Q1 2019 Portfolio Commentary & Outlook – Musical Chairs

April 4, 2019

The U.S. stock market just wrapped up its best quarter since Q3 2009. From our vantage point, technology stocks are back in the driver’s seat and emerging markets are en fuego. Risk assets are giving the all clear…Other asset classes and economic indicators seem to be telling a different story.  

Normally, during a strong stock market run such as the U.S. has had this past quarter, bond prices fall (yields rise). The opposite has occurred. The 10-year treasury started 2019 at 2.70% and is now hovering around 2.40%. The bond market is telling investors that it does not expect strong economic growth and that inflation won’t rise.

Of course, “normal” is not the environment in which we find ourselves investing now. Yields around the world have cratered and the spread (or difference between a U.S. bond and other developed country bonds) is near all-time highs.

Foreign investors are buying U.S. bonds due to their yield advantage. If you are a German investor, why buy a German 10-year bond yielding -0.05% (you PAY the German gov’t to hold your money), when you can sink your teeth into a juicy 2.40% U.S. treasury bond? Therefore, this traditionally dependable bond market warning signal (that being sinking long-term yields) might be diminished due to increased demand driven by yield starved foreign investors.

What about the economic tea leaves? The ones BSW is focused on aren’t painting such a rosy picture either. Manufacturing around the world has been weakening and global trade is slowing. It’s no wonder, since the 2 biggest trade powerhouses are still at loggerheads.

Investors have been worried that global growth is going to languish. It remains to be seen if the jump in China and U.S manufacturing this past month (Germany is still dogging) is temporary, or if production will continue to ramp up into the first half of this year. It seems clear that we need some deal between China and the U.S. to provide any hope on this front. Given the correlation between stock earnings and world trade let’s hope a deal gets done ASAP.

For those of you keeping score, we’ve got one hashmark in the bullish column (thanks stocks!) and we’ll call it 2.5 hashmarks in the bearish column – based on economic data and an iffy bond signal. The question is: what do investors do with these conflicting indicators?

BSW is not trying to predict the future – nobody can with any consistency. We may be in uncharted territory in terms of the length of this economic expansion, but that doesn’t mean it HAS to end this quarter, this year or next year. BSW remains balanced, keeping our chips spread across different asset classes and leaning into fat pitches where we feel the risk/reward is warranted.

BSW continues to be overweight emerging market stocks and Asia in particular. We believe valuations are still very low, even after the run up over Q1. BSW has also added to our Japan exposure through an active manager that focuses on quality companies with strong brands and consistent earnings growth history. Here again, we see valuations as very compelling.

It is our belief that municipal bonds continue to be a key ingredient within portfolios. While current yields aren’t necessarily high-five inducing, we note a few factors that, in our opinion, continue to augur for a heathy exposure to this asset class: 1. Tax rates are poised to move higher, making munis more attractive on a relative basis; 2. Muni bond supply is way down, creating a supply/demand imbalance; 3. Most municipalities seem to be in strong financial shape; and, 4. Munis are typically the stable part of the portfolio that provide consistent cashflows, stability and dry powder for opportunistic purchases in other parts of the portfolio.

Another slice of the BSW investment pie that has done well over the last decade is real estate. The real estate managers BSW has partnered with have taken advantage of low interest rates and trends that have emerged since the market bottom in 2009. Multifamily apartments have benefited from demographic and lifestyle trends that have favored renting over home ownership. Online retail has created a growing opportunity to invest in last mile logistics and tight commercial lending standards have created an opportunity to diversify into high-yielding, privately funded real estate debt and preferred equity. 

Bradlee Danvers Apartments – HGI BSW Fund VI

The recent fall in interest rates has improved the underwriting on several real estate investments, as less of the operating cashflow will be needed to satisfy interest payments.  We believe, our managers remain very disciplined in their underwriting and bidding of new projects and seem to be passing up on many lessor opportunities in favor of more secure rents and projects that align with their secular themes.

Low interest rates have also supported higher valuations in the private equity space. Tempering this is the fact that there seems to be a fair amount of committed, but undeployed, capital known as “dry-powder” waiting to be put to work within private equity funds. Companies in the private markets are staying private for longer before seeking a listing on the public stock market exchanges.  Several notable companies (Lyft and Snap for instance) have either gone public or are planning to do so, which would provide significant liquidity to investors and funds in this space. These initial public offerings could also pave the way for more private companies to seek similar listings. The managers BSW has partnered with allocate across the spectrum from venture capital to large buy-out investments.

As recently as last October, the Fed indicated that it was “a long way” from a neutral rate – meaning there were more interest rate hikes on the horizon. However, just last month, it flip-flopped and telegraphed that it is done raising rates this year (kicking the stock market into an even higher gear). The U.S. has never ended a rate hiking campaign at such a low Fed funds level.  The average over the past 5 cycles was 7.55%. The Fed funds rate is now at a meager 2.40%.

The Fed is seemingly pivoting with the market (funny, shouldn’t it be the other way around?) and appears committed to its inflation target of 2%. However, with inflation stuck below 2%, we don’t believe rates will increase anytime soon. This creates an environment where easy money can continue to flow into riskier assets and those assets with higher yields.

For now, the music keeps playing. However, by keeping rates this low and acquiescing to the market, the Fed just yanked away a few chairs.

Thanks for reading. Happy spring!