What a difference a year makes! A year ago, market watchers were worried about rising interest rates, trade friction (the U.S. – China trade dispute), and geopolitical tensions, which tempered investors’ risk appetites, resulting in a yearly decline for the S&P 500 Index for the first time since 2008 — “The Great Recession”. In 2018, these concerns led to the worst return for the month of December since 1931, and the S&P 500 finished calendar year 2018 down 6%. Fast forward to 2019 and the markets ended with an exclamation point, pressing the S&P 500 to all-time record highs. While the market vacillated between risk-on and risk-off at various times throughout the year, in the end stocks and bonds had an extraordinary run in 2019, posting their biggest simultaneous gains in over two decades. The S&P 500 Index finished 2019 with a YTD gain of 31.49%. We have to go all the way back to 1997 for last time the S&P 500 Index produced a greater return, when it advanced 33.36%.

For the first time in U.S. history, the U.S. economy started and ended an entire decade without a recession. The U.S. Federal Reserve (the Fed) began 2019 forecasting two interest hikes for the year, but ultimately became concerned about the growth trajectory of the U.S. economy, which triggered a pivot in monetary policy as we entered the back half of 2019. When it was over, the central bank ultimately trimmed interest rates three times in the last six months of the year in an attempt to prolong the current economic expansion.

In a historical review of stock market performance by decade, the following chart shows annualized returns of the S&P 500 Index for each 10-year period since 1910. The most recent decade ending December 31, 2019, resulted in a 10-year annualized return of 13.56%, the fifth best in over 100 years. A college graduate of 2020 could reasonably presume that the stock market only goes up considering they were just 11 years old during the last significant stock market decline of -37% in 2008.

On the other hand, those of us that were in the investment industry at that time may recall that 2000-2009 was a painful decade, ending with The Great Recession, and the S&P 500 delivering a 10-year annualized return of -0.95% through 2009. I have often referred to this 10-year period as the “lost decade.” It started out with three years of negative returns (2000 – 2002), with each year progressively worse (more negative) than the last. While we don’t anticipate a repeat of the lost 2000s anytime soon, following the outsized returns of the most recent decade, a review of past poor performance is a healthy reminder that markets don’t always go up, and helps keep risk awareness from fading away.

Looking ahead, with the Fed cutting its short-term benchmark interest rate target to a range of 1.5% to 1.75%, the economy should have a stable tailwind from monetary policy throughout 2020. While the Fed signaled a pause in rate cuts during the October meeting, the central bank made it clear that they were not about to start hiking interest rates either, nor were they on a pre-set course for short-term rates moving forward.

On the other end of the yield curve, long-term interest rates in the United States are likely range-bound for the near future between 2.5% to 4.5%. We believe the main driver of monetary policy will continue to be the U.S.-China trade negotiation outcome. Globally, most economists anticipate that the top 23 central banks, which collectively set policy for almost 90% of worldwide economies, will continue to maintain a dovish stance overall (i.e., accommodative, low interest rate policies).

The challenge that global central banks will have, given current low, ultra-low, and even negative interest rates for some, will involve their ability to address potential economic slowdowns through traditional monetary policy maneuvers alone (i.e., rate cuts). Government officials will therefore need to “pick up the baton” in the event of future slowdowns and implement fiscal policies to help strengthen their respective economy, or at least attempt to soften the blow of a recession.

One trend that stood out during the decade was how pervasive “protectionism” has become throughout the world. Most Americans are familiar with U.S. and China trade dispute, but the rest of the world is also grabbing for a piece of preciously scarce growth. In periods of abundant growth, countries tend to be more forgiving of “unfair” practices by which competitors use to gain access to foreign markets. The world is not in that type of environment. The U.S. Corporate Tax Reform of 2017, deregulation, and new trade agreements were all put in place to better position U.S. companies in the global marketplace, in an attempt to capture growth. The United States-Mexico-Canada Agreement (USMCA), aka NAFTA 2.0, that was passed by Congress in December is another example. The “phase one” trade deal with China was announced mid-December and propelled the market to a relief rally. However, as mentioned previously, we believe contention between the U.S. and China will continue to rear its head in the coming decade and beyond. Entering into a trade deal is fairly easy, but monitoring and holding each trading partner accountable to the terms of the agreement can be quite difficult.

