Volatility has seen the S&P 500 Index drop by -13.52% in the last quarter of 2018. Hear portfolio managers discuss how Saturna Capital is positioned to ride out the rough waters and what lies ahead.
Read the transcript:
HAITHAM AL-SAYED: Alright, good morning and good afternoon to all. On behalf of Saturna Capital and the Amana Mutual Funds, welcome to our call entitled, “Steering a Sturdy Ship Through Rough Waters.” My name is Haitham Al-Sayed, and as your host and moderator I wanted to thank you in advance for joining us and for submitting your questions in advance. We will not be able to get to all of them during this call, however we will make sure someone from Saturna will get back to you regarding any unanswered question in a timely manner. As a friendly reminder, the call will be recorded, and all lines will be placed on mute to avoid any background noise. So, we witnessed some rough waters in 2018, with a combination of GDP growth, lower tax rates, robust labor markets, lower oil prices, record government shutdown, interest rate hikes, unknown tariff outcomes, and the list continues. Hence with 30-plus year history of prudent asset and risk management, I’m very excited to share with you two special crew members helping us steer Saturna’s sturdy ship. We will begin with Scott Klimo, our Chief Investment Officer, who holds his Chartered Financial Analyst CFA designation, and the portfolio manager of the Income, Growth, and Developing World Amana Funds. He will be followed by Patrick Drum, a CFA, a Certified Financial Planner, and an MBA holder designee and Portfolio Manager to our fixed income funds including the Amana Participation Fund. They will provide an overview of the current market and economic environment as it relates to the Funds they oversee, as well as answer as many questions as they can on this call. With that, I will turn it over to Scott Klimo.
SCOTT KLIMO: Thanks, Haitham, and good morning to everyone. Not the greatest day in the market today, as we hold this call. A couple of companies had some disappointing numbers and we’re seeing that drag down the market as a whole, but despite that, let’s just have a quick look at what happened in the 4th quarter and in 2018. Things started pretty rough in January, but then we started a nice little run up over the second and third quarters before just rolling over aggressively. The S&P 500 shed some 13.5% in the fourth quarter of last year. And the thing that we were quite pleased with, as far as the performance of the Amana Funds, was that we often talk about downside protection and that was provided in dramatic fashion, I would say, last year. For the six months leading up to December 31, the Amana Growth Fund lost 1.2% while the S&P 500 was down 6.9% and the Morningstar Large Growth category was down 9.1%. That performance was repeated by the Income Fund, which lost 1.4% versus that 6.4% for the S&P and 7.7% lost in the Morningstar Large Blend category. So, the funds definitely came through as far as protecting, preserving capital in times of market distress. For the full year, the Amana Growth Fund did provide a positive return of 2.4% while the S&P was down 4.4% and the Large Growth Category was down 2.1%. It was a difficult year for value funds and for Amana, so unfortunately that fund was down 5.2%, but again, the large blend category of Morningstar was down 6.3%. Something that we’ve seen over the past, really since the Global Financial Crisis, is that value has underperformed relative to growth. It’s very much been a growth-driven market, and in many ways a technology-driven market. After the dot com era, the 90s, leading up to the dot com crash, it was pretty much the next decade was pretty lackluster for the technology industry. And since the Global Financial Crisis, however, we’ve seen the Apples and Amazons and Microsofts have all staged really incredible, incredible runs in developing new types of technology-oriented businesses. So, I’m sure that the question that a lot of people are asking is, “What is the outlook for 2019?” and one thing that we certainly don’t feel very comfortable about is predicting what the stock market is going to do over any period as short as 12 months. But, if we look at it from, say, an economic perspective, I think obviously there are a lot of concerns. The government shutdown is a significant issue, but on the other hand, we’ve had some pretty good economic numbers. The job numbers that came out earlier in the year, and the wage growth numbers, were quite positive in terms of perhaps keeping consumer spending going, which we saw in the 4th quarter and over the Christmas season, had a very strong Christmas season. Consumer spending was up something like 7% year-on-year. So, there is some, as long as you don’t work for the Federal Government, there is some buoyancy in the consumer market. And so that’s something I think that we can feel good about. You know, interest rates were another area of significant concern last year and a lot of people think that it was the continuation of the rate hikes that really helped push the market off the cliff in the 4th quarter of last year. We’re not nearly as worried about that in terms of choking off economic growth as some others seem to be. From a historical context, the rates are still remarkably low, and you know, if anything, we would perhaps think that a little bit higher rates could… I think it’s fair to say that the Fed has largely normalized the situation and I think it’s also fair to say that them having done so from the unprecedented place of quantitative easing and the zero interest rate policy is really a pretty impressive achievement, because