Fourth Quarter Newsletter
In a year dominated by trade tension, possibly unparalleled political noise, persistent talk of recession, and a broad slowdown in corporate spending, global equity, and debt indices provided returns that have not been rivaled since 1997. Meanwhile, US economic growth stalled, with GDP sinking below its long-term average.
A little perspective is perhaps in order. If we step back to October 2018, investors in US equities were at odds with the US Federal Reserve (The Fed). The Fed held firmly that the US Economy was not only on solid footing, but possibly at risk of growing too quickly, triggering inflation. In an effort to control the US rate of growth, the Fed had been steadily increasing the Fed Funds rate, hiking a total of nine times since 2015. While the Fed does not, in itself, make the economy grow or lead to its decline, they play an important role in stoking the economic fire.
As a kid, I grew up with a large ‘All-Nighter’ woodstove in our family room. It was substantially too big for the space, and I remember vividly wearing shorts and a tee-shirt in the house all winter long in order to cope with the heat. Most of us probably understand the basic functionality of a woodstove. Periodically, more fuel is added by opening the door and tossing in a few lengths of oak, maple, or ash. Ours took up to 18” logs and would burn for 8-10 hours or so when full. Our ‘Allnighter’ had two air vents on the top and one big vent on the door, all of which could be opened or closed to control how much oxygen the fire received. More oxygen led to a hot fire, and closing down the vents choked the fire out. We typically had to dial back the airflow substantially, or else endure the sauna-like conditions that ensued. One chimney fire later, we learned that running a stove to burn slow and cool was not a good strategy, but alas, that’s another story.
The point here is that the Fed does not fuel our economic system, or serve as the wood for the stove. That role for the US Economy is the sum of corporate, government, and personal spending, and is impacted by the combined sum of imports and exports. The Fed is the vent, or damper; decreasing the Fed Funds rate opens the vent, providing oxygen (in this case, liquidity) to stimulate the economic fire, and vice versa. If you close off the flow of liquidity too much, however, the people/businesses who provide the economic fuel may choose to stop loading the stove – as it seems was the case in the fourth quarter of 2018. Investors finally came to the conclusion that the Fed had raised rates too much, too fast, without fully allowing each cumulative rate hike to make its mark. Coupled with the noise over global trade, US companies began reigning in their capital expenditures. Back to our woodstove analogy, this is the equivalent of failing to load up the stove with more wood. Companies began protecting their capital, or ‘stores of wood’, preparing for possibly tougher times ahead, and US equity markets sold off almost 20%.
The Fed promptly reversed course at the end of 2018, citing global economic uncertainty, including a possible trade war with China, as a reason to stop raising rates. Markets rebounded strongly. As trade tensions escalated in the summer, the Fed began lowering rates, with a 0.25% decrease in July followed by similar moves in September and October. The Fed backstop fueled markets even higher, as lower discount rates and the fear of missing out overshadowed tepid earning reports.
Many investors, though, missed the strong returns recognized in 2019. According to Morningstar, investors broadly reduced portfolio risk in 2019, adding more than $547 billion to money market funds and $414 billion to bond funds, while reducing equity fund holdings by $41 billion. At Cribstone, we always seek to understand the risks that we are taking, being mindful that markets can be quite irrational at times. We thus adopt a longer-term view and aim to avoid significant shifts in portfolio composition based on short-term noise. We were quite pleased with how our strategy of investing in high-quality companies with sustainable business models performed this year and we hope that you were as well.
Looking forward, the S&P 500 is trading at a 12-month forward earnings multiple of 18.6x, well above the 5-year and 10-year averages of 16.7x and 14.9x, respectively. Growth in GDP has slipped from 2.9% in 2018 to roughly 2% last year, with the median estimate for 2020 at only 1.9%. While business investment has been weak, consumer spending has grown by 3% or more the last couple of years, supporting the US Economy. It is likely that low-interest rates have helped minimize household debt servicing costs, allowing them to continue to spend as wages grow. As seen below, the growth rate in personal consumption has remained steadily positive in recent years, while debt service has flattened. As wages rise and rates decline, it seems consumers are spending their additional income instead of paying down debt – but at least they are not leveraging increasingly beyond their means as we saw in the last cycle. Hardly an optimistic comment, but it’s not all bad!
Of course, an economy cannot rely solely on its consumers to sustain its GDP. If companies do not spend, they eventually look to cut costs and layoffs occur. Unfortunately, as the graph below highlights, the gap between ‘CEO Confidence’ and ‘Consumer Confidence’ represents the largest gap that it has been in recent years – historically an indicator of an upcoming recession.
The uncertainty in trade talks with China have often been referred to as a factor contributing to weak business spend. Although not resolved by any means, the stage one deal with China is a positive step in this regard. Economic data from Europe and Asia has also shown some improvement. Inflation in the US has firmed up. These signs raise the possibility of a “soft landing”. However, it will be important to see whether the Fed continues with its accommodative policies. The outcome of the democratic primaries, presidential and congressional elections could also impact market sentiment, as the direction of future regulation and tax policy becomes clearer.
Our strategy continues to focus on a diversified portfolio, identifying high-quality companies that can provide attractive returns of capital over the longer term. We also maintain our allocation to alternate strategies, which we expect will provide a hedge should markets encounter a prolonged correction and allow us to be more proactive in asset allocation.
As always, we appreciate you choosing Cribstone as a partner in the management of your financial affairs. We remain available to answer any questions you may have.
Scott Upham, CIMA® CPWA
Contributions were made to this letter Contributions were made to this letter by Amyn Moolji, CIO & COO, & Jeffrey Burch, Director of Wealth Management, & Taylor Haselgard, Portfolio Manager.
 The Fed increased rates by 0.25% nine times, in December 2015, December 2016, March 2017, June 2017, December 2017, March 2018, June 2018, September 2018, and December 2018.
 2019 Fund Flows in 9 Charts, Katherine Lynch and Tom Lauricella, Morningstar, Jan 15, 2020.
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