Bond performance has also been surprisingly positive with returns in the 5-12% range across the different bond sub sectors. Inflation is low, at times worryingly so, as the technologies of our day continue to create efficiencies and drive deflationary pressure. This lack of inflation has provided the Federal Reserve and global central banks justification for lowering rates and providing stimulus. However, the Fed continues to keep interest rates low to compensate for the negative impact of the trade war. If the trade war is ultimately resolved, there is a reasonable chance that the Fed will be less accommodative into 2020, which could upset the stock market. We are skeptical of corporate credit markets being able to adapt to higher rates without some painful spread widening.
This irony of good news becoming bad news is not a comfortable situation for fundamental investors: if things get going well again and the fog clears, then the Fed probably goes back into hiking mode, which would create a headwind for the markets. Conversely, if things do not go well, then rates stay low (or go even lower), which would be supportive for markets. Either way, the markets have become quite dependent on the actions of central banks.
Client portfolios have done well by staying fully invested. However, we do believe the risk/reward balance has tipped into a less attractive place and some trimming of positions is warranted. We will outline our current thinking below.
We strive to keep turnover low and hold our preferred ideas through volatility, but at certain times, it is important to rebalance and realign. We believe that we are in one of those times. Market volatility has been on the increase. Negative news headlines have become more numerous. Financially, the world grinds forward, but the road is getting bumpier. We continue to stay the course, but are certainly more cautious. We have been reducing any equity overweights that have arisen in client portfolios due to market appreciation and are rebalancing portfolios back to market weight. Any cash raised will be held as dry powder to be reinvested opportunistically on any market weakness. We prefer to keep this dry powder in cash due to fixed income being relatively expensive after its remarkable run. With inflation very low and contained, the purchasing power of cash will not be eroded in real terms as it might have been in a more inflationary past.
We are incrementally more cautious after a few new and unique worries have joined the list of concerns. The hurdles for the next leg of market appreciation are no longer just China and the manipulated yield curve. The worries now also include the struggles in the functioning of the repo market, the challenges in the IPO market with the faltering of companies like WeWork and Peloton, the impeachment distractions, and the significant political uncertainty associated with the 2020 election and its potential implications on the corporate tax cut and industry regulations.
There is also a risk that manufacturing sector weakness spills over into other areas of the economy. Manufacturing is a much smaller part of the US economy than it was decades ago, so in that respect, the current pronounced slowdown is less worrisome as long as the services side of the economy and US consumer remain healthy. However, manufacturing is not to be taken lightly either. Manufacturing is important for market sentiment and is, at least partly, a barometer of CEO nervousness toward capital expenditures. Finally, the sector employs many consumers who would be negatively impacted if layoffs were to rise.
Why trim equities? Because the variety of trouble spots is growing. None of these is terribly large independently, but taken together, the odds have risen that something could undermine market confidence more severely and create cascading effects.
Why not trim more dramatically? Because things are not dramatically bad. Earnings continue to hold up and the US consumer is still healthy. The odds of a recession have grown but are not overwhelming. There is probably 5-10% of upside to the market via a relief rally if the China trade war gets resolved.In addition, the “market” has priced in some of these risks already. In fact, the level of skepticism and caution that we are seeing in market sentiment is encouraging as a moderating factor that could allow the market to surprise to the upside.
While we are cautious on the market as a whole, we are still confident about finding individual ideas within the market. The dispersion of returns in Q3 is an example of the breadth of the opportunity set— the S&P 500 was up 2%, but across the eleven primary industries in the index, the range of returns was -6% (energy) to +9% (utilities).
Utility stocks, real estate stocks and consumer staples stocks, along with long US Treasury bonds and gold, were the winning categories for Q3 as the flight to income and safety overwhelmed the market, especially in September. Growth slightly underperformed value in Q3 for the first time in a long time.
The primary change in the market during the quarter was the weakness in momentum stocks after a long run of outperformance. There is the conundrum that in an up market, being in the names with positive momentum is usually a good place to be. However, the reason momentum builds is because others are crowding into certain ideas, both on a quantitative and fundamental basis. This crowding creates more vulnerability when the market mood changes, as was evident in September. We continue to look through these shorter-term technical factors and independently underwrite our holdings for the long term.
International markets have continued to lag the US. There is one line of argument that some of the countries and regions that have been lagging for a while will be the first to recover. We remain conservatively positioned in our international holdings and are not ready to rotate portfolios toward this thesis, but are watching it closely. A resumption of more normalized global trade would likely benefit Asia and emerging markets, especially China and other exporters. The strength of the dollar has also muted returns for US-based portfolios invested in overseas markets, and we would be patient for the dollar to start weakening as an additional tailwind to non-US returns.
We are comfortable with continuing to execute our laddering of positions and holding to maturity through turmoil. We are at a market weight on credit risk, and the majority of our investments are higher quality than the broader bond market. There is currently approximately $14 trillion in negative yielding debt globally and this continues to help support a relative value bid for US Treasuries (and indirectly, support for muni bonds as well).
Consistent with staying the course toward long-term investment goals, we recommend maintaining an appropriate amount of fixed income. However, in terms of the macro outlook for fixed income, trying to specifically time and predict the future path of interest rates is never a prudent strategy, and certainly not in this era of manipulated yield curves. At these very low yields, bonds are not the automatic safe haven they were in a previous era. Therefore, any excess cash would likely remain in cash and very short-term holdings, rather than overweighting longer duration bonds.
Our holdings in opportunistic fixed income remain modest. We have small exposures to dollar-denominated emerging market debt, high yield bank loans and high yield corporate debt. We would look for a more pronounced spread widening in investment grade credit before adding further exposure. We do have room to add on weakness if valuations get sufficiently attractive.
The fourth quarter has started with equities down slightly and bonds up slightly. The global market is nervous, but interest rates remain low and supportive. Virtually all asset classes, sectors and countries are positive for the year through October 8 due to the supportive global interest rate environment. Through October 8, the S&P 500 was up 17% year to date with sector dispersion from 0% (energy) to +29% (real estate & technology). Also, on a year to date basis through October 8, international stocks were up 7% and our two most referenced bond benchmarks were up 7% (government/credit) and 5% (muni bonds).
We remain comfortable with our long-term holdings, but recommend prudent rebalancing and trimming equities back closer to investment policy targets if needed. We are comfortable holding a small cash cushion as dry powder for opportunistic reinvestment.