPTM) and high yield (JP Morgan Disciplined High Yield ETF-JPHY) positions which comprised ~40% of the respective portfolio strategies provided offense. Additionally, the more defensive part of the portfolio strategies provided strong returns also, benefiting from exposure to the preferred stock (Invesco Variable Rate Preferred ETF-VRP) and real estate (iShares Core US REIT ETF-USRT) positions. As we move to 2020, we are cognizant of the strong performance realized in 2019 and are rebalancing appropriately, weighing risk/reward of each component position while remaining tight to underlying profiled allocation levels.
The information provided herein is the opinion of Knightbridge Capital and subject to change without notice. It is not to be construed as investment, legal or tax advice. This publication may contain forward looking statements which reflect our best judgment based on factors currently known but involves significant risks and uncertainties. Actual results will differ from those anticipated in forward looking statements as the result of changes in underlying assumptions including, but not limited to systemic, macro and company-specific risks.
Knightbridge Capital is an investment management option available through Prentice Wealth Management, LLC, an SEC Registered Investment Adviser. Securities offered through Cadaret, Grant & Co. Inc. member FINRA/SIPC. Advisory services offered through Prentice Wealth Management, LLC. Prentice Wealth Management and Cadaret, Grant & Co. Inc. are separate entities.
Exhibit 1, 2, 3: Data source Morningstar Office.
Exhibit 4: Morningstar Market Barometer provides a visualization of the performance of Morningstar Indexes. ©2019 Morningstar