Countries outside of the U.S. and China are also undergoing rising levels of protectionism. With the recent election in the United Kingdom giving Boris Johnson a commanding majority, Britain’s exit from the European Union (Brexit) may soon become a reality. However, “soon” is a relative term since the Brexit process started with a referendum held on June 23, 2016. While European Union Ambassadors agreed to extend Brexit to January 31, 2020, and that is likely the date the U.K. will ultimately “leave” the EU, the U.K. will continue to follow EU rules through December 2020, while negotiators attempt to reach a new free-trade deal between the two sides. Additionally, Spain has recently followed Poland with their own version of Brexit among countries threatening to quit the E.U. in the wake of increasing protectionism.

With that said, as we look to 2020 and beyond, we believe that the equity markets are poised to continue their upward trajectory due to corporate earnings growth and a decent economic backdrop. There may be some bumps in the road, and even major temporary shocks along the way, similar to what we experienced in December 2018, but nonetheless, we anticipate equity markets throughout the world to produce at least modestly-positive returns in 2020.

2020 is a U.S. presidential election year, and the one thing we can forecast with a high degree of certainty is that, after the first week in November, nearly half of the population will be disappointed with whomever is elected. While political rhetoric will heat up throughout the year, it is important to remember that most campaign promises end up empty, and presidential and congressional hopefuls woefully overestimate their power to get things accomplished.

This new world of “low growth” should continue to favor those companies that have been able to capture market share and grow their revenues during the past several years in spite of slow global economic expansion. Therefore, we continue to expect growth investing to outperform value investing for the foreseeable future. Investors need to be aware, however, that the valuation premium for these “growth” companies is relatively high. Any missteps will surely result in significant stock price depreciation, so company selection is critical, and proceeding with caution is prudent. At Kornitzer Capital, we focus on growth companies that are beneficiaries of long-term secular growth trends with the potential to grow regardless of the economic backdrop. We gravitate towards premium companies that have the best competitive positioning within the marketplace and the potential to capture the lion’s share of the growth presented by the trends on which we focus. Onward to the 2020s decade we go!

For all of the excitement that transpired in the 3rd quarter, it was remarkable that the U.S. equity market eked out a modest increase of 1.70% for the quarter, as measured by the S&P 500 Index (total return, including dividends). This result was just enough to help stocks hold on to their biggest year-to-date gains since 1997. Additionally, with interest rates trending downwards since the beginning of the year, high yield bonds (as measured by the ICE BofAML U.S. High Yield Index) have generated robust returns year-to-date of 11.53% as investors searched for yield further out on the risk spectrum. High yield bonds produced a return of 1.41% for the quarter – a level similar to the S&P 500. While the absolute returns continue to help extend the longest bull market on record, the rapidly-changing environment continues to increase the volatility in the market to whatever the flavor of the day is — growth or value, risk on or risk off, international exposure vs U.S. exposure, etc.

We often describe market risk to clients by using the analogy of climbing a tree. When you are on the ground looking up, you see a vast amount of opportunity and limbs that should be easy to hold, elements that are far from your mind regarding risk because there is little downside as you start the climbing endeavor. This scenario is relatable to the time period of 2009, when risk had been washed out of the system via a reset of equity prices, and central banks throughout the world made a concerted effort to stimulate the world’s economies at a level never experienced before. However, as you get higher in the tree, you start to become more aware of your surroundings and doubts start to enter into your mind regarding risk that you didn’t think about previously while on the ground. You become more aware of the data points of the day, because being high in the tree, there is a real consequence to a misstep or miscalculation.