really… there was so much doomsaying out there about what was going to happen when the Fed had to normalize rates and I think they’ve done a good job of managing that. And we actually wouldn’t mind too much if we saw somewhat higher rates going forward because one of the things that has happened is that the cheap cost of borrowing money unsurprisingly has encouraged companies to do so. And one of the things that is of concern to us is that the ratio of US corporate, non-financial debt to GDP, currently stands at a record high, which is really remarkable when you look at the historical record that the level of debt typically declines during a period of good economic growth and solid sales, which we’ve seen for the past several years. And what happens is that debt spikes and recessions, relative to GDP, so it’s an unprecedented situation. It’s something that, you know, for 2019, we’re not terribly concerned about because we think the economy will continue to cruise along at a reasonable clip. Probably something north of 2% GDP growth here in the first quarter, and so that’s okay, but certainly, this economic growth is not going to persist indefinitely. At some time, there will be a slowdown. There will be a recession. Maybe it’s 2020; I don’t know. But that’s something we would certainly be concerned about with regard to debt levels and the effect that that can have on profitability in that sort of economic environment.
HAITHAM AL-SAYED: Alright, very well. Thank you, Scott. With that, I’ll turn it over to Patrick Drum to share some of his thoughts on the fixed-income side.
PATRICK DRUM: Good morning and thank you. Thank you for all attending and thank you for the introduction. So, let’s kinda talk a little bit high level here. We’re all talking about where we are standing. What can we expect and how are we managing risk? The focus here is on capital preservation and what I want to stress and really communicate is how well-positioned the Amana Participation Fund is in preserving clients’ capital while providing current income in a volatile market. And there’s a lot of misconceptions and there’s a lot of narratives that are not necessarily true. So, I kinda want to provide a bit of a walk-through. Let’s do high level. The Fund currently offers, at the end of December, an SEC 30-Day Yield on the institutional side of 3.4%. On the retail side, 3.2%. The effective duration is about 3.4 years. It’s designed to be high-grade, high-quality issuers. Last year was a difficult market, particularly in emerging markets, as identified with Scott with the equity, as well as fixed income. That asset class broad base we are finding in a risk on… excuse me… in an environment where broad interest rates are increasing, a stronger dollar, and for most of the large part of last year—higher oil. Those three have created some destabilizing risk, destabilizing environment for risk-related assets. And as we’ve navigated this environment as well as our company’s history navigating many business cycles: this is no different. The philosophy is gonna stay the same. I can walk through a variety of numbers, but when you’re looking at it, one of the best proxies is the Bloomberg Barclays GCC Credit, both High Yield and Investment Grade, ended up being positive, but if you look to Asia was negative. JP Morgan EMBI Global Core was down 5.17%. Really, we saw in a six-week period ending in 2018, is when we really saw a bit of volatility issues come to the market. Most of the issuers that originate from the Middle East to Southeast Asia, continue to have a favorable and well-positioned outlook. In 2018 there was about 115 billion of sukuk USD that were issued. Outlook is to essentially be at the same level, 105-115 billion by S&P. The amount issued last year was slightly down by about 5%. Over the last several years since the ending of 2016, to the third quarter of 2018, oil has precipitously has continued to increase over that time period and that has really provided the issuers and the sovereigns a meaningful opportunity to improve their fiscal balance to include the fiscal budgets, to improve their overall capital requirements, and more importantly, to be better positioned. That region is at the beginning of a favorable business cycle, and in fact, the IMF has improved or raised the growth outlook for that particular region. There’s other attributes that position this region in a positive favor in 2019. JP Morgan announced, formally, that they’re going to be adding 11% of the emerging market benchmarks, not all but some, to incorporate the securities being issued from the GCC. This is gonna increase the inclusions up to 11% with Saudi Arabia being the largest at 3.1%. What that means is that we’re gonna have a consistent and additional new incremental buyer… ranges anywhere from 20 to 60 billion. The inclusion is gonna be taking and probably will be ending or take place here at the ending of January, but it’s gonna be throughout a time period. It’s not gonna be an immediate investment. That’s gonna provide consistent and additional liquidity and support to the region. The potential pause by the Federal Reserve with regard to interest rates in March seems to be brought on largely as a consensus that is very constructive as well for that particular region. Remember, this region generally lives on the dollar. Even though they have their own currency it’s pegged to the dollar. And so that permits that region not to be subject to some of the volatilities that we’ve seen in other emerging markets. So that provides a bit of an overview, but I couldn’t be more constructive about any other region than when it comes to the Middle East.
