A Year to Re-position...
As this year drew to a close, we found ourselves in the midst of a fairly significant market decline. This seemed to result in headlines often taking on a rather formulaic approach, describing market moves in the context of some past event or period (“Nasdaq suffers biggest drop since Brexit” … “S&P 500 suffers worst Fed Rate-Decision Day since 2011”). While such reference points are likely helpful in driving readership, we find it interesting that these reference periods are all too often days, weeks, or, in some rare instances, months. While we believe it important for investors to have a strong sense of history, the memorization of certain dates or events does little to accomplish this. Knowing that today’s move in the market is as large or larger than that of another trading day, while “interesting”, really does little to tell us where we have been or where we are heading. However, the ability to draw parallels between the current environment and those of the past, as measured in years, or in some cases, decades, is in our eyes far more helpful.
Halfway through this year, we made note of the fact that it seemed that most market participants had finally come to accept that we were likely in the later stages of this economic cycle. While it remained difficult for anyone to discern just how late in the cycle we were, it was clear that many were beginning to recognize a paradigm shift. Though bouts of extreme volatility early in the year abated, markets gyrated more this year than they have in the past, and this was the case even before the final quarter of this year began. As mentioned in the past, some of this is the result of normalization of U.S. monetary policy, in the face of what has been generally encouraging economic data. With moderate wage growth and inflation, buoyant consumer confidence and solid production numbers, it stands to reason that the Federal Reserve has continued to raise rates. While the Fed’s actions have proven controversial, especially as of late, a little bit of perspective is always helpful. Not only is the U.S. central bank acting within its mandate for economic stability (as measured by inflation and employment numbers), these moves provide it with the ability to act should the economic environment turn less favorable going forward. What’s more, interest rates, even after four hikes this year, remain low enough to continue to promote an environment of growth. While this has caused some discomfort for investors in both equity and fixed income alike, especially as markets come to adapt to this environment, the fact remains that such moves are likely more a net positive than a negative.
With that in mind, it is not our belief that tightening monetary policy in the U.S. has been the main catalyst for the volatility we have encountered as of late. Rather, we feel much of it has been the result of several threats to global growth which, though looming for some time, have increasingly weighed upon investor sentiment as their economic consequences become more tangible. One such threat, clearly top of mind, has been increasingly protectionist U.S. trade policy. Heated rhetoric out of Washington, accompanied by increased tariffs, has only brought more of the same from many U.S. trading partners, with the strain particularly pronounced in Sino-American trade relations. Other major exporters have been impacted as well, as concerns about the future of their businesses remain in question. As we gain insights from our portfolio companies both in the U.S. and overseas, it’s very clear that these developments have been a disruption, whether it means shifting production capacity across borders, finding new suppliers or rethinking revenue targets. Regardless of whether a business is based in the U.S., the Eurozone, or East Asia, the changes we have seen recently create uncertainty about the path for global growth going forward.
Several other situations, both at home and abroad, have exacerbated the uncertainties felt by companies and their investors. U.S. mid-term elections in November will lead to a split Congress in January, reducing the likelihood the current administration will have the ability to advance much of its agenda in the coming years. As it was, this election highlighted the increased division amongst Americans and their two mainstream parties, a situation further underscored by the government shutdown that began as the year ended. However, political impasse was not a phenomenon limited only to Washington, with standoffs overseas also weighing on market sentiment. In the UK, debates both internally and externally about the ultimate structure of a Brexit deal almost led to the ouster of Theresa May in December, with still no one sure how Britain’s withdrawal from the European Union will take shape. Meanwhile, in both France and Italy, pressure to adopt more generous concessions to its people have forced both nations to pass budgets that fall outside of the European Union’s deficit prescriptions. Though Brussels has protested to an extent, their ultimate complacency in both situations does raise questions not only about fiscal discipline in the Eurozone, but about cohesion within the block going forward. While such anxieties are far from new, these recent developments have certainly brought them back into focus.
...and Reflect.
With so many causes for concern, it is unsurprising that most equity market indices posted negative returns for the year. Despite these losses, fixed income proved to provide little in the way of a safe haven, as rising US rates weighed on sovereigns around the globe, and the risk-off stance seen towards the end of the year caused credit spreads to widen. It was, undoubtedly, one of the more challenging years we have encountered in some time. While we remain confident in the fixed income managers we are invested in, we feel there will be an increased burden of proof on each of them to recognize the shifts that have been occurring throughout the bulk of this year, and adapt and execute accordingly going forward.
