Q3 2018: PFM Quarterly Commentary
Last quarter, we chronicled budding developments which suggested potential outperformance by domestic equities over international equities on a level not seen since 2013. While both international and domestic equity markets were up sharply that year, the S&P 500 outpaced the MSCI EAFE Index by 9% thanks in part to an accelerating U.S. economy, a rising dollar, a weak bond market, European instability, and a rout in emerging market stocks.
Five years later, we find identical elements in place with similar results up to this point. However, 2018 isn’t over and we have evidence that circumstances may be different this time courtesy of a potential shift in monetary policy. In Peak’s last market commentary, we detailed how the Federal Reserve’s dual monetary tightening protocol (raising short term interest rates while selling longer dated bond holdings from its balance sheet) was moving the interest rate curve toward inversion. Inversion is a rare phenomenon in which short term interest rates are higher than long term interest rates. Historically, this scenario almost always portends a recession and as such the Federal Reserve vowed not to let an inversion occur. At the time of that writing, ten year Treasury bond yields were only 33 basis points (.33%) higher than the two year Treasury bonds’. Three months later, the spread between these two bonds has narrowed to 24 basis points (.24%), suggesting that investors are becoming skeptical of the Federal Reserve’s ability to continue such aggressive monetary tightening.
Additionally, the U.S. Dollar has started to weaken from its mid-August peak against other major currencies after a blistering 10% rally from the February 2018 lows. Traditionally, the Dollar’s path is heavily influenced by the Federal Reserve’s policy decisions. Higher interest rates in this country attract international capital seeking greater returns and, conversely, capital flees if it can find better opportunities elsewhere. The Dollar’s slide over the last six weeks of the quarter may suggest that currency investors are betting that the Federal Reserve may not be as hawkish in the future as they have indicated.
The reasons for a potential change in monetary policy are mounting. Waning economic data on housing, retail sales, durable goods, and domestic vehicle sales imply that the Federal Reserve’s efforts to slow the economy are working. Perhaps, even too well. Additionally, the Federal Reserve has long taken a “you’re on your own” position regarding how its policies impact the global community. However, the continued weakness seen in developed international economies and especially the emerging market economies is difficult for the Fed to ignore. Year to date returns through the end of the third quarter for developed international and emerging market equities as measured by the MSCI EAFE Index and MSCI Emerging Markets Index were down 3.8% and 9.5%, respectively, on a price basis. The strengthening Dollar and tightening monetary conditions in the U.S. has caused turmoil in emerging markets countries, many of which are dependent on our currency for funding and trade. Countries such as China, Indonesia, the Philippines, South Africa, Turkey, Bangladesh, Poland, Hungary, Brazil, and Argentina have experienced stock market declines of between 15% and 50% to date in 2018. Moreover, much of the developed world markets outside of the U.S., such as Germany, Spain, Italy, France, the U.K., Greece, Austria, Canada, and Japan have languished so far this year while mired in trade disputes, internal conflicts, and economic stagnation. While many Federal Reserve members brandish their nationalistic mission, we find it difficult to imagine our Central Bank remaining indifferent to the rest of the globe’s plight – even in light of our country’s perceived immunity thus far to contracting similar economic weakness.
Perhaps the biggest reason to anticipate a potential change in monetary policy comes from President Trump. In July, the President called out the Federal Reserve for raising interest rates too quickly, saying that its hawkish monetary policy “hurts all that we have done” through the administration’s fiscal policy. Days before, the President told CNBC that the strong dollar “puts us at a disadvantage”, adding that the Federal Reserve’s actions are reducing the competitiveness of American exports.
These data points and aggressive comments by the President suggest that a change in monetary policy could be forthcoming. The flattening of the yield curve, the sudden reversal of the Dollar’s rise, and the President’s admission that his administration is pursuing a weak dollar and low interest rates to stimulate growth all lead us to this conclusion. However, this perspective runs contrary to the popular outlook issued by most economists and other national media members. Our contrarian stance fits comfortably within Peak’s long standing investment philosophy of constructing broad based, globally diversified portfolios. This time tested, historically informed approach has been challenged in the one dimensional market that we have experienced so far in 2018, where the U.S. stock market outpaces nearly every other asset by a wide margin. In our opinion, this divergence has been stretched too far and a return to more normal market conditions appears likely. The evidence is mounting that investors may change their preference to non-U.S. equities. Now, only a catalyst remains. A possible shift in the Federal Reserve’s stance could provide that spark, igniting a major tailwind for many assets beyond domestic equities.
In closing, we remain steadfast in our conviction that the best long term path to investment success lies in diversifying globally across many asset classes rather than simply chasing the most recent outperformers. Embracing this philosophy and enduring the cyclicality of markets will occasionally test one’s fortitude, since an investor must often contend with holding both leading and lagging positions in a portfolio simultaneously. Maintaining discipline and focus, regardless of near term market conditions, can be difficult for most investors. Fortunately for us, we consider it second nature.
As always, please do not hesitate to contact the Peak team with any questions. Enjoy the Fall and we look forward to speaking with you soon.
Regards,
Peak has created a monthly “quilt” of returns to track the performance of the major areas of the investment markets over time. We believe that this table best illustrates the fundamental tenets of Peak’s investment philosophy, namely the futility of predicting which investments will outperform over the short term and the unremitting cyclicality of markets. These truths support our firm belief that broad based diversification over many areas of the world economy is the best path to investment success over the long term. Asset Class Quilt of Total Returns- September
This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This presentation may not be construed as investment advice and does not give investment recommendations. Any opinion included in this report constitutes the judgment of Peak Financial Management, Inc. (Peak) as of the date of this report, and are subject to change without notice.
Additional information, including management fees and expenses, is provided on Peak’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Peak does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.