A First Foundation Blog

Santorini Switchbacks

| 10/22/19 9:12 AM

Santorini: the most famous of the Greek islands, with its crescent-shaped caldera, high cliffs draped by picturesque whitewashed villages, and stunning views of the volcanic islands and the azure waters of the Aegean Sea, can quite confidently lay claim to being one of the most beautiful places in the world. There’s really only one way to get there: by boat (or cruise ship). And once you arrive at the ferry port, to get to the top ridge of the island, where the towns of Oia and Fira are located, you’ve got to climb an incredibly steep cliff via a narrow, winding road with a series of switchbacks and hairpin turns. I have firsthand experience with this harrowing road, having visited Santorini with my family a few years back. With our luggage in tow, and figuring we might need transportation during our stay, we decided to forgo the option of taking a “mule taxi” (otherwise known as a donkey) up the 800-foot cliff and rented a car instead. Unfortunately, the only rental car available that day was a small Fiat with a manual transmission. Fortunately, however – and I say this with modesty – I’m an expert at driving a stick shift, having owned one for many years. And I had honed my skills at driving a stick shift, especially on steep hills, while living at one point in the famously hilly town of San Francisco. Please note: I definitely don’t recommend owning a stick shift in San Francisco if you can help it – unless you’re deliberately looking to hone your skills at driving a stick shift on steep hills! But in my case, having such experience served me well when I was charged with driving up the steep road in Santorini.

As we navigated the switchbacks in the tiny Fiat while sweating from the heat due to an ineffective air conditioner, I was focused but otherwise relaxed and confident. My wife, on the other hand, was a nervous wreck, worried that with a stick shift, this was going to be a dangerous journey. With every shift I made on the steep hill, navigating from one precarious hairpin turn into the next, she envisioned us rolling backward, right back down the hill – and even potentially careening off the sheer cliff into that azure Aegean Sea! That would be an awfully embarrassing way to die – in one of the most beautiful places in the world and before we even made it to the top to see the view! I actually don’t blame her for worrying, though, because there were several occasions where, struggling to find the exact friction point of the clutch in an unfamiliar car, we did slip backward a bit. But I eventually made contact, and we successfully lurched forward and up the hill, the tiny Fiat sputtering in the hot Greek sun. Suffice it to say, we made it to the top. We were a bit sweaty but fully intact. We excitedly took in the breathtaking view from the ridgeline. The joke of it all, however, was that our then 10-year-old son was seemingly oblivious to the risks we had endured to get there. He had wanted to take the donkey!

We’re close to the top

The journey up the Santorini switchbacks serves as a metaphor for this year’s stock market. It’s been mostly upward but with a few zigs and zags – and some backward slippage and a fair amount of fretting that we could be in for a major rollback or even careening all the way back down the hill – along the way. Despite all that, we have made it nearly, though not quite, all the way to the top of the cliff. The market is still shy of its all-time highs, but it’s not far off. What caused the slippage and fretting along the way? Investors have become increasingly worried about a slowdown in the global economy and the rising risk of recession, triggered by the protracted and seemingly intractable U.S.-China trade war. But, as we’ve been predicting for some time (and probably sounding a bit like a broken record in the process, as our prediction seemed to get pushed out further and further into the future), we now, finally, have a deal! Well, sort of. It’s definitely not the kind of agreement that the market was looking for, but at least it’s something.

We have a deal!... Er…, I mean, we will soon…

As of now, we only have a sketchy outline of the deal, but at least in terms of what we know so far, China has agreed to purchase more agricultural products (estimated to be on the order of $40-$50 billion in new spending) while the U.S. will hold off on imposing new tariffs. The technology transfer issue, including the cybersecurity issue with Huawei, will apparently be treated separately and dealt with at a later date. The deal is said to include “transparency” on currency. President Trump is referring to the agreement as “a substantial phase one deal” and has indicated that “phase two” talks will begin immediately. According to Trump, the agreement will be signed in “two, three, four, or five weeks.” As Barron’s commented, the deal seems to be more of a “cease-fire” rather than a “true peace.” But, again, at least it’s something. And the market was looking for something. In a sign of relief, the market rallied strongly on the day of the news. However, while the Dow surged as much as 517 points on the news, like a driver driving a stick shift up the Santorini switchbacks, the index slipped back somewhat before the close, to end the day with a gain of 320 points. This suggests that while some investors are perhaps a bit like me driving up the cliff, relaxed and confident that we’re finally making progress on a trade agreement and thus can avoid a recession, others, like a nervous passenger, are still a bit skeptical that we’ve made much progress and think that we could backslide at any time.

For our part, the investment team at First Foundation is taking a middle-of-the-road approach (keeping with the motoring analogy). That is, we’re encouraged by what seems like progress, however tepid that progress may be, and we think a relief rally could be in store for the balance of the year, as investors come to realize that the economy can, in fact, escape recession, at least for the near future, and continue its path of solid, even if slow, growth. On the other hand, we recognize that a modest phase one agreement may not be enough. Phase two negotiations can break down at any time, and with the imposition of the planned tariffs halted only temporarily, we need to be prepared for backsliding. In short, we are cautiously optimistic. Perhaps another way to say it is that we are realistic. We recognize that multiple scenarios can yet unfold.

