By Michael Venuto, CIO David Dziekanski, Portfolio Manager, at Toroso Asset Management

Volatility spikes have returned with concerns around a slowing global economy, quantitative tightening around the globe, trade wars, maturing tech giants, and the piles and piles of debt, at all levels. There are many signs indicating global growth is in the later stages, and concerns of a potential recession in the next 6 to 24 months are real.

We are in the midst of the longest economic expansion in modern history (at least in length, but not so much in magnitude). Let’s take a moment to review one of the themes over the last few commentaries: the growing correlation between central banks’ balance sheets and the MSCI ACWI Index (all country world). As you can see below, the correlation remains strong, and central bank balance sheets are set to continue contracting at a meaningful pace.

U.S. Equities

The iShares Core S&P 500 ETF (IVV) returned -4.42% for 2018, and -13.53% for the fourth quarter. It’s hard to remember that as recently as September 30th, IVV was up over 10.5% for the year. Mid and small caps outperformed large, returning -1.33% and 1.61% respectively for the year, but both coming with additional downside in Q4. The two-year run of momentum stock dominance falls flat on  its face, leaving investors with a very difficult question to ask themselves, buying opportunity or value trap?

(Source: Toroso, Morningstar)

A common theme from the perma-bull camp is the reset of the forward price to earnings ratio (P/E) of 14.4. In historical context, this is “actually quite cheap!” But when you dig deeper, the answer seems less clear. As we have discussed in previous commentaries, profit margins have soared, and continued to soar for US equities for quite some time. Coupled with lofty earnings expectations looking forward; it could all lead to continued volatility in up-coming earnings seasons. We have seen some wage growth to potentially put a few extra dollars in consumers’ pockets, but in our opinion, consumers are stretched pretty thin as is.

In US equities we continue to shift further from traditional market cap weighted index’s weigh huge exposure to the stocks with the most momentum of the past few years. We favor more targeted structures trying to capture value in a “GARP” like approach within large cap equities through the use of the Reverse Cap Weighted US Large Cap ETF (RVRS).

International Equities

International Developed Equities

The iShares MSCI EAFE ETF (EFA) returned -13.83% for the year, but actually outperformed US equities by 1.73% in the fourth quarter, “only” losing -13.59% over the 3 month period. What’s most interesting about this is it all occurred while the dollar actually gained value. The US Dollar measured by the Invesco DB US Dollar Bullish ETF (UUP) returned 7.34% this year. With political uncertainty around Brexit and geopolitical risks surrounding Russia we still view this asset class as neutral, and prefer access through more selective vehicles, such as the Flexshares Morningstar hds. Developed Markets ex US Factor Tilt (TLTD). We don’t see much additional downside relative to US equities in this asset class.

Emerging Market Equities

We are optimistic about Emerging Market equities as we recognize their long term importance in the world economies as driven by changes in demographics and technology. Emerging market populations in China and India as an example are set to embrace and potentially lead technology development as a result of their own cultural needs, i.e. blockchain, robotics, AI and perhaps unfortunately cyber-security. Similar to how Tech took over the as the largest companies in the world, emerging markets are set to become the largest economies in the world.

The iShares MSCI EM ETF (EEM) returned -14.98% for the year, but performed significantly better than both US and International developed equities in the fourth quarter, giving up -7.56%, for an outperformance of 6.76% on the downside. Last quarter we mentioned that at current ratios, the downside in emerging markets, regardless of the risks surrounding China were likely not worse than what may occur within US markets. This was mainly due to how beaten down the asset class has been as of late. China, measured by iShares MSCI China ETF (MCHI) lost -10.85%, and most surprisingly, a basket of emerging market currencies measured by the WisdomTree Emerging Currency Strategy ETF (CEW) was positive 0.89% for the fourth quarter despite the uptick in volatility, leading us to believe a reversal in US dollar strength is due to occur.

Similarly, to International developed, we prefer more selective approaches to this space such as WisdomTree Emerging Markets ex-State-Owned Enterprise ETF (XSOE), KraneShares (KWEB) and The Emerging Markets Internet & Ecommerce ETF (EMQQ). Noteworthy, is the fact that these targeted ETFs do not have a great deal of overlap.

Fixed Income

What 247 trillion dollars of debt looks like (approximately 63 trillion borrowed by central banks).

