The Best of Both Worlds
2019 has given (almost) all investors a reason to smile – but can it continue?
- The story coming into this year revolved around the Fed, China, and how a softer global economy will impact the U.S. – and that narrative remains intact.
- The Fed’s decision to pivot in late December 2018 to a more thoughtful, data dependent approach to tightening monetary policy provided a lift to risk markets in the first half of the year.
- Couple the Fed support with valuations that were well off their recent highs following the pullback in the fourth quarter of 2018, and equities were well positioned for a sharp move higher.
- Balancing the enthusiasm are lingering concerns around the effect of a protracted trade conflict and clear evidence of slowing global growth – both of which show little sign of abating.
From both a market and economic perspective, the second quarter provided investors with reasons to reassess their assumptions and positioning, but did not present a proverbial fork in the road.
After the blistering first quarter, it was unlikely that equity markets could keep a similar pace as we moved through the second quarter. Fears of an imminent earnings recession and the continued lack of resolution in the Chinese tariff showdown certainly created some additional volatility, with May’s negative equity returns a clear response to the threat of expanded tariffs with Mexico. Developed international equities kept pace with the United States, while emerging markets stocks were punished mid-quarter. Bonds, for their part, continued to enjoy both muted interest rate expectations as well as a renewed appetite for credit in the quarter. Expectations for commodities were high at the beginning of the year, but with inflation anchored below targets globally, there was little joy to be found investing metals and energy.
From an economic standpoint, a story of softening is emerging. Sentiment surveys of businesses, particularly manufacturers, indicate the potential for lower growth in the back half of 2019. Consumer spending has been choppy, and hiring – long the stalwart in this prolonged expansion – has slowed, despite a historically high number of open positions. Corporate earnings reports point to political uncertainty as rationale for a delay in spending, particularly in projects based outside of the United States. Outside of the U.S., the inability of accommodative monetary policy to effect prices remains the greatest challenge, and there are few tools remaining for the European Central Bank and Bank of Japan to turn the tide.
Asset Allocation: Our Response to the First Half
In response to the prospect for slower global growth, and based on the gains equity investors have enjoyed this year, we made some changes in our asset allocation recommendations this quarter. We decreased our overweight to equities, by decreasing our allocations to domestic and international large cap stocks. We increased our allocation to high quality fixed income, in which we are now at a neutral weight, and are also recommending a tactical position in preferred stocks, which offer attractive yields and little duration risk. While acknowledge that equity gains could continue through the back half of this year and into early next year, we believe the risks have become slightly skewed to the downside – whereas as earlier in the year we viewed them as balanced. In addition, while valuations remain an important factor in our overall review, we are increasingly focused on the economic data both here and outside of the United States, as we believe this data is critical in determining monetary and fiscal policy over the next 24 to36 months, and thus the response to a potential recession in that period.
What We’re Watching
Fed watching has become a national pastime over the last decade, but heightened interest fueled by the Trump administration’s oversight of Powell and his policies is unlikely to wane any time soon. Overall, the Federal Reserve has offered the equity markets a boost over the first half of 2019, by delaying the anticipated two to four rate hikes expected as we started the year. With inflation unable to gain any momentum, and evidence of softening in certain parts of the economy, there are now expectations for the Fed to cut rates instead – possibly as soon as this month. While touted as merely an “insurance” cut at this time, we believe further action from the Fed likely points to a decision that recession risks are rising. We therefore concede that equities could continue to enjoy gains in the second half of the year, but that an increasingly accommodative Fed would indicate that trouble is on the horizon.
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