Looking Ahead - Q2 2019
As poorly as risk assets performed in the fourth quarter of 2018, it is obvious why investors were looking to 2019 with a mix of both hope and caution. As much as there were catalysts for the declines in the fourth quarter – a looming trade war with China, fear of a no deal Brexit, a change in power in Congress – the reality that the global economy was showing few signs of falling over the precipice into recession sparked a rally in the first quarter of 2019, as positive sentiment carried risk assets universally higher. While there were still some weak economic data points – some of which will likely be attributed to a combination of seasonality and the U.S. government shutdown – the premise that equity declines would push the global economy quickly downward is likely to be proven false. Conversely, the support for equity valuations at current prices is predicated on a number of positive outcomes – a trade deal with China, a reacceleration in output measures such as Purchasing Managers' Index, a continuation of a passive Fed – and as such, we believe the risks are currently fairly balanced.
As such, we have moved from an overweight position in equities to a neutral posture during the first quarter. While we acknowledge that our decrease in equities could be perceived as bearish, we reiterate our view that positive global growth should continue to support equity gains, even if the path is somewhat choppy. In order to achieve this decrease in our positioning, we lowered our allocations to domestic large cap, domestic small/mid cap, and international large cap equities.
Within Boston Private’s managed large cap U.S. equity portfolios, we remain optimistic on technology, as this sector will become somewhat more defensive in nature - with higher dividend yields and lower price-to-earnings ratios - now that the communication services stocks have been removed. In addition, balance sheets in the sector appear solid, with large cash balances and relatively low debt. In our opinion, this enables the group to pursue mergers and acquisitions that might help performance by removing competition and consolidating expenses. Conversely, we are underweight financials which are still negatively reacting to the flattening yield curve. Despite a mix shift to fee income, most banks still generate the overwhelming majority of their revenue from net interest income. Within energy, we see oil supply/demand basically in balance and as such remain selective in the space.
Outside of the U.S., the concern around the slowing of the global economy combined with the overhang of a strong U.S. dollar served to dampen investor interest in international and emerging markets equities in 2018. While we acknowledge that the economy outside of the United States appears to be decelerating at a more rapid clip, we believe the Fed’s move away from near-term interest rate hikes and still accommodative monetary policy in Japan and Europe provide enough of a foundation to create an opportunity to realize gains in these stocks over the near to mid term. While we admittedly decreased our overweight to international developed names in the quarter, we did so as part of our overall move to decrease equity exposure. In addition, we believe that emerging markets equities represent a compelling opportunity in 2019, given the growth still offered within these economies, and the effect of the dollar tailwind.
With the meaningful recovery in equity markets, a new look Federal Reserve, and the reality that we are moving into a late cycle period, we increased our fixed income positions during the quarter to reflect a neutral posture in both high quality and high yield bonds, when compared to our long term strategic positioning. Overall, for Boston Private managed individual bond portfolios, we have been modestly increasing the quality of our individual bond portfolios over the last several quarters, using periods of strength in the credit markets to upgrade quality. While much was made of a yield curve inversion between the 3 month Treasury and 10 year Treasury during the quarter, the most watched metric is the spread between the 2 year Treasury and the 10 year Treasury, and that remains positive, albeit still historically tight. While we would prefer to be adjusting our positioning against the backdrop of a steeper yield curve, we do not believe that higher rates are coming to fruition any time soon, and as such, we are remaining close to the appropriate benchmarks as it relates to duration in both our taxable and municipal portfolios.
Finally, we prefer allocations to commodities over REITs in the real asset space in the current environment, although we acknowledge that REITs have performed well as a yield alternative to bonds which remain at historically low levels. In addition, during the quarter we increased our position to tactical/hedged strategies, as we anticipate increased volatility in equity markets over the next several quarters.
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