We believe that the markets are in late cycle. During late cycle, you start to look for more defensive or hedge positions and extend duration in your high-quality fixed income portfolio. The momentum of the market is strong at this point and we will pay attention to this momentum to help us adjust the portfolio appropriately.
During late cycle markets, the risks within the portfolio can potentially increase, and as you move through different cycles the risk profile of the investments change. We view the portfolio through a risk budget and when the risk within the investments increase or decrease, we need to make changes to keep the risk budget in-line.
When you look at the US equities there is one thing that most analysts agree on is year over year growth is slowing. This doesn’t mean that earnings are getting weaker, instead they are just not growing as fast as they have in the previous years. This tends to be the start of the late cycle. The issue with this indicator is the amount of time from when earnings growth begins to slow, to the time that it negatively affects the market. At this point, the momentum within the US markets is strong and we try not to fight the momentum of the market.
Looking at global equities you will start to see that the valuations in developed international equities are cheaper than the US equities. With these valuation being much lower, we would anticipate that developed international equities should outperform US equities.
There is a consensus amongst most large firms of an overweight to Emerging Markets, with a shared expectation they will outperform US markets. This view on the Emerging Markets is based on the extended underperformance and valuations. We do not agree with this consensus. Emerging market equities tend to be commodity-driven and we do not see commodities breaking out this year. We see crude oil staying in a trading range between $50 and $60 dollars and this does not bode well for Emerging Markets. As with any sector that has been underperforming, you can expect sporadic short-term rallies and outperformance. This is something we feel is possible in Emerging Market equities, but this is not a sufficient reason for an overweight.
We have been introducing more factors in the portfolio. Here is a brief explanation of each of the factors that we are tracking. First, a factor is something that can be isolated within the market. Once you isolate this factor, then you must be able to analyze whether there is a significant performance benefit of having this factor isolated. From an academic standpoint the way they analyzed these factors was to isolate, rank and then build a portfolio that buys the highest-ranking equities and shorts the lowest ranking equites to test whether there was any benefit of the isolated factor. This academic testing is used to confirm the statistical benefit of the factor. The following factors have been tested and show statistical benefit of having them in the portfolio.
1. Size – smaller company weighting achieved by re-weighting stocks within the large and mid-cap stock universes
2. Momentum – is achieved by ranking 6 month and 12-month risk-adjusted returns across the universe and selecting the highest scoring securities
3. Quality – uses the return on equity, earnings, earnings consistency, and debt to equity ratios to calculate a score within the universe, then selects the highest scoring securities.
4. Value – uses the price to book, forward price to earnings, and enterprise to cash flow from operations to calculate a score, then selects the highest scoring securities within each sector.
5. Minimum Volatility – selection based on a minimum variance optimization and covariance matrix risk model, then selects the highest scoring securities and uses a sector cap to make sure the portfolio has a minimum weighting in each sector.
6. Dividend – securities selected based on yield and dividend growth.
There are times within the market cycle that each of these factors tend to either outperform or underperform. We monitor this cycle to try to optimally position the portfolio. The cycle can be broken into four sections.
Section 1 – Recovery
This first part of the cycle is when the market starts coming out of an extended correction or recessionary time frame. The most recent recovery was 2009. During this part of the cycle, Size and Value factors tend to be the best performing factors.
Section 2 – Expansion
This is the second part of the cycle. This portion of the cycle is after the recovery from the correction when the economy and market start expanding. During the expansionary part of the cycle, Momentum tends to be the best performing factor.
Section 3 – Slowdown
The third part of the cycle is when the economy starts to slow. You start to see earnings growth slowing and the market to start to be range bound. During this part of the cycle, Quality and Minimum Volatility tend to be the best performing factors.
Section 4 – Correction
This is the final part of the cycle. The correction is when the economy and market are losing ground and there is no growth. During this time, none of the factors are expected to make money but Quality and Minimum Volatility tend to be the best performers during this part of the cycle.
All of these cycles happen over a longer time frame, but you will have smaller cycles within the larger cycle.
