Global Investment Review Q4 2018

2018 Global Markets Review and 2019 Outlook

2018 was quite a year in the financial markets and took many investors by surprise. We started the year with the tailwinds of U.S. tax reform, strong manufacturing and employment numbers, and high business and consumer confidence. By the fourth quarter, several headwinds entered the picture—including the slowdown in China’s economy and the developing trade war and the Federal Reserves’ continued march toward higher interest rates. In the end, 2018 was the complete opposite of 2017, with most major asset classes negative for the year, including bonds and higher volatility.

From an economic standpoint, the U.S. was strong much of the year, with companies reporting 20% plus earnings growth,[1] GDP growth of 3% plus[2] and continued employment strength[3]. However, as the bad news flooded in from overseas, uncertainty about what 2019 will look like from a profitability and earnings picture made the market increasingly more nervous. The U.S., relative to the other markets, performed slightly better than International and Emerging Markets. While U.S. small cap stocks were the top performer in the early part of the year, they were the laggards behind U.S. large cap stocks by year-end. In particular, large dividend paying stocks fared much better, as we believe does occur in a falling market.[4] There was also a rotation in the fourth quarter from growth and cyclical stocks to more defensive stocks, which resulted in sell-offs in technology, energy, materials and industrials, while utilities, consumer staples and health care performed better.[5]

Currently, there are three major themes we are watching that are affecting the markets, as discussed below, and some other peripheral themes also weighing on the broader markets.

China is the world’s second largest economy in terms of GDP[6] after the U.S. and it has also had high levels of growth for many years.[7] To support the growth and development of China, the Chinese central government has allowed massive amounts of lending and stimulus support.[8] Over the last two decades and more so during downturns, the Chinese government loosened lending requirements to help stimulate the Chinese economy and maintain the higher levels of GDP growth.[9] As a result, Chinese debt is at least 266% of GDP,[10] one of the highest debt levels in the world. China’s President Xi recognized the massive debt problem and put in place policies to deleverage the economy, restrict capital flight and remove guarantees of investment products, which put pressure on the economy and the stock markets. The Shenzen A share stock market was down 33% during 2018.[11] Officially reported GDP is hovering around 6%, but we speculate that it is much lower.[12]

Many U.S. companies have focused a great amount of resources on building out their Chinese operations and capturing the growing middle and upper class. Auto manufacturers, appliance makers, consumer goods—among others—have been impacted by the slowing Chinese economy and demand for U.S. goods.[13] Compounding this situation has been the trade war between the U.S. and China. President Trump implemented 10% tariffs on $200 billion of imported Chinese goods in September and threatened raising the tariffs to 25% on additional goods starting in January.[14] The increased tariffs have been pushed out to March and we are waiting to see if the two governments can reach an agreement.[15] The uncertainty of the tariffs and agreement has weighed on U.S. companies, because we believe it would have a material impact on the GDP of both countries due to higher costs and lower sales.

U.S. Interest Rates/Switch from QE to QT
The U.S. Federal Reserve was a hot topic in 2018 with a new Fed chairman, Jerome Powell, taking over and concern about what action he might take on interest rates. With a strong U.S. economy, low unemployment and stable—but rising—inflation, the Fed raised rates four times in 2018 to 2.0–2.25%.[16] They have forecasted two more interest rate increases for 2019, which has sent the market into a tizzy since it expected that the Fed would halt raising interest rates.[17]

As context, the Fed lowered the interest rate in 2008 to 0.25% and did not increase the rate at all until December 2015.[18] Since then, there have been nine rate increases, including the four this year.[19] In addition, the quantitative easing (QE) that started in 2008 continued until 2015 when the Fed purchased bonds, which provided liquidity (and stability) to the markets.[20] Total assets of the Fed increased to $4.5 trillion or 23% of US GDP.[21] In May 2017, the Fed started allowing those bonds to mature without buying new bonds, which effectively became quantitative tightening (QT).[22]

The Fed raises rates and reduces liquidity when economic data show that the economy is doing well and they hope to manage inflation before it becomes out of control. Some investors believe the Fed, towards the end of the market cycle,[23] typically kill the market by raising rates or tightening monetary policy faster than necessary.