On the equity side, our performance saw headwinds not only from general market exposure, but from exposure to idiosyncratic factors as well. For example, our long-term position in NXP Semiconductors experienced a great deal of pressure in the wake of its aborted acquisition by Qualcomm (the deal, we would note, ultimately a victim of trade tensions between the U.S. and China). While we remain committed owners of this business, the broken deal, followed by a rout in the semiconductor space, caused this position to weigh on returns in 2018. Elsewhere, softer end markets led to a less assured outlook for larger consumer staples names like AB InBev. While we feel this remains a strong franchise in many respects, outsized growth in recent years, mainly the result of major acquisitions, has led us to reconsider this position. In that context, it has also led us to contemplate what constitutes a winning strategy going forward for consumer staples businesses, especially when it comes to fast-moving consumer goods like beverages, packaged food and other consumables.
At the same time, other businesses we owned saw their fortunes improve, including ResMed, a name we feel over the long term has the potential to move from being a more niche medical device provider to becoming a leader in connected healthcare solutions, with a strong focus on the treatment of sleep apnea. Investors took notice of progress on this front, making it a major contributor to portfolio returns for the year. Another new holding, Virtu Financial, saw its market making business benefit significantly from increased market volatility, while continuing to expand its share of equity trading markets globally. While we like owning Virtu as it generally benefits from choppier markets, we remain impressed with the company’s technology portfolio, and its ability to further reduce transaction costs for investors. Though we wish more of our portfolio companies provided us as much encouraging news this year as names like ResMed and Virtu did, we remain confident in the long-term prospects of all the businesses we currently own.
With that being said, we also feel that greater opportunities are on the horizon. We have, admittedly for quite some time now, expressed our concerns about the fragility of the market environment, especially as we move later and later into the cycle. The signs of excess have been visible for years, and as we have pointed out, potential catalysts that can usher in an end to the expansion have increased in both quantity and magnitude. As such, this recent spate of volatility has left us in many ways increasingly comfortable with our positioning across asset classes, especially when it comes to what some may see as an outsized exposure to “flight to quality assets”, be it cash, or short-dated fixed income instruments.
Looking Ahead: Our Outlook for 2019
We believe the final quarter of this year is quite indicative of what the market environment may well look like for much of 2019: increased volatility, with swings to both the upside and downside, and a repricing of assets more in line with economic reality. Like many fundamental investors, the past few years have certainly been challenging, given that the drivers of market performance bore with them either outsized expectations for growth, or risks we as fiduciaries could not underwrite. We feel this is finally beginning to change and expect our opportunity set will widen in the coming year. As some of you are already aware, we have also recently developed the capacity to allocate capital in equity markets overseas, primarily in Europe. It has been our belief for some time that significant inefficiencies can be found in these markets, especially in the small and mid-cap space. A due diligence trip to the region in December confirmed these views, with meetings with management and IR teams further reinforcing our theses on several of the companies in which we have targeted. Leveraging the same methodology we have used for years, we feel this new international strategy provides an excellent complement to our US-listed equity portfolios, offering exposure to well-run, innovative companies yet undiscovered by most investors on this side of the Atlantic. If you are interested in learning more about our work in this area, we encourage you to get in touch.
That said, it is our intention to move deliberately when it comes to allocating capital, given the risks that continue to loom on the horizon. In addition to some of the issues we’ve already touched upon (international trade tensions, political strife both at home and abroad), we also feel that other factors may weigh upon global growth in the coming year. Discussions of Federal Reserve policy abound, especially since the December rate hike, and though we feel the Fed has been justified in its actions, we would be remiss not to recognize the potential for policy missteps at this crucial juncture. The central bank is undoubtedly walking a fine line when it comes to preventing an overheating economy, and potentially choking off what has been solid growth. In addition, we feel other key drivers of the global economy may be showing signs of weakness, with China remaining a key concern. While most discussions surrounding the world’s second largest economy these days seem to revolve around trade, data coming out of China remains a major concern. Credit growth has continued to be robust, perhaps too much so, yet it seems to be doing little to stimulate further growth. Whether mild or severe, a Chinese slowdown would have far-reaching consequences. With these factors in mind, we believe it prudent to tread carefully.
Obviously, one has no real way of knowing how any of these scenarios may or may not play out in the coming year. However, as mentioned, we feel heightened volatility will persist for some time. As such, investors would be well served to be mentally prepared for such an environment and ensure that their portfolios are positioned accordingly. It is our intention to provide you with Investment Policy Statements early on in 2019, and we encourage you to review them and reach out if you feel your current allocations are not in line with your risk profile or current financial circumstances. We also welcome discussions on our general views on the environment, or how that might relate to specific components of your portfolio.
Despite plenty of reasons for concern, we do recognize that this environment will undoubtedly bring new investment opportunities to light. Whatever the coming year may have in store, we remain confident in our diligence process and risk management. As always, we greatly appreciate your support and trust, and wish you all the best in the coming year.
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This memorandum expresses the views of the authors as of the date indicated and such views are subject to change without notice. Drum Hill Capital, LLC (“Drum Hill Capital”) has no duty or obligation to update the information contained herein. Further, Drum Hill Capital makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Drum Hill Capital believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Drum Hill Capital, LLC.