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2Q2019 Market Summary and Outlook


Overall Asset Allocation

Q2 was a solid quarter in terms of absolute performance and performance relative to benchmarks. Generally, our outperformance versus benchmarks continued in the equity portion of portfolios, which increased the overall client portfolio alpha year to date. Fixed income slightly lagged benchmarks but generated positive absolute performance. The markets are at a crossroads between a “don’t fight the (global) Fed” stimulus that keeps driving all financial assets higher and the counterbalancing stresses of the geopolitical landscape and somewhat softer fundamentals.   

Overall, we remain market weight across asset classes and generally neutral to our benchmarks on a macro level. We continue to seek alpha on an individual security and individual sector basis.

The US stock market has been edging higher, but current valuations are getting more onerous to justify and sustain. Depending on how economic data and earnings guidance play out, our debates are more likely to lean toward when/if we should reduce equity risk, rather than when to add more. 

Similarly, fixed income is fully valued after the volatility and euphoria of Q2 brought multiple Federal Reserve rate cuts back into market consensus.  The economy is not as robust as it was, but remains relatively healthy.  Rate cuts would need to be justified more from the perspective of the potentially worrisome lack of inflation than the perspective of urgent economic distress.  Indeed, it was comments around this subject on July 18 that pushed the bond and stock markets higher and solidified expectations for an interest rate cut later this month and perhaps further cuts beyond that.[1]
 
  • Federal Reserve Vice Chairman Richard Clarida: “Disinflationary pressures, if anything, are more intense than I thought six weeks ago.”...”When you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress.”
  • NY Fed President John Williams voiced concern about low inflation expectations, calling it “somewhat worrisome given the otherwise-strong U.S. economy.”  “My concern is that inflation expectations can get anchored too low, and we may be seeing that, have seen that in other countries,” he said.
Source: Bloomberg, 7/18/19
 

US Equities

Domestic stock indexes saw negative returns in May but bounced back in June and remain up nearly 20% for the year. The softening in fundamentals has been offset by the optimism of renewed rate cuts (as referenced above) and a potential easing of the trade war. 

We are underway with the Q2 earnings season. In addition to global trade uncertainties, this year’s earnings have harder comparisons to beat after the big bump they received in last year’s numbers from the tax changes.  However, profit expectations have been coming down during the year such that some of the challenges are already priced in. Therefore, some Q2 earnings announcements are seeing relief rallies as companies beat previously lowered expectations. 

With a few select exceptions, our portfolios have been moving to a more neutral position, both in terms of dollars allocated and in terms of underlying sector and factor risks.  We do continue to maintain overweights to certain technology stocks. Technology exposures have generated excellent long- term performance, including capturing the outperformance of growth over value.  

 

International Equities

International markets, which have lagged domestic markets, also dipped into negative territory in May but are up almost 14% for the first half of the year.  Q2 was especially trying for China (-3.9% return), which has grown to become a material part of international indexes.

We moved our baseline exposure to neutral international in March, but have been gradual and selective about moving portfolios fully back up to neutral, which has helped client portfolios outperform benchmarks.  We are closely monitoring the global geopolitics with regard to China, Iran, Japan, Europe, and our own US election and policy rhetoric. 
 

Core Fixed Income

Bonds continued to perform well, as the 10-year US Treasury yield fell below 2.00% in July, a three-year low, sending bond prices higher.

In fixed income, our maneuvers and positioning are similar to the first quarter.  For taxable clients, muni bonds are core holdings and for tax-exempt clients, Treasury and Agency debt have been added as core holdings. Our strategies are now duration neutral as we believe the Federal Reserve will begin an easing cycle to stem the recent soft patch in economic data. There is currently close to $13 trillion in negative yielding debt globally and this continues to help support a relative value bid for US Treasuries.

Municipal bonds continued their tightening trend from 2018 and are trading at expensive valuations in the front-end of the yield curve. Demand remains strong, especially in high income tax states affected by the new tax code. 

Corporate bonds produced a 10% total return for the first half of the year as spreads tightened and yields declined. There is growing concern about the size of the outstanding corporate debt load. The recent rally has also made the risk/reward tradeoff less compelling going forward as credit spreads have compressed to near historical tights. We are conservatively positioned in higher quality and less leveraged names.

Consensus now argues that the inverted and distorted shape of the US yield curve (as shown below) demonstrates that some of the rate hikes of last year should be reversed via an immediate rate cut (and perhaps more than one).

 

Evolution of the US Treasury Curve - 2019

 

Opportunistic Fixed Income

Our positioning in opportunistic fixed income remains modest. We have small exposures to dollar-denominated emerging market debt, high yield bank loans and high yield corporate debt.  We would look to 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. 
 

Cash and Enhanced Cash

We are comfortable with basic cash as a buffer for portfolios.  We will be closely monitoring changes in the cash and enhanced cash opportunity set as the Federal Reserve starts cutting interest rates again.

 

Conclusion

Political campaigns are ramping up. Global tensions and uncertainties remain high. Reactionary policies and hypersensitive markets are likely to result in continued market volatility and suggest a conservative approach in the months ahead considering the positive market performance already generated in the first half of the year and relatively full current valuations.
 

 

[1] These comments are also reminiscent of the infamous Ben Bernanke speech of 2002 that earned him the dovish moniker of “Helicopter Ben” after his reference to Milton Friedman’s hypothetical example of dropping money from helicopters as a form of stimulus.  That speech also included reference to academic studies studying the Japan case and other deflationary environments that argued: “when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.  By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.” Please see full speech for his academic study sources for the above: https://www.federalreserve.gov/boarddocs/speeches/2002/20021121/