“It was the best of times, it was the worst of times.” Charles Dickens’ famous quote from “A Tale of Two Cities” aptly describes the market environment of the first quarter of 2019 (the best of times) and the last quarter of 2018 (the worst of times). After a dismal end to calendar year 2018, the S&P 500 rallied close to an all-time high and posted its best quarterly return since 2009. Similarly, global equity markets, which did not rally as sharply as the U.S., made up much of their fourth-quarter losses, and fixed income reversed its losing streak, generating positive returns in the first quarter as interest rates declined. The markets became more positive as they focused on the Federal Reserve’s plans to scale back interest rate increases as well as the possible easing of trade tensions between the U.S. and China as negotiations between the two countries advanced.
While the rollercoaster ride over the past six months certainly was not pleasant for investors, at Brown Brothers Harriman (BBH), we viewed this volatility as an opportunity rather than a risk, as it created more disconnects between the prices of securities and the value of businesses, which our managers were able to successfully exploit. In fact, the fourth-quarter sell-off and subsequent first-quarter recovery was a good reminder that the intrinsic values of high-quality businesses do not change as much as their market prices, and therefore, the key to preserving and growing wealth is to be patient and wait for share prices to converge with business fundamentals. While many short-term-oriented investors were becoming jittery at the end of the calendar year, worrying about how much further the markets might fall, our managers were investing cash and taking advantage of the discounted values that the markets offered up. Just imagine how much wealth would have been destroyed if equities were sold at the end of the year to avoid the possibility of further mark-to-market losses!
Equity markets experienced a sharp rebound in the quarter, with the S&P 500 rising 13.6% and the MSCI ACWI increasing 12.2%. From the market low on December 24, 2018, these same indices were up 21.2% and 16.9%, respectively. Taking a slightly longer view, the market is now within spitting distance of its previous all-time high reached on September 20, 2018. In dollar terms, the MSCI EAFE and MSCI Emerging Markets indices were up 10.0% and 9.9%, respectively, through the first three months of the year, but both remain down on a year-over-year basis. U.S. equity markets have by far the highest three-, five- and 10-year performance at 13.5%, 10.9% and 15.9%, respectively. Nevertheless, we believe that valuations in developed international and emerging markets equities are compelling, and these markets stand to perform well in the future. For example, while U.S. markets have outperformed emerging markets equities over the past 10 years, for the 20 years ending March 31, 2019, the opposite is true – emerging markets (up 8.7%) outperformed the U.S. (up 6.0%) by close to 3%.
As we would expect, in the December market sell-off, BBH’s public equity managers were able to put substantial cash to work. In our Domestic, Qualified, Taxable Growth Policy Portfolio, the “look-through” cash levels declined from 9.38% on October 1, 2018, to 4.51% at year-end.1 This deployment of cash helped BBH’s returns in the first quarter.
BBH’s investment style has many attributes that are especially relevant during a downturn. Owning high-quality businesses with moats, for example, is an attractive way to invest partly because it allows managers to hold positions with “strong hands” when the market tests their resolve.2 Furthermore, managing a concentrated portfolio allows managers to follow a smaller number of companies more closely when prices are changing rapidly. Think about how much easier it is to make good decisions about a portfolio of 10 to 20 stocks during a market freefall than 60 to 80 stocks, which is what many active managers own. Our view is that taken together, the combined effect of owning a concentrated portfolio of competitively advantaged, high-quality businesses is greater than the sum of the parts. The benefits of investing this way are clear to us and, while only a short period, resulted in attractive returns as the markets rebounded in the first quarter.
It is also worth noting that buying and selling stocks is a zero-sum game – to outperform the market in a downturn, someone else has to lose. With the growth in index funds, ETFs and other passively managed vehicles, there is an ample supply of indiscriminate sellers providing liquidity to those willing to lean against the wind and buy stocks in a downturn. When investors pull money from passively managed vehicles during a sell-off, stocks are sold in large quantities without regard to fundamentals and based only on their prescribed weight. This dynamic provides an ideal environment for fundamental managers to find bargains and upgrade their portfolios.
Fixed Income Markets
Much has transpired in fixed income markets in the first few months of the year. In December 2018, the Federal Open Market Committee (FOMC) hiked interest rates for the ninth time this cycle to a range of 2.25% to 2.50%. At its March meeting, however, the FOMC substantially revised its forward projections, indicating that the committee did not see the need for future rate hikes in 2019. In subsequent statements made by FOMC members, it is clear that the committee is now placing a larger weight on the inflation side of its mandate. With several economic indicators having softened in late 2018 and early 2019, and inflation consistently undershooting its 2% goal, the Fed believes it can afford to be patient. The federal funds rate is now close enough to its long-term neutral level that the FOMC believes the economy is not at risk of overheating.
