Q4 2018 QUARTERLY LETTER - JANUARY 2019 - Keebeck Wealth ...
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KEEBECK QUARTERLY LETTER
Q4 2018
Q4 2018 QUARTERLY LETTER – JANUARY 2019
Happy New Year to you and your families. We hope 2019 brings you
health, happiness, and success!
In the following pages you will find our year-end letter. Within this
letter, we discuss the underlying causes behind recent volatility,
central banks and crowded trades. We also discuss some longer-term
secular opportunities and themes worthy of your attention.
We hope you find our publication thought provoking. Enjoy the read!
- Mathew Klody, CIO
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KEEBECK QUARTERLY LETTER
Q4 2018
Introduction
As you can see from the chart below, the traditional 60/40 mix has come under significant pressure in
2018, with both stocks and bonds generating negative returns for the year. It is worth keeping in mind
how rare this is. It is only the second time in the past 27 years where this has happened. This didn’t even
occur in 2008 - and the other year it occurred was 2015, when stocks were only slightly negative.
Source: Blackrock
Still… All About Central Banks
However, this is not an unexpected event given valuation levels and the recent shift in central bank policy
from expansion to contraction.
Academically, there are many yet unknown
consequences of the experiment of
quantitative easing (QE), and the
zero/negative interest rate policies of global
central banks over the past decade.
Practically speaking, however, it is fairly
obvious that artificially suppressing interest
rates and boosting asset prices created an
excess of debt and risk taking.
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KEEBECK QUARTERLY LETTER
Q4 2018
The sell-off itself appears to be the result/payback from the past decade of global central bank quantitative
easing which temporarily elevated all asset values above normal levels. This wasn’t sustainable in the long
run. As Stan Druckenmiller and Kevin Warsh wrote in a late December Wall Street Journal Editorial,
“It can’t all be rainbows and unicorns. In a first best world, the Fed would have stopped QE in
2010. It might then have mitigated asset price inflation, a gov’t debt explosion, a boom in covenant
free corporate debt, and unearned wealth inequality. It might have avoided sowing the seeds of
future financial distress.“[1]
The next few years will be a critical time in the economic history of modern civilization, the global financial
systems and global political establishment. You see, the global economy simply has not yet proven that it
can grow in a self-sufficient way without the stimulus that quantitative easing and zero interest rate policy
has provided. It is little wonder that at virtually the moment global quantitative easing is about to go
negative, assets began to sell off dramatically.
As global central banks shift from expansion to neutral or contraction, we expect this pressure to continue,
thus volatility will remain elevated until we have a better indication on where true economic growth and
asset prices lie.
2019 Recession? Not a Forgone Conclusion
Are we headed into a recession? It’s hard to tell as current domestic indicators remain robust. Market
pundits are concerned about an inverted yield curve which has a good historical track record of predicting
recessions.
However, I tend to take a different view. Modern history has never seen a decade of zero/negative interest
rates prior to the past one. It was an anomaly and we should look at is as such. From this low level, a
sharply upward sloping yield curve would imply the inflation genie will get out of hand which would sharply
pressure corporate margins and asset prices due to the double whammy of earnings pressure and rising
discount rates.
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KEEBECK QUARTERLY LETTER
Q4 2018
In some ways, the best scenario for most asset values is a slight slowdown, perhaps a moderate recession
which limits inflationary pressure and keeps long term rates anchored. There is simply too much debt in
the world to have materially higher rates without significant adverse economic consequences and pressure
on asset values.
Along these lines, the Federal Reserve has come under a lot of criticism in recent months. Even the
President himself has publicly criticized the Fed which is rare and considered blasphemy in techno and
plutocratic circles. We think that for the first time in a very long time, the Fed is doing what should be its
job - to let markets function freely and achieve true price discovery. In the long term, for a free market
capitalist system to thrive, or even just survive, price discovery is the single most important factor. When
price discovery is crippled as it has been over the past decade, efficient allocation of resources cannot
occur. When the cost of capital is severely manipulated, over and underinvestment occurs and in response
asset bubbles and crashes, wealth inequality becomes more extreme, and politics become unstable.
