Jason Blackwell, CFA, CAIA®
Chief Investment Strategist
September 4, 2019
By: Jason Blackwell, CFA, CAIA®, Chief Investment Strategist; Brian Katz, CFA, Chief Investment Officer & Richard Steinberg, CFA, Chief Market Strategist
Movies developed using technicolor appear highly saturated if viewed from afar. However, if you zoom in closely, you may notice that each individual pixel is represented by only two colors: red and green. In August, the markets zoomed in on just two pixels: the US-China Trade Negotiations and the Inverted Yield Curve. While that zoomed-in view can be useful when making small edits, we find it far more profitable over the long term to zoom back out, identify the trends, and position our portfolios with a broader view.
Markets are generally driven by expectations of the future rather than the present. The announcements of further tariffs between the US and China have not yet made an impact on companies’ profits. Nevertheless, investors are concerned about the longer-term negative impact of tariffs on the revenues and profits of global companies. Moreover, yield curve inversions tell us not that a recession is happening today, but that one may be on the horizon. One might think that with the increasing amount of data available to market participants that they would zoom out from the red and green pixels, but August was a reminder that while investor objectives are long, news cycles are short.
August saw US equities down 1.6% (S&P 500). While it’s never comforting to see a negative return number, August’s headline number smooths over a good bit of volatility beneath the surface. Indeed, half the trading days included market movements of more than 1%, and three days experienced declines of at least 2.6%. Interestingly, if we re-ordered the daily movements by order of return rather than date, we would have experienced a decline of 12.4% followed by a gain of 12.3% (for those doing the math as to why this doesn’t add up to -1.6% for the month, that’s the power of compounding).
Outside the US, markets were less volatile on the downside but also experienced smaller recoveries as the tides changed. There’s a view among many investors that markets outside the US – both developed and emerging – are inherently riskier than US markets; yet we’ve seen the opposite during the past year. Market selloffs have generally been steeper for the S&P 500 than international equity markets; however, recoveries have been stronger in the US than abroad. In fact, looking at only down days, the S&P 500 has lost a cumulative 59.0% while the MSCI EAFE has lost 49.0% and MSCI Emerging Markets 58.7%. Returns during up days have been 151.2%, 91.1%, and 131.7%, respectively. While we can’t be certain of when the current market cycle may end, we do take some comfort in the additional risk reduction provided by our international holdings, and recent performance trends support our positioning.
Daily index returns sourced from S&P and MSCI via Morningstar Direct
Treasuries rallied strongly during the month with the Bloomberg Barclays US Aggregate Government-Long-term up 10.5%, bringing its year-to-date return up to 22.8%. As investors sought the perceived safety of government bonds, they piled into long-term bonds pushing the yield on the 30-year Treasury to record lows below 2%. The move also drove the 10-Year Treasury yield below the 2-Year yield. Effectively, investors are willing to accept the same or less return from the US government even though their principal will not be returned for 10-years versus 2-years. While many market commentators seem to talk about a yield curve inversion as something happening “to the market;” it’s important to recognize that the so-called invisible hand driving this phenomenon is the market participants themselves. As investor concerns over inflation diminish they are willing to take on longer holding periods in risk-off assets. Interestingly, while we saw risk-off positioning unwind in the equity markets, Treasury bonds didn’t experience a similar reversal. We believe this speaks to investors taking a barbell approach to risk management – i.e., they’ll continue to participate in risky assets like stocks but seek insurance in the form of a credit-risk free bond portfolio as an offset.
We continue to take generally defensive positions within our asset allocation recommendations. We’re focusing on areas of the market (both in security selection and in our regional exposures) that offer lower valuations and differentiated sources of return. We believe that the barbell approach, while appropriate for managing daily risks to the portfolio, is inappropriate to meet our clients’ return objectives over the long term. We’d prefer to help our clients watch the movie rather than the worry about the pixels.