With these developments, yields declined noticeably at the end of March, with the benchmark 10-year Treasury at 2.41%. At current levels near 2.55%, the 10-year Treasury is roughly 70 bps below its recent high reached in the fourth quarter of 2018. This downward shift in rates along the yield curve has led to strong performance in fixed income; however, at current yields, the forward-looking return prospects for fixed income are less rosy. Over the first three months of the year, both U.S. aggregate bonds and U.S. municipal bonds returned a solid 2.9%, and all fixed income sectors produced positive returns. Over the past year, only global bonds had negative returns, while U.S. aggregate bonds were up 4.5%, and municipal bonds were up 5.4%. Municipal bonds, in particular, have benefited from strong mutual fund inflows in 2019, especially in high-tax states, where investors are realizing that the cap on state and local property tax (SALT) deductions has raised their effective tax rates, driving them to look for tax-advantaged income streams.
In mid-2018, BBH added substantially to clients’ holdings of longer-duration taxable and tax-exempt fixed income; however, as yields and expected returns have decreased, our purchase activity has also declined. Currently, our clients’ fixed income portfolios have a roughly 50-50 mix of short-duration and longer-duration bonds, and absent a large increase in yields, this stance is unlikely to change. As always, we search for the highest after-tax, after-fee yields for our clients, and we stand ready to add to our fixed income allocations when yields move in our favor.
What Does an Inverted Yield Curve Mean?
As yields have declined in 2019, an old phenomenon – the inverted yield curve – has received much attention in the press. The normal state of the yield curve is upward sloping, with long-maturity bonds yielding more than short-maturity bonds. Most of the time, investors demand extra yield to take the additional interest rate and inflation risks associated with longer maturities. On rare occasions, the opposite occurs when short-term yields exceed long-term yields. Historically, recessions have followed nearly all instances of yield curve inversions – hence the elevated press coverage.
Whenever we hear the phrase “This time is different,” we typically cringe. We believe today’s low level of real short-term interest rates in the U.S. and the wide prevalence of negative-yielding foreign sovereign debt cast the most recent yield curve inversion in a different light from past inversions. Historically, yield curve inversions occurred at the end of Federal Reserve tightening cycles that left domestic real short-term rates at around 2%, on average. This is a significantly higher cost of short-term funds than today’s paltry 0.3% to 0.4%. We find it logical that, in the past, high real short-term rates helped contribute to economic slowdowns, if not contractions. We view today’s short rates as still accommodative.
Following the financial crisis, the world’s major central banks cut short-term rates and flooded the financial system with liquidity. They went further and enacted large-scale asset purchase programs, known as quantitative easing. Today, as an aftermath of these policies, nearly $10 trillion of foreign sovereign debt trades at negative yields. Even 10-year German bunds ended the first quarter with a negative yield. Although the U.S. has moved to normalize its monetary policy, our domestic bond market does not function in isolation. Higher rates in the U.S. have attracted significant foreign capital, helping to suppress U.S. longer-term interest rates. Despite the Fed’s efforts to normalize policy, our bond market remains affected by central bank policies overseas.
We view the combination of today’s accommodative short-term interest rates and artificially suppressed long-term rates as offering a significantly different context for the recent Treasury yield curve inversion. Although we respect the historical significance of the inversion, we will not alter how we invest because of it.
We are regularly asked when the bull market in equities is likely to end. We cannot possibly predict where we are in the cycle, but we can say that as markets move higher, we will be increasingly disciplined. We will continue to invest according to our tried-and-true investment philosophy, and we won’t reach for yield, use excessive leverage to increase returns or abandon our patient, value-oriented strategy that seeks to preserve and grow clients’ wealth over multiple cycles. As always, we will scour the world for top-tier managers and investment opportunities that can add value to clients’ portfolios. We recently returned from a trip to Asia, where we met with multiple managers that invest in that part of the world. We believe there is a compelling opportunity in parts of Asia and are seeking to partner with managers there whose investment philosophy aligns with ours.
Finally, while timing the markets is a fool’s errand, we are recommending that clients work closely with their relationship managers to rebalance portfolios with a keen eye toward ensuring that overall equity portfolio weights are on target. As suggested previously, the worst outcome would be if a client’s asset allocation is not aligned with his or her tolerance for drawdowns, which leads to the selling of equities at exactly the wrong time. Choosing the appropriate asset allocation and rebalancing when asset classes are out of tolerable ranges is the best way to protect against this outcome.
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1 This data was not yet available at the time we wrote our fourth-quarter market update.
2 A moat gives a company a competitively advantaged position that helps insulate it from competition, allowing the company to maintain high levels of profitability and returns on invested capital over long periods at rates above market averages.