As we move into a late cycle, we are focusing on high quality fixed income. Moving down in credit quality in fixed income is not a risk we feel comfortable currently taking.
Based on our late cycle and slowing growth prediction, we do not expect rising rates. The only way we see higher inflation is further Central Bank intervention. Inflation is currently subdued and there is no sign of higher rates at this point. We are keeping the duration of the portfolio between the 5- and 7-year range.
Currency – US Dollar
The consensus from most of the major firms is that there is not a potential for significant upside in the dollar. This is based on the fact that they do not see rates or inflation moving up any time soon. We only slightly agree with this analysis and believe that the US dollar will be range-bound, but the risk is to the upside because there is still an arbitrage opportunity between the US dollar (positive rates) and International currencies (negative rates).
Commodity – Oil/Gold
We believe that oil prices will be range bound this year. The range that we see is between $50 and $60 dollars. The supply should start to slow down as we start to see the decline curves overtake new drills based on the slow down in rig count for 2019. This will help prices, but the demand has also slowed which should keep the prices range bound.
Gold has been and continues to be a safe haven for economic and market shocks. We are not calling for either to happen at any point soon, but the trend and momentum in gold has been strong and this could be forecasting some possible issues in the future.
The consensus at this point is that we stay divided with Trump re-elected the House staying Democrat and the Senate staying Republican. This type of division has historically been good for the market. Even though this should be good for the market, the volatility will probably pick up as we get closer to the election.
US – China Trade
We have had several conversations with our clients around the US-China trade deal and one of our points has always been we believed that nobody has ever asked China to stop taking advantage of the US. If you listened to the State of the Union, he basically confirmed our point.
Stage one has been implemented in the US-China Trade deal and since that time the trade deal has been rather quiet. We don’t see a lot of focus on the trade deal at this point. If we do start to get more rhetoric on the trade deal, it could increase market volatility.
At the end of last year, the consensus was that the Fed would be on hold for 2020. As we have moved into 2020, we believe that there is a higher probability that the Fed could be cutting rates this year rather than being on hold.
There are several potential concerns that could increase volatility this year. After coming off of a low volatility year in 2019, we do see several issues that could increase volatility this year.
The first and most recent issue is the Coronavirus. When the Coronavirus initially started to make news, it did start to increase volatility, but the market has shrugged it off at this time. There are a lot of reports out that this is not going away anytime soon, since it has the potential to hurt the China consumer. The China consumer is a much bigger part of the Global GDP than they have ever been.
If recessionary talk re-emerges, we could see volatility to kick back in. We had an inverted yield curve, where the 2-year yield was higher than the 20-year yield and this has signified a recession in the past. We did not believe that it was a good indicator this time because of the arbitrage between the US positive yields and the International negative yields. We felt like the inverted yield curve was more based on this arbitrage trade, rather than the 20-year yield reflecting no inflation growth.
The Presidential election is happening this year 2020. Anytime you have the potential for significant government changes this can increase volatility. This is due in part to the market not liking change or unknowns. Assuming that we don’t get a surprise, this likely will not affect volatility. However, if we get a surprise as we move towards the election, expect volatility to increase. There is a consensus that if we get a surprise March 3rd, “Super Tuesday” that volatility could increase.
Late cycles within the economy and the market are ripe for higher volatility. This usually proceeds the potential correction, so we will be paying attention to momentum of the market and the volatility to help us navigate shifts within the portfolio to a more defensive position.
We are continuing to pay attention to the momentum of the market and the late cycle of the economy. These two items will help drive our decisions as we add factors to the equity model, decide on the duration of fixed income and look to add gold as a safe haven. Along with this, we are being mindful of the potential volatility to help us position appropriately.
We appreciate each and every one of you and hope that this new decade has started off with nothing but happiness and blessings for you and yours. Please feel free to reach out and let us know if you have any questions or would like to discuss anything mentioned. We look forward to talking or sitting down soon.
All the best,
Syntal Investment Team
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