Despite the Fed raising the fed funds rate, which is the interest rate that the Fed charges to lend to the large money center banks, the 10-year Treasury which started the year at 2.44%, climbed to a high of 3.23% and then fell to 2.68% by year end as investors rushed to safety.[24] We also saw that the yield curve, which is a curve of the interest rates of the different maturities of U.S. Treasury bonds, flattened over the course of the year and concerns over an inverted yield curve.[25] An inverted yield curve historically has been a sign of an impending recession.[26] The yield curve did not invert.[27]

Global Debt
Another area that has raised concern is the total amount of global debt. In an era of ample liquidity provided by central banks and record low interest rates, corporations around the world took on more debt. In the U.S. many have noted the BBB rated bonds (lowest end of the investment grade rating) have increased from 17% of total loans to over 40% of total loans and the leverage ratios as measured by debt to EBITDA (earnings before interest, taxes and depreciation) have increased from 2.5x to 4.0x.[28] When news of General Electric came to light regarding its woes and the amount of debt that it has (over $100 billion), investors took notice.[29] Other companies use of debt to make acquisitions, like Campbell Soup and CVS, and the level of debt they hold has also caused concern.[30] If these companies have their debt downgraded, then there may be additional selling pressure given that many insurance companies and pension funds must hold mostly investment grade debt. Many bond watchers are worried about whether we will start to see bonds default, which would suggest a weakness in the economy.

U.S. Dollar
With the rising U.S. interest rates came strength in the U.S. dollar. As mentioned earlier, this year a rising U.S. dollar has been negative for emerging markets and they certainly faced a number of challenges across many markets in addition to China. The U.S. dollar was up for the year by 4%.[31] This also created headwinds for U.S. companies that have operations abroad and impacted financial performance.

Early in 2018 there were reports that a barrel of oil would reach $100, but in a very short period, oil went from $78 a barrel to $43 a barrel by year-end.[32] It was expected that increasing global demand and a reasonable supply situation would support higher oil prices. However, as the full impact of China’s downturn and subsequent impact on other economies became apparent in October, oil prices pulled back significantly.

After the U.K. voted to leave the European Union (EU) in 2016, Prime Minister Theresa May was tasked with negotiating the agreement to leave the EU.[33] There are several components to the agreement—including manufacturing, financial services, immigration and the border between Northern Ireland and the Republic of Ireland.[34] May needs approval from both the U.K. parliament and the EU for the separation agreement prior to the March 29th deadline or the U.K. will have to leave without an agreement.[35] The U.K. would revert back to the original tariffs and rules of trade under the WTO.[36] There is uncertainty about what would happen to different businesses and people that have immigrated to the U.K. May presented the agreement to the U.K. government in mid-January, and the agreement was rejected by the U.K. parliament.[37] May will try to negotiate a revised agreement by the deadline. The other option is to extend the March 29th deadline and either propose a new deal or hold a referendum for U.K. citizens to vote. The impact of this uncertainty has been detrimental to the U.K. economy and stock market. Housing prices are down significantly and the British pound is down 6%.[38]

One of the largest, but weakest, members of the Eurozone is Italy. It has been plagued by a slow economy since the 2008 Global Financial Crisis and has run a fiscal deficit each year.[39] Rome provided the EU with its projections showing a higher than expected fiscal deficit of 2.3% and this is on top of the second highest debt to GDP in the Eurozone of 131% after Greece.[40] Italian banks are in better shape than they were, but bad loans still total 11.4% of the total loan books.[41] Plus, there is a new Italian government that has voiced concern about staying in the EU. This turmoil has put pressure on Italian government bonds and the Euro.

We are concerned that much of people’s wealth is tied to their financial assets and the continued pressure on the stock markets will cause confidence to decline quickly and to the point that spending and investing pulls back and causes a recession. FactSet has estimated earnings estimates for 2019 at 7% for the S&P 500,[42] which is in line with what we have historically seen. U.S. GDP is projected to be 2.7% for 2019.[43] These measures do not indicate a recession, but the market movements, investor behavior and pressures in global economies could cause a slowdown in the U.S. Value investing is at Anchor’s core and we focus on downside protection. While the current volatility is unsettling, it has created potential opportunities for Anchor to buy stocks and asset classes that we believe are trading at attractive valuations. 

Themes we are watching in 2019

Initial Public Offerings (IPOs)
2018 was one of the strongest years for IPOs since 2014 with valuations of $61 billion.[44] Of the companies listed on U.S. exchanges, 38 of them were considered “unicorns” with a valuation of over $1 billion.[45] 2019 is looking to be equally strong with a number of companies wanting to go public before a recession hits. It is expected that some big IPOs will occur in the first half of the year—including Lyft, Uber, Airbnb, Pinterest, Slack and Palantir.[46]

One of the biggest flameouts in 2018 was Bitcoin. It started the beginning of the year trading at $20,000 and it is now $3,600.[47] There was a lot of mania about whether Bitcoin was a new asset class. We have no idea where Bitcoin will go or how it will evolve, but it still has a long way to go to being considered an asset class. The underlying technology behind cryptocurrencies, including Bitcoin, is a distributed ledger system called blockchain. We think blockchain, as a system of keeping records securely, will continue to evolve and be helpful for many purposes—such as insurance, electronic payments, and records like mortgages, deeds and trusts.[48]

