A Year-End Synopsis
Liquid equity markets (e.g., stocks) have a nasty habit of lulling investors to sleep, only to shock them awake in the middle of the night. Case in point, when the post-financial crisis bull market crossed over into the longest in history back in August 2018, investor sentiment ran high as billions continued to flow into equities in spite several metrics suggesting stocks were historically expensive.
At that inflection point, we at Atomi updated our investment outlook as we began to anticipate market volatility. By August, our liquid model investment portfolios had an 8% allocation to PIMCO Enhanced Short Maturity Strategy Fund ETF (Ticker: MINT), which essentially acts as a cash-equivalent holding. Moreover, in an effort to decrease portfolio volatility, we decreased our exposure to emerging markets and increased our exposure to lower-correlated liquid alternatives, such as Anfield Capital Diversified Alternatives ETF (Ticker: DALT) and VelocityShares Inv VIX Medium Term (Ticker: VIX).
Illiquid direct investments, (e.g., “alternatives), which by design have little to no correlation to liquid equity markets, were not immune to some valuation volatility in 2018. Most notable were collateral loan obligations (CLOs) and other forms of corporate debt that saw mark-to-market repricing in the 5 to 10% range. In other words, CLO sponsors reduced their net asset values (NAV) to reflect what they could get, should they sell off their entire portfolio immediately.
Tracking an illiquid investment to its potential resell value, rather than its cost basis, is a good idea because it provides investors with additional transparency. However, it is important to note that mark-to-market pricing is fundamentally an accounting issue and does not necessarily represent the intrinsic value of the asset. We believe a more significant factor in determining the value of an illiquid debt investment is its default rates. To that end, we’re happy to report that all our corporate debt investments have default rates that are well below not just market comparables but also internal expectations.
Another illiquid investment that experienced moderate valuation volatility in late 2018 were Interval Funds, which are ’40 Act Mutual Funds, but are less liquid because a portion of their portfolio will consist of illiquid investments. It should come as no surprise that Interval Funds endured some moderate downward pricing pressure, as, in general, two-thirds of an Interval Fund’s holdings will be liquid securities, thus increasing their correlation to liquid markets during pullbacks, like we saw in October through December. However, none of the valuation changes we’ve seen are outside our expectation levels.
Since August 2018, U.S. economic growth has slowed, and leading sectors such as housing appear to be stagnating. This slowing economic data eventually was accompanied by a reduction in investor confidence, with an October market pullback that extended into November and December.
Now, the path ahead looks less clear than it did just a few months ago.
For the economy overall, things have slowed a bit since the start of 2018. Consumers are still spending, but businesses are investing less. Also, while government spending should continue, it probably won’t accelerate, and trade is likely to be a drag. This should leave 2019 U.S. GDP growth at around 2% to 2.5%.
Inflation / Short-Term Interest Rates
Inflation, meanwhile, has remained moderate through 2018, and the most recent data suggests that it is unlikely to accelerate much further in 2019. Current levels are slightly above but generally consistent with what the Fed considers acceptable. With moderate inflation, the Fed is likely to raise rates two to four more times in 2019. Also, expect the Fed to continue reducing its asset base, currently at a rate of $50 billion a month.
Notwithstanding temporary market spats, the effects from higher rates and the unwinding of the balance sheet should be minimal, as they have been so far.
Long-Term Interest Rates
Longer-term rates should also rise nominally in 2019. Given stable growth and ongoing low inflation, the rate on the 10-year Treasury can be expected to drift up to around 3.5% to 4% by year-end 2019. The risk of being wrong here is most likely to the downside, but this seems a reasonable target. Overall, monetary policy and interest rates should continue to normalize through the year.
This normalization means that stock markets are likely to trade on fundamentals such as revenue and earnings growth. Here in the U.S., both revenue and earnings growth were much greater than expected at the start of the year, due to the 2017 tax legislation that reduced rates. While this is a trend that should moderate in 2019, revenue growth is expected to remain strong, at levels last seen in the immediate recovery from the financial crisis. This should support continued growth in earnings through 2019, albeit at a slower pace than 2018.
With the threat of a recession starting in 2020 looming, any new capital invested into illiquid investments in 2019 will focus on opportunities that traditionally are minimally affected by a weakening economy. When purchased correctly, Student Housing, Storage, Multifamily, and Office have historically weathered recessions well. The key is finding opportunities to drive intrinsic value, rather than rely solely on market demand to lift valuations.
Between the U.S. Federal Reserve tightening, trade wars, China uncertainty, Italy’s budget standoff with the European Commission, and Brexit, we expect recent volatility to continue well into 2019. Moreover, we believe that 2020 marks the danger zone for a U.S. recession, which gives markets some upside in the short-term.
However, late-cycle risks are rising — and monitoring these risks will be critical to avoid buying a dip that turns into a prolonged slide.
What to Do?
So, with all this information, the real question is what should Atomi investors do? While each of you have unique situations, requiring a customized plan of action, we believe all investors should consider the following:
Don’t panic. Market corrections are an inevitable part of investing, so we shouldn’t be surprised by the recent pullback. Even the highest of quality investments will experience some volatility during times like these. Nonetheless, we maintain confidence that our holdings are well-positioned for the volatility that is likely to come.
Don’t be greedy. Conversely, now is not the time to go all-in in an attempt to take advantage of the recent dip in valuations. Prudence, above all else, is the right approach. A moderate deployment of dry powder may be appropriate when personal goals have long-term horizons.
Confirm long-term goals. If you haven’t done so recently, take stock of your long-term financial goals. Has anything changed? If so, please let us know.
Assess liquidity needs. Perhaps the most important action you can take is to determine what your short-term liquidity needs might be over the next 12 to 24 months. Do you have enough reserves to cover a large purchase, such as a car or house? Do not put money at risk that might be spent in a relatively short period of time.
Of course, we are always here to answer your questions and concerns. Feel free to reach out to us if there is anything we can do to help.