Selected Sector Observations
As a reminder, as an independent advisory firm, we are not going to regurgitate consensus views here.
Our job is to take a critical, independent lens on various Wall Street prognostications, conduct our own
research and identify areas where the risk/reward appears attractive or unattractive. By applying a
pragmatic view to this, our hope is to garner higher returns while maintaining the discipline of risk
management. For reference, our last quarterly letter can be found here.
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KEEBECK QUARTERLY LETTER
Q4 2018
Beware of Falling Angels
As most economic cycles progress, you generally see the level of debt held by corporations decline as high
margins, profits and cash flows enable for the repayment of debt and the reduction of leverage. This can
be analogized to Aesop’s fable of the ant and the grasshopper, in which the latter spent the summer
singing while the ant worked to store up food for winter. When winter arrives, the grasshopper finds itself
dying of hunger and begging the ant for food. Well, if an economic expansion is summer, the current one
ranks as one of history’s longest.
However, instead of repaying debt, corporations have been piling it on, investing some, but using a
significant portion to repurchase stock at record levels and valuations.
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KEEBECK QUARTERLY LETTER
Q4 2018
The following chart shows business loans to GDP at the highest levels since the depths of the recession.
This corporate debt expansion has come primarily from growth in BBB or lower investment grade
borrowings, the riskiest tranche of investment grade debt.
Bloomberg Businessweek reported on November 29th, that “The portion of that debt that is owed by
corporations, not real estate developers or nonprofits, is now nearly $9.5 trillion, or more than 50 percent
what it was a decade ago. Consumer debt, on an absolute level at $15.3 trillion, is higher than it was at the
peak of the mortgage bubble, but it’s much lower as a percentage of GDP… It’s not
clear there is enough credit in the system to activate the corporate debt airbag that usually cushions
businesses when the economy gets bumpy, especially with interest rates on the rise.” [2]
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KEEBECK QUARTERLY LETTER
Q4 2018
The first wave of this debt will begin to mature in the coming years. The impact of higher rates and a
potentially less robust economy could be significant.
Early signs of the end of this
debt binge may be here as
new issuance of domestic high
yield debt has been reduced
to a trickle in recent months.
The Financial Times reported
in late December that the
average price of leveraged
loans has fallen 3.1% in
December to just below 94
cents on the dollar, according
to an index run by S&P Global
and the LSTA. This is the
largest one month move since
August 2011, when the US
government lost its AAA credit
rating.
Key takeaways:
1) It may be prudent to underweight most forms of US high grade and high yield debt at recent prices
as the upside is very limited if all is well, while downside is material if the economy deteriorates
and/or margins contract and interest rates continue to rise. An explosion in “Fallen Angels” could
occur.
2) Overweight unleveraged or moderately leveraged businesses to leveraged ones. Those who have
been prudent with their capital structures should have less downside and more potential to “eat up
the grasshoppers” who weren’t prudent and prepared for winter
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KEEBECK QUARTERLY LETTER
Q4 2018
Is the Dollar Peaking? Value in International and Emerging Markets?
Last quarter, we began to
touch upon this theme, but
would like to develop it further
as the direction of the dollar
has the potential to be the
single biggest factor
influencing global politics,
economic developments, and
dollar denominated investment
returns over the next few
years to the next few decades.
According to a recent BofA
Merrill Lynch Manager survey,
long US dollar is the “most
crowded” global trade. As
shown by the recent results of
the former most crowded
trade, FAANG (down 23% on
average in the fourth quarter
of 2018), it hasn’t paid to hide
in crowds.
Recent dollar strength has come primarily from stronger relative domestic growth compared to the rest of
the world, higher interest rates and the perception of increased global instability (dollar serves as a flight to
safety asset historically).
However, the strong dollar (especially vs. emerging nations) has become a long-term chronic problem. In
the spring of 2017, I had the opportunity to speak at Grant’s Interest Rate Observer conference at the
Waldorf in New York. The link can be found on Grant’s website.
