The US economy showed slight signs of slowing last quarter after a very strong 2018. Not slowing is new job creation which continues at a sturdy pace, pushing unemployment down to 50-year lows and bringing formerly discouraged, retired, and part-time workers back into full-time employment. Stocks and bonds recovered from their December 2018 sell-off, and while we expected a bounce off the Christmas Eve bottom, we didn’t expect it to be delivered with such strength. The market strength was not a function of an improvement in economic data, but a result of the surprisingly swift reversal in Fed policy after markets hit the skids in December. The almost 20% decline in stocks proved to be the “pain point” that turned a hawkish Fed dovish. Planned interest rate hikes and balance sheet reduction have now been put on hold. This change in direction increases the likelihood that the economy continues to grow through 2019, making it the longest expansion on record.
The Fed is changing the way they think about inflation emphasizing a “symmetric” target around 2%. This means inflation would average 2% rather than 2% being a ceiling. Despite all the monetary and fiscal stimulus over the past 10 years, inflation has had a difficult time punching through 2%, leaving it chronically below target. A key benefit of higher inflation is to allow wages to accelerate further (already running at 3+%), which is great for American households whose inflation-adjusted wages have been stagnant for the better part of two decades. The higher target would also be good for risk assets if held in check.
Risky investments were rewarded by the dovish shift but interestingly, so were low risk bonds. Simultaneous bursts upward in both the riskiest and the least risky investments are a rare occurrence. Typically, low risk assets like US Treasuries spike when investors panic and flock to safety, coinciding with a risk-off market where stocks fall. With assets at both ends of the risk spectrum rising in the first quarter, an inconsistency of logic has emerged: Are lower yields (the flight to safety) discounting a near-term recession? Or, are higher stock prices discounting stronger growth? However these questions are ultimately answered, stock investors took heed to the old saying “Don’t Fight the Fed” and were duly rewarded for staying the course over the past 3 months.
The US economy continues to stand tall amongst developed economy peers, particularly in Europe where Germany and Italy appear poised for recession. Germany’s economy is the engine of Europe but has been beset by lower exports, specifically to China. In China, slower growth last year appears to be bottoming as massive fiscal stimulus works its way through consumer spending and manufacturing. The growth recovery there (from a bottom of 6% – still the envy of the world) is also evident in yield curve steepening. A stronger China would have positively impacted the global economy, particularly Europe who has the most to lose. China now represents 40% of global growth and is the 2nd largest economy in the world behind the US and ahead of Europe and Japan. The trade tensions that have taken a toll on China will abate as an agreement approaches. Removing that uncertainty should lift animal spirits around the globe.
Despite a strong recovery, stocks are still not back to their September 2018 highs. Setting new highs from here will not come easy. Valuation compression (lower P/Es) and higher volatility were ushered in by Fed tightening in 2018 and are likely here to stay even with the Fed pause. As we move through the remainder of the year, we are focused on the impact of slower earnings growth (off an incredibly strong 2018) and lingering recession fears (investors seem to have an itchy trigger in year 10 of the expansion). Both are likely to keep investor enthusiasm capped this year despite a low chance of recession over the next 12 months. We continue to believe late-cycle portfolio positioning and exposure to diversifying investments will serve us best this year regardless of whether we are in the 7th, 8th or 9th inning of the expansion. Late innings of a cycle are the hardest to navigate.
1st Quarter 2019 Performance
- Stocks globally rebounded strongly (↑12.5%) led by US Small and Mid-Cap stocks (↑15.9, ↑15.5%), US Large Cap (↑13.7%), Emerging Markets (↑10.5%), International Developed (↑10.1%), and International Small Cap (↑10.0%). The strong US Dollar continued to weigh on non-US equities although that appears to be waning.
- Non-US equites continue to trade at a valuation discount to the US. They also carry a 4% dividend yield, earnings growth this year expected to be 7–8%, and 10x–13x price-to-earnings ratios, all more attractive than US levels. US earnings need to beat growth expectations to provide support for stocks which will be difficult. Non-US stocks appear to have more upside given lower valuations, good earnings growth despite low GDP growth, prospects of US Dollar weakness and reduced trade war fears.
- Total return for Taxable bonds turned in an extremely strong quarter (↑2.9%) as interest rates plummeted. Municipal bonds were also strong (↑2.4%). Securitized Credit (high quality mortgages and asset-backed securities) also had a strong quarter (↑2.8%). High yield corporates (junk bonds) recovered most of their 4Q losses (↑8.1%) Ultra-short US Floating Rate Treasuries (↑0.54%) rose at an annualized rate of 2.24%, in line with Fed Funds, as expected, and continue to be earmarked for higher yielding credit sector investment when risk/reward ratios return to more compelling levels.
- Looking forward, shorter duration is preferred over longer duration given the flat yield curve and the dramatic move down in rates. The US Treasury bond market is discounting an elevated likelihood of recession which is at odds with credit spreads that are near all-time lows. Higher interest rates may still be in the cards later this year as central banks move to neutral or easing and massive amounts of new supply enter the market due to deficit funding and refinancing.
- The Alternatives portfolio performed in line with expectations (↑1.6%) on track to achieve our 5.5% annualized return target with overall risk closer to bonds than stocks. Category performance was led by Hedged Equity (↑3.5%) and Multi Strategy (↑3.9%), followed by Market Neutral (↓1.8%) and Managed Futures (↓1.5%).
- Hedged Equity was helped by a strong recovery in the Emerging Markets Long/Short strategy and solid performance in Multi Strategy due to strong fixed income positioning that took advantage of credit spreads and duration following the Fed change of course at the start of the quarter. In the 4th quarter, however, Managed Futures (↑4.26%) and Market Neutral (↑1.54%) provided diversification and downside protection during that quarter’s equity market correction.
As always, contact us if would like to discuss these topics further.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer