2019 Year-End Review

Bullish investor sentiment prevailed over the course of 2019 despite geopolitical uncertainty and periodic bouts of market volatility.   The resumption of accommodative monetary policy was a key driver of waning risk aversion.  After previously indicating it would hold policy rates steady in 2019, the Fed pivoted and cut rates during the second half of the year.  Meanwhile, the European Central Bank (ECB) relaunched an open-ended quantitative easing program and China undertook various stimulus measures.  Additionally, greater clarity on several geopolitical risks such as the U.S./China trade war and Brexit toward the end of the year were received positively by investors and fostered an improved global growth outlook, causing capital markets to rally.

U.S. equities produced strong gains, outpacing international developed and emerging markets (EM) equities.  After an extended period of strength, the U.S. dollar (USD), as measured by the Dollar Spot Index, rose a modest 0.2% during 2019.  However divergence among EM currencies was pronounced.  Bond markets reacted favorably to Fed actions; longer-term yields in both the U.S. and abroad fell, leading to gains in U.S. Treasuries and global sovereigns.  Additionally, credit spreads meaningfully tightened, which aided investment-grade and high yield credit.  Lastly, strength in real assets was notable, with gains in sectors such as REITS largely a function of falling yields.  Other categories seemed to benefit from a reflation trade related to the improving view of the global outlook.

In December 2018, the Federal Reserve raised rates by 25 bps—its fourth rate increase in the tightening cycle—and vowed to take a patient approach in 2019.  In the early months of 2019, the Fed’s tone softened and markets began to expect a rate cut.  The Fed began to prepare markets for rate cuts at its June meeting and lowered rates for the first time in 10 years at its July meeting.  In total, the Fed cut rates three times in the second half of 2019.

The Fed also began to advise that it would stop shrinking the balance sheet later in the year.  By shrinking the assets on its balance sheet, the Fed removed bank reserves from the system.  In mid-September, the funding markets experienced a spike in repo rates, indicating there were not enough reserves in the system.  The Fed instituted temporary lending measures and announced in October that it would begin buying $60 billion in T-bills each month, which once again led to an expanding balance sheet.

The U.S. yield curve flattened further in the first half of the year.  In May, the curve inverted between the three-month T-bill and the 10-year Treasury note, while the two-year Treasury and the 10-year Treasury (2s10s) spread remained positive until it went negative in August.  Historically, a recession has occurred within 18–24 months of an inversion.  Once the Fed began to reduce policy rates, the yield curve steepened and became more positively sloped.

Technology accounted for nearly one-third of total gains of the large cap S&P 500 Index during the calendar year.  Apple (+89.0%) and Microsoft (+57.6%) accounted for nearly 500 bps of the S&P 500’s 31.5% gain.  Within the communication services sector, Facebook (+56.6%) was also an outlier contributor on the year, but its impact was not nearly as meaningful.  Alphabet (+28.2%) and Amazon (+23.0%) were the next largest contributors. As a group, these mega cap holdings accounted for 17% of index assets at year-end.  The presence of those market leaders, which accounted for an astronomical 30% of Russell 1000 Growth Index assets at the end of December, largely explains the dominance of growth relative to value.

Despite lagging the outsized gains for U.S. equities, international equities also posted robust returns in 2019.  Developed and emerging markets, as represented by the MSCI EAFE and MSCI EM Indexes,  returned 21.9% and 18.3% respectively.  The stylistic trends observed in the U.S. also applied in non-U.S. markets.  In the developed space, the MSCI EAFE Growth Index (+27.9%) bested the MSCI EAFE Value Index (+16.1%) by nearly 1,200 bps.  Within EM countries, the more than 1,300-bps spread between the growth (+25.1%) and value (+11.9%) benchmarks was just as significant.  The continued success of IT (41.6%) drove style leadership in the developing world.  Tech-heavy economies such as Taiwan (+36.4%) generally performed well as a result.  Tech names (+37.7%) also excelled across developed markets, but given the sector’s relatively small weighting in the broad benchmark, the relative struggles of value were driven more by energy (+7.6%) and financials (+17.7%) failing to keep pace in the rally.

Long/short equity managers were generally positive in 2019, with most generating double-digit gains.  Many managers took advantage of the market stress experienced in late-2018 to lean into their highest conviction long ideas and increase net exposure entering 2019, which benefited portfolios as the market rallied early in the year.  Alpha generation was generally positive over the course of the year and manager performance exceeded net-adjusted market exposure in many instances.  Managers that tilted toward growth stocks tended to generate the greatest alpha on the long side; however, stock selection within financials was also an area of strength.  Top contributors included established tech companies such as Facebook, Apple, and Microsoft, and companies within the payment sector such as Visa and Mastercard.  Short alpha varied across managers as broader themes of shorting mall-based retailers, Canadian cannabis companies, and segments of the energy market generally worked.  However, value-oriented managers that shorted higher priced growth stocks such as Tesla struggled in the momentum-led market.

Performance across absolute return-oriented hedge funds was muted relative to broader credit and equity markets.  Default activity remained low and performance across widely held distressed positions varied significantly.  Bankrupt California utility PG&E was a profit center for many credit investors early in the year, but new wildfires and ongoing legal uncertainty created headwinds for investors in the back half of 2019—particularly for those concentrated in the company’s equity.  Many investors also closed out profitable trades in Puerto Rico in the first half of the year and top performer Steinhoff in South Africa also remained a top position for many.  However, there were fewer winners in the final two quarters.  Distressed investments in retail, energy, and wireless spectrum produced mixed results, with a handful of outsized detractors such as Sears and Brazilian telecom Oi.  Outside of credit, merger-arbitrage generated positive results despite a year-over-year decline in merger volume.  Ongoing geopolitical uncertainty led to fewer complex, cross-border deals.  Market conditions remained generally favorable for corporate activity and managers remained hopeful that deal volumes will pick up in 2020.

Within real assets, real estate stocks posted notably strong results (+22.9% FTSE EPRA/NAREIT Developed Index, +28.9% S&P Real Estate ) on declining interest rates and solid fundamentals, including modest new supply and continued growth in demand.  Within the U.S., there was significant dispersion amongst sub-sectors, with growth- and tech-related areas sharply outperforming.  The industrial/warehouse sector continued to benefit from e-commerce trends and growing online purchases, gaining 48.0% for the year.  Similarly, cell tower and data center property stocks  benefited from surging data usage.  Laggards included retail (+10.0%) due to continued distress from brick and mortar retailers, and the related shift to e-commerce.  Hotels (+15.0%) also trailed with slowing growth in revenue per average room night and pockets of oversupply.

Crude oil (WTI) rallied 34.5% during the year, rebounding from a steep decline in the fourth quarter of 2018 (−38.1%).  Support for higher prices came from continued Organization of the Petroleum Exporting Countries and Russian production cuts and U.S. sanctions on Iran and Venezuela.  Easing U.S. trade war concerns and escalating Middle East tensions also boosted prices in the second half of the year.  Flashpoints included tanker seizures in the critical Gulf of Hormez (where 25% of the world’s daily supply flows), and drone attacks on Saudi production facilities, which temporarily took out 6% of the world’s daily crude supply.  To begin 2020, tensions again escalated in the Middle East, with the U.S. killing a key Iranian general/commander in Iraq.

Outlook

It is not unusual for a number of potential catalysts for volatility to be on the horizon as we enter a new year, and this year is no different.  Investors will continue to face the uncertainty associated with Chinese trades talks, as well as the lingering concerns related to the U.K.’s exit from the European Union.  Per usual, it will be important to monitor not only the Fed’s actions, but also the subtext within its commentary—as well as the other influential central banks.  And, of course, there is the U.S. Presidential election.  Election years breed uncertainty, and uncertainty typically leads to capital market volatility.  While acute bouts of volatility can be uncomfortable, having a plan in place when choppy markets commence can make them more tolerable.  If 2020 proves to be a year of elevated volatility, establishing a plan to redeploy capital into short-term underperforming segments of your investment program can pay dividends in the long-term.

Indices referenced are unmanaged and cannot be invested in directly.  Index returns do not reflect any investment management fees or transaction expenses. This report is intended for informational purposes only; it does not constitute an offer, nor does it invite anyone to make an offer to buy or sell securities.  Information herein has been obtained from third-party sources that are believed to be reliable; however, the accuracy of the data is not guaranteed and may not have been independently verified. The content of this report is current as of the date indicated and is subject to change without notice.  It does not take into account the specific investment objectives, financial situations, or needs of individual or institutional investors.   All commentary contained within is the opinion of Prime Buchholz and intended solely for our clients. Unless otherwise noted, FactSet was the source for data used in this report. Some statements in this report that are not historical facts are forward-looking statements based on current expectations of future events and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Past performance is not an indication of future results.