Once again, the devil is in the details. U.S. stocks were up; global stocks were down. Real estate investment trusts (REITs) were up; energy and master limited partnerships (MLPs) were down. Investment grade and high-yield bonds were up; emerging market debt was down.
Overall, the quarter was a mixed bag, with a typical diversified portfolio ending the quarter about where it began.
Unprecedented Swings in Stocks?
If you spend much time following the news, you might quickly conclude that the world is crazier than ever. But has market volatility increased?
One of the most recognized measures of volatility is the VIX Index, or the Chicago Board of Options Exchange (CBOE) Volatility Index. The VIX is a market indicator of 30-day expected volatility measured through the options market.
This measure tells us that volatility is actually below average.
But hasn’t the market had more big moves recently? Through the end of Q3, the S&P 500 had 32 daily movements of 1% or more. A typical year has more than 60 of these 1%+ days. So, while it may feel like there is more volatility, the numbers do not show it.
However, the world certainly seems more unpredictable. Last quarter, Argentina implemented capital controls as the country approached bankruptcy for the ninth time in modern history.
Tariffs are still a hot topic in Washington. In the course of two years, the U.S. has gone from having among the lowest tariff rates in the world to among the highest.
UK’s Boris Johnson and Brexit, Hong Kong protests, and teacher and union strikes also trigger the feelings of unpredictability.
During one week in August, two seemingly incongruous things occurred. The Business Roundtable – an association of top U.S. CEOs – declared that the purpose of a corporation is to serve the benefit of all stakeholders, including customers, employees, suppliers and shareholders (instead of a purpose solely focused on shareholder value). While we may all agree with this statement, it is a radical statement from a group of American capitalists.
In the same week, President Trump ordered U.S. companies to “start looking for an alternative to China.” Since when does the White House tell U.S. companies what to do?
Despite the number of surprising headlines during the past quarter and the frequency of significant market declines, the capital markets seem quite resilient. Big declines were often followed quickly by recoveries.
Markets Awash with Capital
One of the biggest surprises in Q3 was an alleged Iraqi drone attack on a Saudi oil processing facility. The ensuing damage took fully half of Saudi oil production offline. This caused oil prices to jump 14%, the biggest single day move in a decade.
Historically, violence in the Middle East and a massive cut to oil production might have sent oil prices over $100/barrel. This time, Brent crude peaked around $70/barrel and West Texas Intermediate crude peaked around $63/barrel. Prices returned to prior levels within a week.
Perhaps because of the amount of energy production from U.S. fracking, the energy markets are increasingly resilient to supply shocks.
What may be helping capital markets be resilient is the glut of capital in the U.S. and internationally, held in both stocks and bonds.
This quarter the investment giant Blackstone closed a record-setting $20 billion global real estate fund, Blackstone Real Estate Partners IX. This sets a record for Blackstone and the private real estate market.
Additional evidence of surfeit capital comes from the fast-moving market for IPOs. This market cooled toward the end of Q3 as the WeWork deal was pulled, not for lack of capital but because controversial CEO Adam Neumann stepped down.
Unlimited capital can have an upside and downside. The good news is that the supply of capital supports valuations and provides liquidity. The bad news is that too much capital can result in speculative investments and excessive valuations.
Currently, the market appears to still be relatively healthy, without excessive valuations.
Bonds, Bonds Everywhere, But Not a Drop of Yield
In the poem “The Rime of the Ancient Mariner” by Samuel Taylor Coleridge, a sailor is surrounded by saltwater that he cannot drink. He laments: “Water, water everywhere/Nor any drop to drink.”
Currently, the capital markets are similarly flooded with bonds issued by corporations and governments. These governments, from the U.S. to Europe to Japan, have issued record amounts of debt to finance budget deficits. And still there seems no shortage of buyers, even when most of the bonds yield less than 1%.
At quarter-end, over $14 trillion of debt is priced at negative yields. Trillion! And $14 trillion with no better place to be invested than bonds with yields less than zero. This is yet another indication of how much capital exists.
Meanwhile, the U.S. Federal Reserve reduced the Federal Funds rate twice during the recent quarter fueling a rally in the bond market (up 10% in 2019) and the REIT sector (up 17% in 2019). These were the Fed’s first rate cuts since 2008, and they are not expected to be the last in 2019. Among global developed market central banks, the trend has shifted toward rate cuts, not increases.
But just as American retirees were starting to see a glimmer of hope that their bond portfolios might generate income … interest rates are being cut again. In developed nations around the world (U.S., Japan, Europe), interest rates likely will remain low for the foreseeable future. The low-risk bonds of the past that had a conservative yet predictable yield are gone.
This is a wake-up call for retirees, who may have expected to live off the income from a bond portfolio. This leaves them with a dilemma between “income with risk” and “no risk and no income.”
Updated Outlook: Dry Powder
As Conifer Bay Capital cautiously forecast in the Summer edition of OUTLOOK, the best returns of 2019 may have occurred in the first half of the year. We remain slightly optimistic over the coming year but have taken actions to reduce exposure to equity markets.
These steps may include shifting assets from growth stocks to value stocks, and shifting assets from international equities to precious metals, such as gold. We also continue to sell “covered calls” on equity portfolios, generating income in exchange for the market’s upside.
In addition, we have started to shift assets away from traditional municipal and corporate bonds in search of higher yields. The specific mix of these changes varies among clients, depending on circumstances.
Heading into Q3 earnings season, year-end and 2020 elections, an “ideal” portfolio may be positioned somewhat defensively with some “dry powder” (or liquid reserves) to take advantage of any sharp declines in the markets.