It’s Never One Thing. Well, Maybe it’s Interest Rates.
The third quarter was another period of great volatility with a little underlying market rotation. Against a back drop of much better economic numbers, the markets began to fear that the party will someday end, and that the Fed will be the one who sets the curfew.
The Federal Reserve has been very clear for five years – yes, it has been five years since we ended quantitative easing – that it will raise rates as the economy strengthens. Higher interest rates create the opportunity to move toward a more historically neutral interest rate policy. The only control the Federal Reserve really has is to push up the short end of the yield curve and then expect the market to tighten the rest of the way. It continues to do this in a metered and deliberative fashion – no surprise here.
The rest of the interest rate environment is dominated by the markets. Our markets are influenced by market expectations, inflation expectations, relative yields of similar risk assets, and expectations of economic activity. It has been anything but a stable rate environment. Over the summer as short term rates were being pushed up, long term rates remained low, causing market historians to grow concerned that the yield curve could invert. Inverted yield curves invariably precede recessions. However, the inversion fears abated and the market appreciated through August and September. In the past few weeks, spurred on by slightly more hawkish Federal Reserve notes and higher European interest rates, the longer end of the yield curve rose quickly. Although many breathed a sigh of relief that the inversion was not on the horizon, the broader markets sold off on fears of higher future rates. The markets clearly fear that the Federal Reserve will end the party early. The stock market may be getting a bit ahead of itself, and our domestic bond yields continue to be attractive relative to yields across the globe. As our rates rise they are likely capped by foreign demand for the safe haven of U.S. Government bonds.
Wage, input cost, and consumer product inflation are all having an effect on market sentiment and, to some degree, interest rates. We see interest rates as both a cause of change and a result of change. It has long been said that the bond market is smarter than the stock market. The stock market is manic-depressive while the bond market is hyper-rational and boring.
Emerging markets are another area where U.S. interest rates are having an outsized effect. Many Emerging market economies rely on dollar denominated debt that becomes expensive as U.S. rates rise and the dollar strengthens. Should rates continue to rise, these economies will drag on global markets. Struggling foreign economies add to the growing concern of global economic weakness ahead. Tariff concerns also continue to be a drag on global economies and a worry to investors; although those concerns are lessening now that the U.S. Mexico Canada Agreement (the new-NAFTA) & Korean trade deals are complete. While most expect a trade deal to be hammered out after our mid-term elections, the blustering back and forth with China seems to roil markets with each tweet.
What does this mean for markets?
Global Market Weakness
Global stock markets continue to diverge as U.S. markets have outperformed the global markets since the financial crisis. In its simplest form, interest rates are a cost to the market, and higher costs eventually dampen earnings. If earnings are what matter in the long run, interest rates are a long-term headwind. However, the problem with this simple math is that higher rates are a result of better economic activity, and for some time economic activity can drive earnings growth faster than rates can eat them away.
Bonds as an alternative
Conservative investors seek to earn a “safe” return, and rising interest rates create an opportunity for the most conservative investors to move out of equities and into fixed income, where a reasonable yield can finally be earned. Therefore, after ten years of historically low yields on safe investments, higher rates may finally bring bond investors back from the riskier asset classes.
Relative value versus go-go growth
We were clearly early in our view that the FANG (Facebook, Amazon, NetFlix and Google) stocks were overvalued. However, this quarter produced a divergence in FANG performance. Netflix and Amazon continued to outperform the market year to date, but Google and Facebook are now below the market averages for the year.
Bulls will argue that the latter’s woes are due to concerns of government regulation – which may indeed be the case. However, our belief is that valuation always matters; so when overvalued companies report anything but good news the stock prices are particularly vulnerable. We were also too early calling the turn of the “Growth verses Value” cycle. Our position was primarily based on valuation – that, ultimately, everything trades to fair value. Unfortunately, timing a return to fair value can be difficult. That’s what economist John Maynard Keynes meant when he said, “The market can stay irrational longer than you can stay solvent.” Basing our call purely on valuation proved to be insufficient.
Over the past month it feels to us like Value is turning, evidenced by the number of days when value stocks have outperformed the overall market during both up and down market performance. Value has historically offered better downside protection, but the recent outperformance during both up and down days feels very different to us.
Is it different this time, or just wishful thinking?
We decided to look for reasons why it is “feeling different” to us. A recent research piece by Stephen Suttmeier of Merrill Lynch quantified our opinion. Over the years he has researched valuation and price momentum of growth and value stocks. Exhibit 1 shows the price ratio of growth and value stocks over a long period time. As can be seen, we are now at price levels of growth to value not seen since the dot-com bubble. We all remember how that period ended; investors in the growth darlings at the time suffered multiyear losses, whereas exposure in more solid, modestly valued companies had years of gains ahead of them.
This said, the ratio was even higher during the dot-com period; so why can’t this cycle continue for a long time? Clues lie in the price action, or momentum, between the two groups. It appears that investors are reducing their exposure to the high priced growth stocks and reinvesting their profits in more modestly priced value companies.
In Exhibit 2, Suttmeier looked at the Relative Strength measure, or RSI, of growth verses value stocks. This is a technical, or price, measure that is calculated by dividing a group of securities average price gain during up periods with the average loss during down periods. An RSI value of over seventy generally indicates that the group has become overvalued with possible downside on the horizon. The RSI for growth to value stocks peaked at eighty in the beginning of the year and dropped to 58 by the end of September. This broke a support level last seen in September of 2017 according to Suttmeier. When this measure broke levels of support in 2014 and 2016, it was followed by value stocks outperforming for at least a year. Other anecdotal data points include more defensive sectors such as healthcare and consumer staples leading the way since June of this year. So we are seeing encouraging signs that the market is once again paying attention to valuation and what it’s willing to pay for companies.
Given the current environment, we are applying two strategies to our various investment disciplines. In the Value and Dividend Growth strategies, we are sticking to our core beliefs and not drifting towards more expensive companies. Style drift is when a manager gives up on their discipline after a period of underperformance to chase the investment style that is working. Style drift usually results in under- performance as the manager gets whipsawed on both sides. Second, we continue to control risk in our Core Growth portfolio by decreasing our weightings in some companies that we believe were getting too expensive, and reinvesting the proceeds into more attractively priced companies.
Overall, we remain positive for the foreseeable future. Longer term, we will continue to monitor any increase in global debt levels. In a sense, the solution to the Financial Crisis – which was in fact a debt crisis – was more debt. That is, central banks shifted debt from the private sector to governments around the world, kicking the can down the road instead of reducing overall debt levels. We will go into more detail on this topic in our year end letter. We look forward to a prosperous year for you. As always, we thank you for the trust and confidence you place in Granite Investment Advisors.
Scott B. Schermerhorn
Managing Partner and Chief Investment Officer
There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors' recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.