HAITHAM AL-SAYED: Very well. Thank you, Patrick, for your tremendous update. As this point, I would like to ask the portfolio manager some questions that came in and, again, thanks to all who submitted a question. Scott, one of the questions, and I know you earlier in the call said you know there’s no way to really predict, but you know, is will we have a recession in 2019 and also, can you discuss a little bit about a correction versus a recession if you don’t mind.
SCOTT KLIMO: The general consensus seems to be that the odds or the risk of a recession in 2019 are low. There’s a variety of organizations that put out, for lack of a better phrase, recession meters that provide a percentage estimate for what is the likelihood of there being a recession, and most of the ones I’ve seen so far are around the 25% range. So, it doesn’t seem to be, and it’s something that the Fed isn’t predicting or projecting for this year, either. So, I think we’re pretty comfortable that there will be continued economic growth throughout 2019. One thing that’s important to recognize is that there’s not a 1:1, linear relationship between economic performance and stock market performance. So, obviously stock market performance depends upon rising earnings and a portion of that is dependent upon a rising economy, but you don’t necessarily have them moving in lockstep. So that’s why we could potentially have a decent economy and we may not have a great stock market. Or vice versa. Those things don’t have to be hand in hand. I’m not exactly sure what you meant between recession and correction, but a recession is just two quarters of economic contraction, and a correction is generally some double digit decline in the stock market, so certainly we saw a correction in the 4th quarter. If you measured the S&P 500 from its peak to its bottom, which occurred I think in the week between Christmas and New Year’s, we had over a 20% decline, so… and that’s generally a benchmark for even kind of a bear market. And it was pretty sharp, and it was pretty significant, and I don’t think that there is still a good sense amongst the investing public or the investing profession as to which way things should go in 2019 which is why we’re seeing the type of volatility we have been seeing. Friday was a very, very strong day and today is a big down day, and we’ve been seeing that kind of up and down volatility for some time as people have tried to come to grips with what is going to happen for the next twelve months.
HAITHAM AL-SAYED: Okay, thank you. Appreciate that. We have a question that asks: a lot of analysts think that emerging markets are behind developed markets in their economic cycle. With that in mind, does Saturna agree with that view, and if they do, do you plan to invest more in emerging markets?
SCOTT KLIMO: I would say that it’s probably correct that they are behind the United States. I don’t know if I would be so broad as to say developed and developing. I mean, countries are all over the map in terms that some emerging market countries such as Indonesia are pretty far along. Others like Turkey are well behind. But even within the developed world, it’s hard to say that much of Europe is at the high point of the cycle. I mean they’ve been struggling for quite some time. As far as the investment opportunity in emerging markets, if you look at the benchmark, the largest countries are China, South Korea, and Taiwan, and obviously China has been in the news quite a bit. I think over the weekend I read three different articles: one from Bloomberg, one from the Wall Street Journal, and one from the New York Times about the slowdown in the Chinese economy. And that’s obviously a market that performed very, very poorly… I think the Shanghai index was down something like 36% last year, and so that’s a big problem. And of course, unsurprisingly, Taiwan is very closely tied to activity in China, and so, um… China sneezes and Taiwan is definitely gonna catch cold. South Korea is a little bit more insulated but still has some influence, so large swaths of the emerging markets are not particularly attractive right now. Southeast Asia is potentially a beneficiary of some of these things, particular if there is increased trade tension between the United States and China… we’ll probably see an acceleration of investment out of China and into Southeast Asia. Not necessarily countries that are that easy for us to invest in—Vietnam for example, has been benefitting quite a bit from migration of activity from China. Bangladesh has been getting some lower-end activity as well, and textiles and other areas. So, I have to say, and I guess just to cover all the bases: South America… okay, Brazil, maybe, is showing some signs of rebounding, but I mean, Venezuela, it’s not even a functioning economy. Argentina just can’t seem to be able to pull itself out of the doldrums. Things are very tough there. So, it’s not an asset class that gets me tremendously excited for 2019.