The latter describes the investing environment we are in today with an abundance of data points impacting the marketplace. Some of the news has been influencing the marketplace for years (Brexit, Central Banks’ policies, trade disputes) but others have reared their heads recently.

One of the relatively new events that influenced the market temporarily was the recent attack on the Saudi Arabian oil facilities, which crippled the world’s largest oil exporter, knocking out 5% of the global supply. Prior to any time before this, if 5% of the world’s oil production were taken offline, there would have been a lasting impact on crude prices, and more direct impact to the consumer at the gasoline pump. That wasn’t the case with this disruption, as crude prices quickly retreated back to pre-attack levels following the initial price spike (illustrated in the chart below).

While a portion of this can be attributed to fears of a slowing global economy, record crude oil storage levels, and reassurances by the Saudis that production will be back online fairly quickly, the most significant factor is the changing landscape in oil production and America’s role in cushioning the world markets from geopolitical supply shocks.

U.S. oil production is on track to reach an average of 12.2 million barrels a day this year, up from last year’s average of 11 million barrels per day. To put this increase into context, in 2009 the U.S. was producing approximately 5 million barrels per day after decades of declining oil production from its peak in early 1970s. The uncertainty will remain in the Middle East, but its geopolitical impact to the United States has been minimized by U.S. exploration and production success over the past decade. Nonetheless, there are economies that could be severely impacted by oil production disruptions in the Middle East, most notably China.

China, while no longer the fastest growing oil consumer in the world (that distinction now belongs to India), is still the largest single importer of oil in the world today, importing more than 9 million barrels of oil per day in 2018. The Middle East is the largest collective source of Chinese oil imports, accounting for over 45% of its supply from nine Middle East countries, mostly Saudi Arabia, Iraq, Oman, Iran, and Kuwait. Rising prices from oil supply shocks wreaked havoc on U.S. economies in the past, and could provide a template for China going forward, which leads to the next data point impacting the marketplace: trade.

We admit that at the start of 2019 we were optimistically forecasting that a trade agreement with China would be forthcoming by the middle of the year. Today, the only thing that has become certain about any trade negotiations with China is the uncertainty of President Trump’s Twitter tweets regarding increasing or decreasing tariffs that vary day to day.

Although China celebrated its 70th anniversary of the founding of the People’s Republic of China on October 1st, with strong words from President Xi Jinping about the strength of their country, the reality is China is struggling on multiple fronts. We continue to expect some type of resolution to the current trade dispute between the U.S. and China, with a good probability of reaching a deal in the next six months. However, after the news headlines announce the deal, the tugs and pulls between China and the United States will likely continue for years to come. Going back to our tree climbing analogy, any news of a trade resolution will give the market a strong limb to grab, potentially propelling the markets to new record highs.

The third data point that continues to influence the market is monetary policy throughout the world. During the 3rd quarter, 16 global central banks lowered interest rates. With more than $15 trillion dollars of worldwide debt currently yielding negative interest rates, investors continue to gravitate towards equities. In the U.S., rates are likely going lower. With the U.S. Manufacturing Purchasing Managers Index from the Institute for Supply Management coming in at 47.8% in September (the lowest reading since June 2009), this marked the second consecutive month of contraction — any figure below 50% signals a contraction. This confirms the concern that Federal Reserve Chairman Powell had during his September press conference, after lowering short-term rates by a quarter of a percent to a range of 1.75% to 2.0%, its second cut this year. We aren’t convinced that additional rate cuts will have much effect to address anxieties over trade uncertainty and delayed capital spending by corporations, but we wouldn’t be surprised if the Fed were to cut rates one more time before year end. While there are other factors influencing market volatility, we believe a resolution to the trade dispute between China and the United States would be the biggest development to help buoy the markets higher.

