Quarterly Review – October 2018
October 30, 2018
World equity markets enjoyed decent gains during the third quarter of 2018, with the All Country World Index (ACWI) rising by +4.3%. However, not all sectors or countries rose equally, with certain segments, such as US growth and tech stocks, outperforming the more modest returns of the broader equity markets. Meanwhile, bonds gave up some ground this quarter, as interest rates moved higher globally. The resulting return for a balanced 60% stock/40% bond global portfolio invested in the indexes was about +2.2%—overall, a return that was in line with their long-term averages. Despite their recent underperformance, we believe that the diversification provided by bonds and non-US equities will ultimately prove to be a prudent strategy. We may have already received a hint of what that may look like during the month of October, with bonds outperforming US stocks by a meaningful +8.2% amount through yesterday. Market corrections are often inflection points when leaderships changes. It’s still too early to tell, but we may be seeing the start of a catch-up by bonds and non-US markets that will play out over the next several quarters.
Stocks moved largely higher during the third quarter of 2018, with the ACWI index finishing the period up +4.3%. This robust performance in the broader global index masked the major divergences which occurred among the sectors, countries and individual equities, as just a handful of categories contributed to the bulk of the market’s gains. For example, US indexes clearly outperformed their foreign counterparts this period, returning +7.7% to the latter’s +1.4%. Similarly, “growth” outperformed “value”, with growth stocks returning +9.3% versus the +5.8% for value. Bonds, meanwhile, fell slightly, as benchmark interest rates moved higher across the world. This hurt near-term performance, but the higher rates bode well for future fixed income returns. Overall, a balanced 60% stock/40% bond global portfolio gained +2.2% during the quarter – a respectable absolute amount, but less than that experienced by a 100% US equity investor.
Over the short-term, this lopsidedness can be convenient or inconvenient depending on your exposure to those few outperforming categories. But we’ve seen time and again how trends can reverse course in just an instant, and we may have already received a hint of what that may feel like during the month of October, as the S&P 500 has fallen by -9.4% through yesterday, while the 15 highest percentage gaining stocks through September have fallen by -17.4% on average. When markets turn, as they always do, new leaders typically emerge, and investors in globally diversified portfolios are likely to be in a better position to take advantage of this shift. We explain this in more detail below.
The World Is a Very Big Place
One question that we have been hearing over and over this year is why we invest internationally at all, and the key to that answer requires viewing the question from a longer-term perspective. Or rather, a view that lasts for years rather than just a few months. For example, in 2017, foreign developed market stocks bested the US by +3%, while emerging markets left US stocks in the dust, outperforming by +15%. Looking farther back, we see that foreign stocks have beaten the US in 9 of the past 20 years, sometimes by very significant amounts. And, over the past 20 years, returns from each were fairly in-line with one another, at least until very recently. Given that general dynamic, we believe that it makes sense to increase the geographic diversification of our clients’ assets, just in case something happens that negatively impacts only US stocks.
Tariffs, Trade and Trump
It is also interesting to note that the underperformance of non-US equities this year only started in May, as the chart below illustrates. When looking back over the last 9 months, US stocks’ outperformance does not totally surprise us, although we did expect to see less disparity in returns between the US and international markets, in part because we didn’t fully appreciate how the trade battle would unfold. Trump has rattled the tariff saber much more than we think makes sense, either economically or politically, and yet he still appears to be continuing down this course. This has pressured our allies, raised interest rates domestically, and encouraged a flight to the relative safety of US markets. The boost to US corporate profits were from tax-cuts and deficit-fueled economic stimulus has also certainly helped.
Meanwhile, more risk has been priced into international stocks this year due to the aforementioned threat of US tariffs and countermeasures by other countries. Here, too, we believe that the market is pricing in extremes. Based on the experience with the renegotiation of NAFTA, we anticipate that other updated trade agreements will end up largely unchanged from current incarnations. That bodes especially well for European stocks, which still carry an overhang from Trump’s threatened auto tariffs. We also think that Brexit will eventually work out and that Italy will, as usual, muddle through. The trade war with China, on the other hand, may be more protracted, but with Chinese stocks already in bear market territory, and the currency having already fallen by 6% this year, the impact on Chinese equities may be mostly behind us.
Remember that stock prices at any given time aim to reflect all available information, and as new information is regularly received, prices adjust in an effort to equalize risk-adjusted returns going forward. But, we think international stocks are pricing in a lot of likely temporary uncertainties, while at the same time, the US seems to be baking in a number of unsustainable positives. The combination of ever higher valuations (particularly in the Technology sector), 10 years of record profit margins, an expensive US dollar, and large federal budget deficits as a result of the 2018 tax cuts, lead us to modestly underweight the US market in anticipation of a further correction or a coming recession. So far in 2018, that has worked to our disadvantage, but as it is impossible to say when the worries weighing on international stocks will abate, or when investors will start looking past them, we plan to maintain this underweight in the US unless significant new information causes us to change our stance.
KCS aims to build diversified, risk-managed portfolios designed to help our clients reach their financial goals. Our accounts have beaten the major indexes in some years, and in others have slightly lagged. Perhaps more importantly, we have avoided the kinds of wild swings exemplified by overconcentration to one market area, while simultaneously aiming to minimize internal costs and managing taxes. This, we believe, is what most people want. It would be great if stocks would just behave and rise a consistent 8% – 10% a year, but that’s not how markets work. Returns vary a lot from year to year around that average. The key is to come to expect those short-term variations in return and focus on the long term. You’ll be less prone to surprise or disappointment and will sleep better at night.
Dr. Ken Waltzer, MD, MPH, AIF®, CFA, CFP®
Managing Director, KCS Wealth Advisory
Laura Gilman, CFP®, PFP, MBA
Managing Director, KCS Wealth Advisory
Nick Nejad, CFA
Director of Investment Research, KCS Wealth Advisory
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