2019 Half Year Review

Recession Fears

The current period of economic expansion in the USA has just recently (June 2019) become the longest in the post-war era. As the expansion continues, investors like us all over the world are wondering how long it can continue and when and why it might turn. In a late-cycle environment where future longer-term returns are intuitively expected to be lower than previous returns, asset allocation decisions made or not made now will have a substantial impact on those future returns. It is therefore of key importance that we try to assess this risk as correctly as possible.  Recessions affect the business cycle and confidence which in turn affect cash flow and liquidity, both of which will have a real knock-on effect on valuations, growth assumptions, and portfolios. In the light of this, trying to predict recessions is obviously important.

Looking at the market and recession data from the 1951 we see that recessions matter to markets, but they are not the only reason for a market downturn. Since 1951, there have been 27 major equity drawdowns, 16 non–recessionary and 11 recessionary. The non-recessionary equity drawdowns were less expensive, averaging -17% and lasting an average of 4.7 months with a time to recovery of 5 months. Recessionary equity drawdowns were more expensive, averaging a minus 27% and lasting an average 11.7 months with an average time to recovery of 13.2 months. The latest non–recessionary equity drawdown of -19% was in late 2018 and the market recovered exceptionally quickly. A 2018 drawdown and 2019 recovery is in itself a late-cycle indicator, so one needs to take note.

There are many reasons why the market can turn suddenly; trying to guess them is futile. The “why” is not as important as the “what” investors do to prepare. The key risks to making late-cycle adjustments are:

• De-risking too early
• Liquidity and loss of the drawdown itself and
• Missed opportunities on the rebound. Without getting too technical, it suffices to say that different approaches to protecting a portfolio have advantages and disadvantages and we favor a broad mix of all of them.

Within our portfolio, we will be making changes starting now and towards the rest of 2019 to reduce risk (not just equities but the type of equities) and we will remain vigilant on key market and other developments.

Why it's not 2007

Today, we can clearly blame the 2008 crisis on the rating agencies. That is not to say that the financial institutions which sold poor-quality mortgages are innocent. The rating agencies applied one method to certain property-linked products and then during 2008 changed this methodology for fear of personal risk. This means that certain financial products went from a very good rating (e.g. AAA) to a very bad rating (e.g. CCC) literally overnight. As a result, massive institutions which have strict rules on what they could own all became huge sellers at the same time. This is what nearly caused the system to collapse.

Since then there have been substantial improvements in rating agency work and it is unlikely that huge volumes of financial instruments will all be sold at once. So whilst we may have a recession or growth slowdown in 2020/2021 we do not expect a repetition of the crisis we saw in 2008.

BrexiT

It's actually getting boring to talk about Brexit. Boris Johnson is likely to be Great Britain’s next leader but it’s very difficult to see him coming to power and immediately pushing through what Theresa May tried 3 times to do and failed. Therefore, Brexit remains a permanent agenda item. Yawn. Regardless of whether one fears Corbyn or Brexit or a weakening of the Pound or all three, the UK has a clear agenda to tax the life out of its wealthy. Aliyah numbers are therefore expected to increase.

Outlook

The two significant factors which are of concern to us are the inverted yield curve (when long-term rates are lower than short-term rates) and the growth of debt of the last few years. Neither of these on their own are decisive factors for market difficulties, however, they are sufficient for us to start protecting our recent portfolio gains. To clarify, a recession, occurs when the economy shrinks or has negative growth in GDP. So while that feels a long way away from the current levels of growth in the USA of above 3%, even a dramatic slowdown from +3% to +1%, while technically not a recession, will be  enough to see a major risk asset sell-off. This scenario has a much higher probability than a full recession in 2020.

USA data on consumer sentiment, jobless claims, housing permits, retail sales, profit margins, truck shipments and corporate debt prices are all giving us all-clear signals. So that is genuinely comforting. Wage growth and commodity price growth (particularly gold) are not yet worrying, but are not as healthy as other data. It used to be a common saying that if the USA sneezes the rest of the world catches a cold, but with the growth of globalization it’s now a case that if any major economy sneezes we all catch a cold, especially if that sneeze comes from China.

This leads us to the most topical headline item, which is Trump's trade war with China. This seems to change on a daily basis. It is a critically important issue and the mood of it affects risk-taking across the globe. Trump has made ambitious comments to address what he calls “being a sucker”. We feel that the trade war is more of a political war against China’s increased world power and less of an economic war. So we expect this to continue long into the future.

Europe is actually of greater concern to us than China. Huge amounts of bonds are trading at negative yields in Euros and the ECB has already tried other monetary policy methods to revive growth. One of the fund managers I shared a table with at Pimco told me that his large institutional portfolio (where they have strict rules on risk) is producing a return of only 0.5%. This does not bode well for the future of Europe.

It must be said that the USA is in a considerably better position to deal with a downturn than the rest of the world.  With this in mind, part of our preparation will be an increased tilt towards the USA at the expense of the rest of the world, particularly Europe.

Our bottom line is that whilst we have an elevated level of concern we are still committed to our long-term asset allocation values. However, we must be realistically prepared for some volatility.

Market Summary Year to Date    

In the constant tug of war between fear and greed, greed is the clear winner of 2019 year to date.  2019 has been an exceptionally good year so far. Global equities are up 12% and global bonds are up a little over 5%. The NASDAQ technology theme has produced an exceptionally strong 20%. In our opinion this is a once-in-4-year rally that many investors around the world missed, as fear was the winner in 2018. 2019 has been a clear case of the more equity you had in your portfolio, the more money you made. Reward for risk.

Till 120

Previously in these client communications we have raised the super-important issue of “what if” planning. This includes serious and often difficult discussions about what will happen to the family wealth after the key person dies or becomes incapacitated. Too often, as financial advisors we see families who have not done enough to prepare and on top of the emotional burden, the survivors have to deal with legal, bureaucratic and financial burdens. Clients with international assets have even greater complexity in this area. In Israel there have been legal developments to address this in the form of a document called “continuing power of attorney” (“yipuy koach mitmashechet”). This can be a simple standard document to be signed at the bank or it can be extended to include a wide range of decisions and powers for the family that assist in the period from death/ incapacitation until the estate is finally wound up. It is strongly recommended that investors make a list of all their assets and bank accounts and make sure there is an understanding in the family about what happens if. At Pioneer, we are working with legal specialists in this area and we recommend each and every client consider this issue.

Israel at a glance

The strength of the shekel vs. all major currencies is the most interesting and somewhat perplexing element of the local market. Lower interest rates in shekel support a weaker shekel, gas exports have not yet started to flow to the point where it could affect the shekel/USD and no other reason stands out to explain why the shekel is back below 3.60 to the USD. Local investors who had unhedged dollar exposure will see this as a drag on their 2019 performance.

Pioneer’s strategy has always been not to take too much currency risk and it paid off well this year. Tactically, we are more comfortable increasing currency risk at these levels but we still won’t be betting heavily on the shekel weakening. Investors who are overweight shekel might find this the perfect time to be buying some USD for long-term strategic reasons.

Another interesting aspect of the local market is that the stock market is quite far behind global markets. The main two reasons for this are that two of Israel’s giants, Bezek and Teva, have gone through problematic times and the prospects for each are not good. These two stocks are major parts of the Tel Aviv stock exchange index and are -25.78% and -42.13% down year to date. The interest-rate prospect in shekel remain poor and we foresee a continued low-rate environment, so those investors wanting to see yield can look to the bond market instead of the cash deposits from banks.