With Christmas and New Year’s falling on Wednesdays, the calendar has afforded us more time to reflect on 2019. The decade ended with a bang – 2019 was the single best year in the past ten years for the MSCI All Country World index and the S&P 500 missed sharing the same status by less than 1%. It was the “everything” year — the year in which every single major asset class recorded a positive return and, in most cases, an outsized one.
2013 was the most comparable year, but in 2013 core bonds and commodities all lost value on the year (which made sense at the time). US equities were up over 30% on the year and the Barclays US Aggregate recorded its worse loss since 1994 – down 2.0%. In stark contrast, the Agg returned nearly 9% last year, its best year in well over a decade and a half. Even commodities – which have had a brutal decade – managed to make money last year.
That’s about as much of a recap as anyone needs. It was a great year. It didn’t matter the asset class, sector or the style – everything made money. We believe it is more important to understand the “why”. In our view, multiple expansion and the Federal Reserve were the biggest contributors to markets last year.
During 2018, the S&P 500 earned $161.93 per share and by the end of the year, expectations for earnings during 2019 were for $173.43 per share, a 7.1% year-over-year increase. While we are still waiting for Q4 earnings to be announced, consensus expectations for full year earnings for 2019 are nearly unchanged from the previous year at $162.06. It’s almost hard to believe the headline index was up nearly 30% in a year where earnings were flat.
In Q4 of 2018 we had a 20% peak to trough drop in the S&P 500 driven primarily by fears the Federal Reserve was going to overtighten and cause a recession. During that period the price-to-earnings (PE) multiple dropped from nearly 17 times expected twelve-month earnings to as low as 13.5x, ending the year at 14.5x. The move from 14.5x to 17x by the end of April 2019 was simply a return to where stocks were valued prior to the correction in 2018. Said differently – the 17.5% return in the first four months of the year could be seen as getting back to “normal” and accounted for 60% of the return last year. The remaining 11% return on the year came as the multiple expanded from 17x to 18.3x, a cycle high.
Fed to the Rescue
The Federal Reserve first started raising its target rate in December 2015. First slowly, under the leadership of former Chair Janet Yellen, and then more quickly in 2017 and 2018 under current Fed Chair Jerome Powell. In all, the Fed raised short-term interest rates nine times over thirty-six months to a range of 2.25%-2.50%.
During the same period, the Fed’s balance sheet, a key tool of implementing monetary policy, shrank from an all-time high of $4.5T to ~$3.75T.
Cracks in the financial markets did not emerge until late September of 2018 after the Fed’s eighth interest rate hike. As the market started to fear higher rates would choke off growth and access to cheap capital, equity markets started to fall. By the time the Fed met for its last meeting of 2018 US equities were already down 13% from all-time highs. The situation was made worse when, during the regularly scheduled press conference, Chair Powell implied the Fed’s tightening process was on “autopilot.” Equities took a final leg lower into Christmas dropping an additional 7%. In early January 2019, at a speech in Atlanta, GA, the chairman gave the markets the signal it needed to resume a rally to all-time historical highs. In stark contrast to the press conference just two weeks prior, the Fed chair signaled a willingness to be flexible on policy decisions and that the Federal Reserve was listening to markets. This set the groundwork for what we now know to be one of the single best equity and fixed income return years in history. In March, the Fed signaled it would cease balance sheet runoff later in the year stabilizing its balance sheet at around $3.5T. Starting in late July, the Federal Reserve implemented the first of three successive interest rate cuts on the year (ref Chart 2 above).
The final shot of kerosene came in September when an important (although rarely discussed) portion of the financing market started to show stress. Commonly referred to as the “repo market,” this portion of the securities financing market provides short-term funds secured by the highest quality collateral. Typically, the securities are AAA-rated US government securities and the financing is most often provided by banks. For a variety of reasons outside the scope of this piece, there was a classic mismatch between the provider of funds and the market participants seeking funding. In mid-September, repo rates on the safest collateral rose to 6.0% with some prints being reported as high as 10.0%. Take a minute to think about that: if you were a bank or financial institution that had the ability to lend funds in the repo market, you could earn 6.0% on an annualized basis by lending excess cash to borrowers who would, in turn, hand you US treasuries to fully back the loan. Most of the unsecured high yield market does not yield 6%. Enter the Federal Reserve – over the remainder of 2019 the Fed lent funds into the repo market fully reversing more than 50% of the cumulative quantitative tighten we of the past two years (ref Chart 3 above).
So, there we have it. It was a year where not much had to go right, apart from avoiding recession, for the market to post strong returns. Then, we got lucky and received an additional shot in the arm from the Fed. Interestingly, earnings expectations for 2019 dropped from a high of $180/share in mid-2018 to what will likely be a realized $163/share (-10%) all while the market charged higher.
The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.