The most important chart from that presentation was the one that compared the dollar not only to other
developed countries, but to the whole world, including emerging markets, particularly China. As you can
see from the chart below, since the 1970s, the trade-weighted dollar has increased over four-fold.
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KEEBECK QUARTERLY LETTER
Q4 2018
We believe what held true then continues to hold true now. The dollar is simply too strong, creating
unsustainable global trade imbalances, economic dislocations and exacerbating wealth inequality which is
leading to increasingly extreme domestic politics.
On November 29th, the Wall Street Journal reported that U.S. Life Expectancy has fallen for another year.
This recent trend is alarming and runs completely counter to the steady expansion of life expectancy the US
has seen since the industrial revolution. A major reason for this is increasing suicide rates and drug
overdoses. The erosion of the U.S. middle class and living wage roles likely plays a major part in this.
Drug Overdose by Age
Source: Wall Street Journal
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KEEBECK QUARTERLY LETTER
Q4 2018
Finally, similar to corporate debt, the US debt and deficit levels are extremely high for this stage of the
economic cycle, a time when we should have a surplus.
Government Debt as a % of GDP
Source: The Economist
Should the fed blink and the US economy stagnate, the impact of recent borrowing and deficit explosion
will come to the fore, which would truly pressure the dollar and benefit international assets. The setup is a
good one, as one of the poorer performing asset classes has been international and emerging markets,
particularly in dollar terms. You can see from the following charts the historically low valuation of
international emerging markets.
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Q4 2018
Fundamentally, emerging markets have very powerful long-term demographic advantages, including
growing populations and middle classes. As these consumers come online, the spending power will be
tremendous.
Key takeaways:
1. Overweight emerging market equities.
2. Overweight emerging market fixed income.
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Q4 2018
Is it Finally Time for Domestic Value Over Growth?
The past decade has been one of the worst periods for domestic value vs. growth equities in history. Much
of this can be attributed to the easy money, low rate environment that the QE era fostered. Lower discount
rates reduce the importance of the timing of cash flows which favor growth. With both of those factors
changing, we see the coming years as a period where value may very well outperform growth.
Source: Blackrock
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Q4 2018
Dimensional Fund Advisors’ research also shows a similar pattern. We are in rare territory with the length
of this most recent period where value has underperformed growth:
Value Opportunity in Housing?
The recent equity correction has been swift and severe. While the hardest hit have been the overvalued,
momentum, growth-oriented stocks, the selling has been fairly indiscriminate, pulling down already
depressed sectors and creating some opportunities for the first time in a while. One of these areas may be
the US housing industry. Housing ETFs, S&P Homebuilders (XHB) and iShares Dow Jones US Home Const.
(ITB), proxies for the sector have lost 26% and 30% respectively in 2018 compared to 4.38% for the S&P
500.
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Q4 2018
XHB (green) and ITB (orange) vs. S&P 500 (blue)
Source: Bloomberg
Concerns over decreased affordability due to prices rising well in excess of wages during the economic
recovery and rising mortgage rates have weighed on the sector.
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Q4 2018
This has begun to weigh on recent housing activity.
While housing starts have grown over the past ten years, annual starts remain well below the historical
average and the amount needed to match annual projected growth in household formation moving
forward. The current housing recovery has been one of the slowest and weakest on record.
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Q4 2018
However, there are powerful long-term secular demographic forces that will be coming into play in the
coming years. Millennials are the largest segment of the population, larger than the baby boomer segment
and they are beginning to enter the prime household formation and house purchase stage of their lives.
While near term affordability and potentially a recession could weigh on near term demand, the longer-term
outlook appears very bright.
A number of housing related securities are now on sale and certainly pricing in a material slowdown. A
number I have followed for years now
trade between 6-7x consensus 2019
EBITDA and less than 8-11x consensus
2019 earnings. While it is impossible to
time perfectly and there is the risk of being
early, this sector appears to hold long term
value at these price levels. This is
particularly true to more mass-market
providers as there is an apparent shortage
in entry-level homes which can be seen by
stronger price appreciation than higher
priced homes.