Marijuana/Cannabidiol (CBD)
Two major events happened related to the cannabis plant. Canada legalized recreational marijuana across the country in 2018 and four companies listed on the Canadian stock exchange saw their stock prices initially soar.[49] Due to supply shortages in that market, the stock prices have come back down to earth.[50] In the U.S., recreational marijuana is still illegal at the Federal level, but legal in ten states and the District of Columbia. In an additional 23 states, medical marijuana is approved for use.[51] There is an active market in the U.S. and some U.S. marijuana companies plan to list on the Canadian stock exchange in 2019.[52] For companies based in California, which has a market in size similar to Canada, they could potentially do very well.[53]

The major news is that the 2018 Farm Bill approved the production of hemp, which used to be considered illegal.[54] Hemp comes from the cannabis plant (yes, the same one that produces marijuana), but hemp cannot contain more than 0.3% of THC (the compound in the plant most commonly associated with intoxication).[55] From hemp comes an oil called cannabidiol (CBD) and it is being used in a number of products and for many different uses.[56] The New York Times published an article on the explosion of CBD products, ranging from beauty products and dog treats to anti-anxiety treatments.[57]

5G – Mobile Broadband
5G is the next generation of mobile broadband that will eventually replace or at least augment the 4G LTE connection.[58] With 5G, upload and download speeds will increase significantly, because it adds more capacity to the spectrum.[59] As the world around us has higher needs for connectivity, the broadband spectrum needs to be able to support that connectivity.[60] AT&T and Verizon are selectively rolling out 5G in big cities and will expand across the country.[61]

Digitally Native Brands
Younger populations and mobile devices have created massive disruption in retail, but also with brands. Many people are seeking out new and unique brands and those brands are able to build a presence on-line through blogs, Instagram, YouTube and other social media channels very inexpensively. Some brands solely exist on-line and do not have a retail presence at all, which is why they are called digitally native brands. Kylie Jenner of the famous Kardashian family, built Kylie Cosmetics and sold her products exclusively on-line. The brand, estimated by Forbes, is worth $800 million.[62] Cosmetic retailers are now carrying Kylie in their stores. WalMart, which is going head-to-head with Amazon, bought three years ago to build out its on-line presence. Since then WalMart has been on a spending spree, buying digitally native brands such as Bonobos and ModCloth.[63] More recently, the Wall Street Journal published an article on millennials buying furniture on-line from digitally native brands.[64] We expect the trend will continue and is continuing to reshape retail.

Artificial Intelligence (AI)/Machine Learning (ML)
Artificial intelligence is a broad term defined as the creation of intelligent machines that work and react like humans.[65] We often think of Siri on the Apple iPhone or Amazon’s Alexa, but many devices and consumer goods are incorporating natural language processing.[66] Machine learning is a branch of AI that analyzes data, identifies patterns and makes decisions with minimal human intervention.[67] Autonomous vehicles are using machine learning to enable a car to recognize whether there are objects in its path.[68] Financial services firms are using machine learning to search through credit card data to identify fraud.[69] There appear to be limitless opportunities for AI and ML, which more and more companies are incorporating across their entire operations.

Aging Population – Evolution in Medicine/Telemedicine
Healthcare globally continues to evolve and adapt to an aging population. There are several areas of medicine that we find interesting. Many large corporations like Amazon and CVS/Aetna are looking at the large amounts of health data and exploring how patient population health concerns can be managed.[70] Another area that is growing and has large potential is telehealth and telemedicine, where patients can receive medical care remotely.[71] In more of a consumer focus, doctors and health insurers are trying to use data from Apple Watches and FitBits to track a patient’s physical state.[72] At the biotechnology level, there are interesting drugs being developed that potentially could slow down the progression of Alzheimer’s disease, cure different cancers and improve genomics.[73]

Robotics are increasingly becoming a part of our world. Originally, large robots were used in manufacturing, but that has expanded to warehouses, hospitals, surgery, and more operational types of activities.[74] There are several robotics makers that specialize in different areas, like healthcare. We believe that robotics will become increasingly more sophisticated and used for an even wider range of applications.

Water Supply/Farming
The world food supply and farming is another important topic. The Wall Street Journal published an article on the Harvard Management Company buying vineyards in California and the underground water rights.[75] Water is an important resource and having access to it will be valuable. In looking at farming, there have been a number of strides in improving crop yields through new seeds, improved irrigation and better harvesting techniques.[76] In some cases, farmers are using sensors and drones to monitor crops.[77] Farming is also moving to vertical farms in order to get fresh food faster to the end consumer.[78] There is a belief that vertical farms take up less resources than large horizontal farms.[79] We think there are a number of companies that support the farming industry that could be interesting investments.


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