Since the founding of Kornitzer Capital Management in 1989 and Buffalo Funds in 1994, we have diligently focused on investment management based on in-depth, fundamental research and intimate knowledge of the companies in which we hold in our clients’ portfolios. Returning to the tree climbing analogy, we like to climb strong oak trees, which provide solid footing and hand holds for when the winds blows. Our investment strategy leads us to investments with the potential to weather the storm.

Special Feature
by John Shepley, CFA
Portfolio Manager of Private Clients

Below is a brief summary of individually managed accounts (IMAs) offered through Kornitzer Capital Management, based on some common questions we’ve received from clients over the years.

What is an IMA?
Kornitzer Capital Management (KCM) has been managing individually managed accounts (IMA) since KCM’s inception in 1989. An IMA is an investment portfolio consisting of individual stocks, bonds, cash, or other securities. The unique structure of an IMA provides the flexibility to customize the portfolio to address a client’s personal preferences, risk tolerance, and investment objectives.

How do IMAs compare to ETFs?
A comparison of IMAs and exchange-traded funds (ETFs) uncovers some advantages for investors. With an IMA, investors benefit from direct ownership of securities, compared to investing in an ETF where the investor’s money is pooled with that of many other investors.

This difference results in the following advantages of a KCM IMA:

• Customization – An IMA can specialize in certain types of securities, such as dividend-paying stocks and high yield corporate bonds. The account can be custom-tailored to meet unique investment goals, risk tolerance, and income needs. It can also be designed to avoid investing in certain industries that a client may not wish to support, such as tobacco stocks.
• Greater Tax-Efficiency – Since an IMA owns individual securities directly, the realization of capital gains can often be strategically offset by selling another security, which may carry an unrealized loss. This process is called “tax loss harvesting” and leads to greater potential after-tax returns.
• Transparency – With an IMA, clients receive a quarterly report of the entire investment portfolio, which shows the individual securities owned, number of shares, and other details to help the client understand how the investments are performing.
• Professional Management – Portfolio managers and research analysts at KCM perform rigorous investment research and conduct detailed securities analysis in an effort to make the best, most-informed investment decisions for clients. We meet with company management teams in our office on a weekly basis to get a unique perspective on potential investment opportunities. Knowledge and experience are two important qualities that professional money managers should possess. It’s not uncommon for us to host several hundred meetings with publicly-traded companies each year.
• KCM Personalized Approach – Designing an IMA is just one step in an ongoing consultative relationship between KCM and our clients. KCM never stops working to ensure that an investment portfolio is on track to meet the unique goals and needs of each client. We know risk, needs, and objectives can change over time, and the composition of the IMA portfolio can and should evolve to meet the new parameters as they arise.

Contact KCM today for more information on our customized IMAs.

John Shepley, CFA, has been with KCM since 2005 and has 36 years of professional investment experience.

  Download newsletter in PDF format

Equity markets produced a significant reversal in the 1st quarter of 2019 following one of the worst periods of performance to close out 2018. Year-to-date through March 31, the S&P 500 Index posted a return of 13.65%, its biggest quarterly gain in nearly a decade. Much of the reversal in market sentiment was a result of the change in the Federal Reserve’s (the Fed) policies, providing a more growth-friendly backdrop, combined with the anticipation that a U.S. – China trade deal is imminent.

Regarding monetary policy, recall that in late 2018, Fed officials were targeting between one and three short-term interest rate increases for this year and a continued reduction in the Central Bank’s $4 trillion balance sheet – a wind down of quantitative easing (QE). However, expectations for monetary policy changed in March as the Fed disclosed it is not likely to increase interest rates in 2019 and will stop shrinking its balance sheet by September, extending quantitative easing. This pivot in the Fed’s policy provided a more growth-friendly tailwind for capital markets.

Furthermore, nearly all of the world’s central banks are keeping interest rate increases on hold, a signal to investors that low rates will continue significantly longer than most expected just a year ago. The European Central Bank (ECB) ended its quantitative easing program in December, where it was carrying monthly purchases of $35 billion of government and private debt to keep interest rates low. However, in March, the ECB announced it intends to launch a new QE stimulus program to support the eurozone economy via cheap loans for banks, and hold the key interest rate at -0.4% throughout 2019.