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Q4 2018
The Importance of Avoiding Crowds
“The worst thing you can do is what everybody has done” [3] - Jeff Gundlach, CNBC Interview 12-17-18.
The speed and dramatic nature of the selloff is likely a result of a mania in crowded passive index products
and robo-advisors. This trend exacerbates the volatility at peaks and during sell offs.
Outside the long only and index world, many “hedge funds” were exposed during the third quarter as a
number of high-profile funds posted returns just as bad or worse as the long only indices. Instead of truly
“hedging”, it appears many were caught in the same crowded, momentum trades, like FAANG. It turns out
we were seeing a lot of momentum chasers masquerading as “hedge funds.” However, there are high-
quality, value-oriented funds out there. Our goal will be to weed out the bad and find the innovative hedge
fund managers that provide an opportunity to generate alpha.
Conclusion
In conclusion, we believe markets are in store for a sustained period of higher volatility (up and down) until
markets and economies find a true equilibrium in a post-QE world. That said, there are likely to be
opportunities resulting from this volatility as sectors with powerful long-term secular tailwinds come on sale.
The long-term creation and growth of middle classes in the emerging markets, and a powerful demographic
wave coming to US housing are two of these. One of our goals for 2019 is to research and identify more of
these “big rock” opportunities at reasonable prices. Thank you for reading, and please reach out with any
questions you may have.
Sincerely,
Mathew T. Klody, CFA
Chief Investment Officer
Keebeck Wealth Management, LLC
mklody@keebeck.com
17KEEBECK QUARTERLY LETTER
Q4 2018
Appendix
Biography
Mathew T. Klody, CFA is the Chief Investment Officer at Keebeck Wealth Management,
LLC.
Mathew is also an adjunct professor of finance at the University of Notre Dame.
Prior to joining Keebeck, Mathew was the Founder, Managing Partner and Portfolio
Manager of MCN Capital Management, LLC, the advisor to a private long short investment
partnership.
Mathew was the Senior Vice President and Analyst at Chicago-based Sheffield Asset
Management, a long/short equity hedge fund from 2007-2012. From 2003-2007, Mathew
was an Investment Analyst at the holding company of Alleghany Corporation (ticker "Y")
covering the equity portfolio, corporate development and the reinsurance portfolio. Mr. Klody began his career as a
credit analyst at the Global Corporate and Investment Bank at Bank of America.
Mathew has been selected to speak at a number of industry events, including the Spring 2017 Grant’s Interest Rate
Observer conference, Invest for Kids - Chicago (Fall of 2017), and the MOI Global - Best Ideas Conference (2018). He
has served as a guest lecturer to the Notre Dame Institute for Global Investing, the Behavioral Finance and Applied
Investment Management programs at the Mendoza College of Business. He serves as a member of the Parish Council
at St. Joan of Arc Church in Lisle, IL.
Mathew graduated summa cum laude from the University of Notre Dame with a degree in finance and business
economics. Mr. Klody is a Chartered Financial Analyst.
DISCLOSURES
Content should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors
on the date of publication and are subject to change. Content should not be viewed as personalized investment advice or as an offer to buy or
sell, or a solicitation of any offer to buy or sell the securities mentioned herein.
Past performance may not be indicative of future investment results. Different types of investments involve varying degrees of risk, and there
can be no assurance that any specific investment or strategy will be suitable or profitable for your investment portfolio. All investment
strategies have the potential for profit or loss.
Charts and graphs do not represent the performance of our firm or any of our advisory clients. All information is based on sources deemed
reliable, but no warranty or guarantee is made as to its accuracy or completeness. Projections and estimates are based on assumptions that
may not come to pass. Changes in investment strategies, contributions or withdrawals, and economic conditions may materially alter the
performance of your portfolio.
1: https://www.wsj.com/articles/quantitative-tightening-not-now-11544991760
2: https://www.bloomberg.com/opinion/articles/2018-11-29/fed-should-take-another-look-at-corporate-debt
3: https://www.cnbc.com/2018/12/17/gundlach-says-passive-investing-has-reached-mania-status.html
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