HAITHAM AL-SAYED: Thanks again, Scott. I believe I have one more question geared toward your side of things and the question is what are your thoughts on investing in artificial intelligence? There’s been a couple of companies that have shined in this area as far as Apple and Nvidia. So, the question is, what is your opinion regarding this topic, as far as investing in artificial intelligence?
SCOTT KLIMO: Yeah, artificial intelligence is a topic that’s been garnering quite a bit of ink for some time. It’s something that’s difficult to exactly define. What does it mean and what does it mean for individual industries? But we are seeing evolution from systems that simply provide data into systems that are able to analyze that data, and parse it, and create usable information for companies and for various activities. You know, it’s something that, obviously, is very closely tied to automated driving, for example. Pharmacy R&D is another area that’s talked quite a bit about AI. So, we think it’s a real thing. We think it’s pretty hard to define. And it’s probably being somewhat overhyped. But it does fit into a thesis that we have going into the 2020s which is that there’s going to be a strong rebound in the semiconductor cycle. Those of you who have read our comments in the past may recall that when things were really booming in the semiconductor cycle earlier in the year, we kinda put out there, “Well, there’s a lot of stuff coming down the road that’s gonna push that, whether or not there’s some correction to this cycle in between today and that happening we can’t really say.” Well, obviously we have seen that correction and Nvidia and Micron and companies of that nature have been absolutely crushed…but we still believe that the demand is coming down the road and that AI is going to be a big part of that. So, as we move into 2020, as 5G wireless communications take off, cloud computing continues to grow, various artificial intelligence, augmented reality/virtual reality applications, we think we’re gonna see a real strong semiconductor cycle that could last for several years and so that something that we are definitely positioning ourselves for.
HAITHAM AL-SAYED: Great, thank you. Patrick this question is geared towards your end regarding the Participation Fund and the performance since its inception and maybe talk about its performance last year and maybe what you are doing specifically in the Fund as far as, you know, things that you’re seeing, opportunities, that may help performance-wise as well.
PATRICK DRUM: Yeah, more than happy to. So, last year as indicated the institutional Participation Fund provided a return of .11% or 11 basis points positive versus the benchmark that was 27 basis points positive. As I was earlier pointing out, this is really the attention is emerging markets, particularly fixed-income and even more so the equity standpoint, experienced negative returns. This region was one of the only regions that I came across that demonstrated positive performance, and this is in part of the conservative nature and conservative approach that we employ. The issuers that we own in the region tend to be large, tend to have a long history, and generate on a standalone basis positive cash flow. So, these are very large issuers. The positive outlook, and the reason I’m so constructive on this region, is again, this region is going through an economic improvement, because it had, since 2016, when oil recovered from the lows around the high 20 range, got as high as 70, and clearly, oil has pulled back, and the range around the mid 50s is kinda where consensus seems to form. This region is very astute with regards to oil prices and oil management. And during the time of improved oil pricing, each of these countries improved their overall fiscal positions. You have quite a few positive outlooks that are hitting the region. You have the World Expo 2020 that’s taking place in Dubai, the inclusion of 11% of JP Morgan’s Emerging Market benchmark. That’s gonna be a long driver of institutional flows into this region. They are continuing to be a very strongly, or rather, the issuance that comes from this reason still obtains high degree of coverage, i.e. both by US investors, European and Asian investors, like this paper because it’s high grade. Qatar, Kuwait have a AA rating. That’s equivalent to the UK rating even though they’re facing Brexit. Saudi Arabia has a credit rating of A-, equivalent to China. There’s very few regions that have such a strong credit rating with strong capital reserves. They’re small economies, and so as a result our team really focuses on the issuers that have strong credit quality and good liquidity. And that practice isn’t gonna change.
HAITHAM AL-SAYED: Okay, very well. Thank you, Patrick, for taking that. With that, I just wanted to say thank you all for joining out call today. We’ll hopefully have more of these calls throughout the year. We hope you benefitted from the call today and I do want to thank both Scott and Patrick. Appreciate you being available to answer the questions. On behalf of the entire Saturna Capital and Amana Mutual Funds team, I thank you and have a great rest of the week.