Historically, one way a recession develops is from interest rates being too high, which inhibits the economy’s ability to grow. The Fed’s recent halt to interest rate increases has alleviated this fear, but now the worry has shifted to signs of slowing economic growth in spite of a more dovish Fed. In fact, some market strategists are forecasting the Fed may have to lower short-term interest rates before year-end to stimulate additional growth.

The uncertainty in the trajectory of our economy is reflected in the inverted yield curve (illustrated below). An inverted yield curve occurs when the yield on short-term Treasury bills become higher than the yield on intermediate term bonds, in spite of the term-premium investors usually require for longer maturity bonds of the same credit quality. This unusual phenomenon generally signals falling growth expectations and has preceded every recession in the U.S. since 1975 (except a brief inversion in 1998), although it often takes over a year for this to materialize once the yield curve becomes inverted.

While we do not believe a recession is imminent, the markets are at an inflection point. The Fed’s change in monetary policy is either going to extend the current 10-year economic expansion period or be a signal that the end of the growth cycle is near. A recession is defined as two consecutive quarters of economic contraction (negative economic growth) as measured by the Gross Domestic Product (GDP). Since official GDP numbers are typically released two months after the end of a quarter, the economy could be in a recession up to eight months before it’s “officially” announced. Financial markets don’t wait for official recession announcements and stock market drawdowns occur quickly once signs of an economic recession appear. With that said, we believe an extension to the current economic expansion is the more likely outcome for the remainder of the year.

The sustained robustness of the U.S. economy relative to the rest of the world provides some confidence to believe domestic economic expansion will continue. While the U.S. economy is experiencing some deceleration, growth is simply moderating from above trend to in-line. In early March, the Commerce Department reported that the U.S. trade deficit hit a record last year. As imports grew faster than exports, the U.S. economy accelerated throughout 2018 while many of the world’s economies slowed. While some media outlets portrayed this as a dire consequence of ongoing trade disputes, we view the smaller trade deficit goal that President Trump is seeking as unrealistic. As the world’s largest economy, the U.S. is also the largest importer of goods and services, consuming about 14% of total worldwide exports.

The U.S. accounts for nearly 25% of the world’s GDP and is the largest export destination for China, India, and Germany, and the second-largest export destination for Japan. These four major economies are heavily dependent on exports – nearly half of Germany’s GDP comes from exports, therefore a global decline in demand has the potential to affect their financial systems, employment rates, and even internal political dynamics. The U.S., by comparison, is fairly insulated from the global trade economy. Only about 13% of our GDP comes from exports, and nearly half of those goods and services go to our neighbors Canada and Mexico. The U.S., Canada, and Mexico form a stable trading bloc despite the occasional Presidential tweet. Low dependency on exports limits U.S. exposure to foreign business cycles, while export-dependent countries are vulnerable to fluctuations in global demand, especially from the world’s largest economy.

A U.S. recession would decrease demand for goods, and depending on its severity, could have a significant effect on the business cycles of other countries. The greater the dependence on exports, the more destabilizing the effect of an American recession could be. Some of the most vulnerable economies are already facing serious challenges that would be compounded by a decline in exports. China is already in an economic downturn and Germany is showing some signs of a slowdown in manufacturing. The economic implications of Britain’s exit from the European Union are also still uncertain. This is why modest growth in the U.S. has appeared to be so robust when compared to the global economy.

In our last newsletter, we stated that the resolution of trade disputes was a critical factor in the probability of positive market returns for 2019. Thus far, whenever there are indications of a U.S. and China trade deal agreement, the market responds favorably. We believe trade deal negotiations will come to a close within the next six months, but “ending” the trade war appears to mean something quite different to each side.