Sports metaphor

Although we’re optimistic that some progress appears to have been made, since we’re not yet ready to declare that we’re fully out of the woods, we are maintaining our stance of playing offense and defense simultaneously. Perhaps this is a bit like getting ready to pull the parking brake quickly should you mis-execute the shift from one gear to the next and the car begins to quickly slip back down the hill. For the investment team at First Foundation Advisors, it means continuing to be overweight in stocks and making sure we have at least some exposure to overseas markets (“offense”) but, at the same time, staying diversified and holding some cash, Treasury bills and notes, high-quality bonds, and non-correlated or less correlated asset classes such as infrastructure, real estate, merger arbitrage strategies, and gold (“defense”).

To be even more specific, within equities, we continue to focus on high-quality, large-cap domestic stocks. We have exposure to quality value and quality growth names, and thus we think we stand to benefit no matter which style is dominant. We have generally avoided small- and mid-cap stocks, which we view as more volatile and expensive than large-cap stocks. We have trimmed our exposure to international stocks, especially European stocks, given the weakness in Europe and the slowdown in global growth generally, owing to the ongoing trade war. Many international economies are heavily export-oriented and thus are more impacted by trade than is the U.S. However, we continue to maintain some exposure. We also remain committed to owning some emerging market stocks. Should progress continue on the trade front, emerging markets, especially China, should benefit. Emerging markets are where some of the world’s most dynamic companies are, and, importantly, they’re relatively cheap. Emerging markets represents the most attractive equity category from a valuation standpoint, which may bode well for generating strong returns longer term.

Bonds: An emphasis on quality and shorter duration

Within bonds, we continue to emphasize quality and a shorter-than-average duration. With credit spreads still relatively narrow and credit metrics deteriorating at the margin, we don’t think it makes sense to take much credit risk. As such, we remain focused on Treasuries, investment-grade corporate bonds, high-quality municipal bonds, and mortgage-backed securities. We continue to avoid dedicated high-yield exposure. Even though interest rates are declining, and the Federal Reserve is poised for more rate cuts in the future, with the yield curve as flat as it is, we don’t think it pays to extend duration for such a modest incremental yield, taking on interest rate risk in the process. Accordingly, we maintain a shorter-than-average duration in our fixed income strategies relative to broad-based fixed income benchmarks.

Still on recession watch

When the trade war was escalating and it seemed like there was no end in sight, we estimated that the risk of recession had risen from approximately 10% to perhaps as high as 40% to 50%. That’s a big move in a short period of time, which is why investors suddenly became spooked. It’s no wonder we saw some backsliding in the stock market. But now, with a trade deal on the horizon, we would expect the odds of a recession to go back down to a more modest level. And thus we expect investors to breathe a collective sigh of relief and the market to continue its upward climb on the back of solid earnings growth. Despite the new development on trade, we remain on “recession watch.” Several of the key recession indicators that we watch carefully – most notably the yield curve, which has inverted briefly at various points in time, and the Purchasing Managers Index (PMI), an index of manufacturing activity, which dipped below the threshold level of 50, signaling contraction – represent warning signs. We would expect some improvement in recession indicators going forward as business and consumer confidence stabilizes in reaction to the progress on the trade war. But, rest assured, we’ll be continuing to watch these indicators carefully and react accordingly, to position our clients’ portfolios as best we can to try to protect and preserve capital.

Climbing a wall of worry

Apart from the good news on trade, there is still plenty to worry about: a natural maturing of the economic cycle after the longest economic expansion on record; the impeachment inquiry; the political divide in Washington and the country at large; the deficit and the national debt; foreign influence in our elections; the Turkish incursion into Kurdish territory in Syria; Russia, Iran, India/Pakistan, and North Korea; terrorism; and cyberespionage. The list goes on and on. However, while these are very real risks, the stock market has shown resilience in the face of such risks. Even with the escalating trade war and a certain amount of backsliding and fretting, the stock market has still gained as much as 21% year-to-date on a total return basis. We have a term for this in the investment business: “climbing a wall of worry.” It’s like a passenger worrying about my ability to successfully get that Fiat up the Santorini switchbacks. Even with all the worrying, we made it! None of this is to say we take any of these risks lightly, of course. We are always vigilant about the various risks out there and their potential to impact the markets. We seek to create portfolios that can weather different types of storms. And we certainly seek to proactively position our clients’ portfolios to guard against growing risks. We discussed this in our previous commentary and our more recent Market Action Update, where we outlined our process of shifting some assets from the “offensive” category (e.g., selling an international equity fund) to the “defensive” category (e.g., initiating a position in gold as a hedge against risk). However, at the same time, we recognize that all that can go wrong won’t go wrong. The market can continue to climb a wall of worry. And thus, despite the risks, we maintain a sense of optimism about the future. The global economy is reasonably sound, and with progress on the trade front – finally! – we can escape the recessionary scenario.

A truly stunning view

If you’ve been to Santorini, you know how stunning it is. If you haven’t been and you get the chance, I highly recommend it. My advice: Don’t take the mule taxi. Rent a car instead. Try to procure one with an automatic transmission if possible. Oh, and make sure the air conditioner works well! It will make your life easier. But if you end up getting stuck with a manual transmission and you know how to drive a stick shift, clamber up those switchbacks with confidence. The stunning view at the top is worth it!

As always, if you have any questions, please don’t hesitate to reach out to your wealth advisor.


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