Looking Ahead – Q4 2018
- Credit & Lending
- Financial Planning
As we move into the final quarter of 2018, the landscape is dotted with both opportunities and challenges, created by a combination of Federal Reserve policy, the Trump Administration, and frankly, time. Just as the financial crisis of 2008-2009 was an extraordinary event, the rally in equities which has occurred since the market lows has exceeded expectations. To be sure, this rally has occurred on the back on stimulative measures; however, the negative repercussions of the massive infusion of liquidity into the global economy, which were almost universally anticipated, have not come to fruition, at least in any meaningful sense. This has allowed the economy to grow unencumbered by the Fed, which has been able to rely on the lack of inflation as justification of its policies until the most recent months. The tax cut, too, which was enacted in late 2017, has provided a lift to what had been perceived as overvalued equity markets here in the U.S.; this positive effect has continued throughout the third quarter. Offsetting these opportunities is concern that this unprecedented expansion must come to an end sooner rather than later, and that the Trump Administration’s focus on trade policy may accelerate that end. Add in a looming Brexit, rising interest costs for companies and countries worldwide, and the threat of political upheaval in emerging markets, and there are plenty of risks to keep investors up at night.
With that said, in U.S. equities, we have and continue to favor sectors which we believe can benefit from stronger growth in the economy, while insulating the portfolios from areas which face meaningful inflation induced cost pressure and significant exposure to continued escalation of tariffs.
While technology stocks have most certainly led the market the last two years, we are thoughtfully positioning ourselves in stocks which can benefit from corporate capital expenditure, and avoiding stocks for which the valuations are just too lofty.
Health care, which we have been overweight to for some time, posted excellent gains in the fourth quarter, and we expect investors to continue to mine that sector as an alternative to technology for strong earnings growth.
Within financials, we migrated to an underweight to bank stocks over the course of the year, given the challenging yield curve, but believe the sector overall should perform better as we move into 2019. We have become more constructive on energy, given the steady increase in oil prices which we expect to persist. We still expect interest rates to rise over time, so our underweight stance on the defensive sectors of the market remains in place.
Outside of the U.S., we have been disappointed with the performance of international developed and emerging markets equities this year, but believe the underlying thesis for remaining diversified and incorporating these exposures into portfolios remains intact. Global multinationals based in Europe, the U.K., and Japan are trading at multiples significantly lower than the U.S., and represent the opportunity to garner exposure to global growth at more reasonable prices. Admittedly, the strength in the U.S. dollar, coupled with the threat of fiscal spending increases and subsequent financial deterioration of the Italian government have hindered names this year, and further uncertainty around the end game in the U.K. could weigh on stocks in the coming months as well. As for emerging markets, while headlines around Turkey and Argentina have swirled, the real culprit this year has been China. While much has been made about the increased prices American consumers would pay on the enactment of widespread Chinese tariffs, the Chinese economy would be the bigger loser, and this has weighed on sentiment. To be fair, the Chinese government has some tools at its disposal to offset this impact – a government stimulus program would surely come quickly – but the tariff situation is likely to remain an overhang for the time being.
As has been our stance for several years, we remain underweight bonds versus equities. Within our taxable bond portfolios, the team remains constructive on corporate bonds, but is continuing to migrate the overall quality of the taxable bond portfolios higher. As part of this transition, the exposure to MBS and agency issues has increased, as they provide an avenue to garner additional yield to Treasuries with less risk than corporates. From a duration standpoint, the team is targeting duration close to that of the benchmark. Within the municipal markets, modest outperformance over the last several months does not in our view indicate any change in the opportunity for investors looking for tax-exempt income. From a portfolio positioning, we are neutral to the benchmark and intend to remain so for the near to mid-term. Overall, we are more constructive on high yield municipals versus corporates, but acknowledge that for clients looking for income, a modest allocation to high yield bonds in either taxable or tax-exempt accounts makes sense given the still low overall yield levels.
Finally, we prefer allocations to commodities over REITs in the real asset space in the current environment, against a backdrop of rising prices and rising yields. REITs should continue to perform positively on the tailwind of economic growth, but we believe the gains will be limited versus the broad equity market by the rising cost of capital.
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- Credit & Lending
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