(Source: Visualcapitalist)

The iShares Core US Aggregate Bond ETF (AGG) returned -0.05% for the year after returning 1.62% for the 4th quarter. Longer term treasuries, measured by the iShares 20+ Year Treasury Bond ETF (TLT) returned, -2.07% for the year after gaining 4.16% for the quarter. High yield, measured by the iShares iBOXX $ High Yield Corp Bd ETF (HYG) was down -1.93% for the year, giving up -4.34%  in the fourth quarter.

Treasuries started to perform somewhat differently than they have in recent past. Some have been selling by foreign nations (Russia all but removed all Treasuries from their reserves in exchange for gold and other currencies). We see short term potential for US treasuries as treasury yields have somewhat broken out from their typical historical ratio to the cooper/gold ratio, but long term, we don’t like the prospects of the only developed nation with plans to significantly increase their annual deficit over the next 5 years. Interestingly, US Savers became the largest owners of treasuries, which leaves us questioning, are we becoming Japan?

US Treasury Yields

Treasury Rates to Cap Out

Before we transition to alternatives, we thought it interesting to note the changing dynamics occurring between equities and treasuries. Diversification benefits of treasuries appear to be diminishing:

Alternatives

Commodities, measured by Invesco DB Commodity Tracking ETF (DBC), returned -12.02% on the year, after giving back all gains and then some in the fourth quarter, returning -18.47%. Alternatively, Gold, measured by SPDR Gold Shares (GLD), ended the year down just -1.54%, after recovering 7.84% in the fourth quarter. The Bloomberg Galaxy Cyrpto Index (BGCI) was down -81% for the year and -65.4% for the fourth quarter. We have been using a specific market neutral ETF for quite some time that finally showed its true colors in the most recent market volatility; the AGFiQ US Market Neutral Anti-Beta ETF (BTAL) returned 4.7% for the fourth quarter, and 14.7% for the year. Treasuries will no longer be as impactful of a diversifier as they once were and its extremely important to analyze your alts at time like this to make sure they are at least somewhat alternative in nature.

Conclusion

Two occurrences we mentioned as potential signals of an upcoming recession in our last commentary continue to show signs of breakdown. Traditional recessions are preceeded by inverted yield curves and expanding high yield credit spreads. Despite this information, trying to time such an occurrence is unlikey to result in a benefit. Credit spreads have begun to expand two other times over the course of this recovery, only to revert back to historical lows. Even when they do continue, determining the time in which it may occur is challenging in the face of market volatility. Historically, these trends would imply market disruptions in the next 6 to 24 months, but in a world where a tweet can significantly distort global markets, we caution over taking action according to emotions due to these signals. Extreme positions in volatile markets requires optimal timing and hindsight in a forward journey where we simply don’t always have a clear path.

This article was written by the team at Toroso Asset Management, a participant in the ETF Strategist Channel.

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Disclaimer: This commentary is distributed for informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. Nothing in this commentary constitutes an offer to sell or a solicitation of an offer to buy any security or service and any securities discussed are presented for illustration purposes only. It should not be assumed that any securities discussed herein were or will prove to be profitable, or that investment recommendations made by Toroso Investments, LLC will be profitable or will equal the investment performance of any securities discussed. Furthermore, investments or strategies discussed may not be suitable for all investors and nothing herein should be considered a recommendation to purchase or sell any particular security.

Investors should make their own investment decisions based on their specific investment objectives and financial circumstances and are encouraged to seek professional advice before making any decisions. While Toroso Investments, LLC has gathered the information presented from sources that it believes to be reliable, Toroso cannot guarantee the accuracy or completeness of the information presented and the information presented should not be relied upon as such. Any opinions expressed in this commentary are Toroso’s current opinions and do not reflect the opinions of any affiliates. Furthermore, all opinions are current only as of the time made and are subject to change without notice. Toroso does not have any obligation to provide revised opinions in the event of changed circumstances. All investment strategies and investments involve risk of loss and nothing within this commentary should be construed as a guarantee of any specific outcome or profit. Securities discussed in this commentary and the accompanying charts, if any, were selected for presentation because they serve as relevant examples of the respective points being made throughout the commentary. Some, but not all, of the securities presented are currently or were previously held in advisory client accounts of Toroso and the securities presented do not represent all of the securities previously or currently purchased, sold or recommended to Toroso’s advisory clients. Upon request, Toroso will furnish a list of all recommendations made by Toroso within the immediately preceding period of one year.