2018 Q2 Investment Report Commentary
Things rarely play out the way people foresee them. Take the FIFA World Cup for example, which recently concluded its 21st installment. The tournament began with 32 national teams vying for soccer’s ultimate prize, with tournament stalwarts Germany, Brazil, or Argentina favored to lift the trophy again. Against all odds though, each of these favorites crashed out, eliminated by seemingly lesser teams. No one could have predicted this result or that the tiny nation of Croatia would make the final. However, that is the nature of a contest with numerous potential outcomes; it is unpredictable and full of surprises.
In this way, financial markets are like the World Cup. Both are complex systems that are extremely hard to predict with any recurring accuracy. This was again shown in the first half of 2018, as most market predictions proved wrong.
Right out of the gate, the first quarter shattered the expectation that 2018 would see a continued rise in asset prices as was the case in 2017. Volatility, which had been uncharacteristically low in 2017, spiked in the first quarter of 2018 as the S&P 500 experienced 27 pullbacks over 1%, four over 5%, and one over 10%. The quarter ended with all four asset classes—Equities, Diversifying Strategies, Real Assets, and Fixed Income—in negative territory.
The second quarter’s results were lackluster as well. Even though volatility diminished from the first quarter, it was still higher than the entirety of 2017. In this environment, global equities eked out a 0.5% return. Of course, not every market appreciated. International equities posted negative returns in both developed and emerging markets. This decline was a surprise result as many investors, including Daintree, expected international equities to lead the market. Year-to-date though, U.S. equities, as measured by the S&P 500 Index, were up 2.6%, while international equities, as measured by the MSCI ACWI ex U.S. Index, were down 3.8%. From our perspective, investors seem to have a blind-eye toward asset valuation, instead focusing on a small cohort of expensive stocks with extreme revenue growth. While we do not know when this trend will end, history informs us that cheaper assets prevail over the long-term.
Of course, there are many factors at play right now. Since April, the dollar has risen precipitously against a broad basket of foreign currencies and this has eroded the value of most international investments held by U.S. investors. Another development currently weighing on asset performance is the heightened possibility of a trade war. Going into the year, markets did not give much credence to the possibility of a trade war. Beginning in the second quarter though, the White House began placing (or further threatening) tariffs on a significant number of imported goods from multiple nations. Largely due to these currency moves and tariff skirmishes, emerging markets dropped 8% over the quarter, making it the worst performing subsector.
Halfway through 2018, volatility, dollar appreciation, tariff skirmishes, and a desire for the same expensive assets within equities have all weighed on total portfolio returns. Through June 30, most client portfolios are hovering around flat, either up or down less than a percent. While this muted performance may be unwelcome, it can also serve as a powerful reminder as to why Daintree constructs globally diversified portfolios. Many assets have moved to the upside including U.S. equities and certain allocations within Diversifying Strategies, Real Assets, and Fixed Income.
The overall impact of this diversification is that portfolios have avoided any outsized moves to the downside in this year’s choppy markets. Additionally, some of the most expensive assets (such as U.S. growth stocks) have also recently been the most popular. We see the best value elsewhere, such as in non-U.S. equity markets, especially emerging markets. We also see value in pockets of fixed income such as TIPs and Bank Loans. We understand patience can be tested until markets recognize this value. However, such patience paid off for us earlier this year with MLPs and we expect markets to reward this patience again.
Here are a few additional items of note:
Daintree’s traditional asset classes generally experienced negative returns over the quarter, with Equities and Fixed Income down slightly. Daintree’s non-traditional asset classes generally performed better on an absolute and relative basis, with Diversifying Strategies and Real Assets notching positive returns.
After marked depreciation in the first quarter, energy infrastructure MLPs (“Master Limited Partnerships”) rebounded strongly to finish the second quarter in slightly positive territory year-to-date. As Daintree predicted based on our research, the subsector’s Q1 pullback was the result of short-term investor misconceptions and was not an indication of their long-term return prospects. This snapback highlights a vital tenet of thoughtful asset allocation: invest for the long-term with careful analysis and put little weight on short-term fluctuations. Stay resolute during turbulent times; only realized losses are permanent.
Global REITs performed well in aggregate over the quarter, with U.S. REITs up 8% and Non-U.S. REITs down 3%.
In Fixed Income, Daintree portfolios again benefitted from an overweight to Treasury Inflation Protected Securities (“TIPS”), which outperformed the benchmark by 0.7% as inflation expectations continued to firm.
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