China would prefer all tariffs be lifted immediately. However, with China’s history of backsliding on negotiated deals, the U.S. will likely demand that current tariffs remain and the lifting of tariffs occur incrementally, as evidence of compliance to the agreement is substantiated. Trade deals are difficult to monitor and enforce, so Washington needs to hold on to at least some leverage to ensure China follows through. While the general market will see the initial advantage of a trade pact, and some sectors like agriculture will have immediate benefits, others may have to wait for fundamental improvements to business through the reduction of current tariffs in the future.

No period of economic growth in U.S. history has lasted longer than 10 years, dating back to before World War II. While economists are apt to point out that we are now reaching that yardstick, with the last recession ending in 2009, we point out that there are other forces impacting the marketplace that have never existed before, specifically ongoing accommodative monetary policies of virtually all of the world’s major central banks. While a U.S. recession is likely to occur at some point, we don’t believe it will be in 2019. While equity investors should enjoy the 1st quarter’s outsized returns, we wouldn’t be surprised to see a pause or even some giveback in stock prices over the next six months. In spite of this outlook, we recommend investors hold firm, as we believe stocks have some runway for growth into 2020.

BREXIT UPDATE

With the failed series of Brexit votes last month, a Brexit resolution remains in flux, as of this newsletter’s publication date. Multiple outcomes are still possible as British Prime Minister Teresa May continues to negotiate a solution. We expect the most likely outcome will be a delay to allow for continued negotiation. Any movement forward on a negotiated Brexit will likely happen over a long transition period, with an estimated completion around 2025.

The economic impact to-date has been relatively modest. Many analysts thought capital planning and economic activity generally, would have slowed substantially, as the uncertainty of Brexit put a damper on spending plans. However, fear mongers have recently been walking back their predictions of eminent doom. Original financial job losses of up to 200,000 were predicted but are now estimated at only 5,000 to 10,000. Financial job losses will be even less than recent estimates given likely “regulatory equivalence” and ability for the UK to be proactive in providing work visas.

Bank of England Governor Mark Carney says the economic impact of an abrupt exit will still be substantial, but the UK is much better prepared now, and the impact will be less severe than originally thought.

The EU will also feel the impact. Job losses and economic performance could be worse in aggregate for the EU, but spread amongst many countries. Brexit will impact the UK in larger relative proportion on a per-capita rate.

Most of the recent weakness across the EU is primarily due to trade disputes, a slowdown in China, and the softness in the auto industry. As Brexit negotiations drag on, capital investment plans could continue to be pressured, until flows of goods and services become normalized. An orderly, negotiated Brexit on the other hand might actually induce a boost to economic growth from increased investment and pent-up demand.

A hard, no-deal Brexit, will create the most risk and uncertainty compared to other potential outcomes. However, as BoE Governor Carney recently stated, the UK is much better prepared than when the process began over two years ago.

General risks from a hard Brexit include:
– Economic malaise from job losses and logistical repositioning;
– A seizing up of the global financial system, reduced liquidity or increased volatility;
– Increased inflationary pressures from logistic delays and increased tariffs and taxes;
– Increased regulatory burdens and operating costs as companies may need to duplicate or restructure their regulatory and compliance apparatus to deal with multiple jurisdictions; and
– Continued uncertainty.

In regards to clearing, settlement, and custody within the financial markets, the EU and the UK have agreed to keep existing structures operational for at least 12 months and that existing equivalence rules will continue to apply, with central securities depositories continuing to be fully functional.

The EU and UK support continued access to UK and EU central counter-party clearing, so there should be no disruption to the financial settlement processes now in place. According to the BoE, banks and financial firms in the UK have the capital and liquidity to bear a disorderly, no-deal Brexit, and the European Central Bank and BoE are prepared to provide additional liquidity if necessary.

We continue to monitor the situation, but currently expect any substantial economic disruption caused by a disorderly Brexit to subside within six to nine months as supply chains are reorganized and normalized. The UK was an economic beacon long before it became more entwined with the European Union, and we expect the country to continue to prosper over time.