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Investment Commentary - July 2019

MARKET RECAP: EVERYTHING WENT UP!


The first half of 2019 saw robust gains across most asset classes, but it certainly wasn’t a smooth ride. Global stock markets got a jump start on the year thanks to progress in U.S.-China trade negotiations and a newly “patient” Fed, but an abrupt breakdown in the trade talks (announced via Presidential tweet) spurred a sharp market sell-off in May. Stock markets subsequently shook off their swoon in June, rebounding on expectations of Fed rate cuts later in the year and (tentative) signs of re-engagement on the U.S.-China trade front. 

The S&P 500 hit a new high near the end of June. Large-cap U.S. stocks shot up 7.0% for the month—their best June since 1955They were up 4.3% for the second quarter, and a remarkable 18.5% for the first six months of the year—their best first half since 1997.

Developed international stocks gained 5.9% in June, 3.2% for the second quarter, and 14.2% for the year to date. European stocks have done a bit better, gaining 15.6% on the year so far. In April, the “Brexit can” was kicked down the road at least until October 31, but the risk of a disruptive “no-deal” exit remains.

Emerging-market (EM) stocks also rebounded in June, gaining 5.4%. Although EM stocks were only up 0.8% for the second quarter, their first-half gains stand at 12.6%. The dollar was roughly flat versus EM and developed market currencies over the six-month period.

Moving on to the fixed-income markets, the 10-year Treasury yield continued to plunge from its multi-year high of 3.2% last October, dipping below 2% following the Federal Reserve’s June meeting. This was a near three-year low, and among its lowest levels ever. The 10-year yield ended the month at 2.0%. Bond prices rise as yields fall, driving the core bond index to a 2.6% gain for the quarter and an impressive 5.0% return so far this year. Our non-core positions in high-yield and emerging market debt continued their run and are up 9.9% and 11.3% respectively for the year.

As an aside—and as further evidence of the consistently poor track record of market forecasters—the consensus of 69 economists and analysts surveyed in January by the Wall Street Journal was that the 10-year Treasury yield would rise to 3% by mid-year. None of them predicted the yield would fall below 2.5% this year, let alone down to 2%!

Mid-Year Outlook: Heightened Uncertainty

In our year-end 2018 commentary, we emphasized the wide range of plausible macroeconomic scenarios and financial market outcomes for the year ahead. At the time, stocks were experiencing sharp short-term losses, reflecting worries of a global economic slowdown, central bank monetary tightening led by the Federal Reserve, ongoing U.S.-China trade tensions, and geo-political uncertainties in Europe (Brexit, Italy) and elsewhere. We highlighted the potential for either a bullish or bearish shorter-term path to play out.

Through the first half of 2019 we’ve gotten a little bit of everything—signs of both the bullish and bearish scenarios. When it comes to short-term market predictions, “Anything can happen… and so far this year, it has!”

Below, we recap our outlook and provide updated perspective on some of the key issues and uncertainties we highlighted at year-end, including central bank policy, global and U.S. economic growth, trade conflicts, and political/geopolitical risks.

Central Bank Monetary Policy

Central bank policy has had an enormous impact on financial markets since the 2008 financial crisis. We’ve seen that continue in 2019, marked by two major shifts in the Federal Reserve’s stance. First, the Fed shifted from tightening monetary policy in 2018 (where it was raising the fed funds policy rate and unwinding some of the assets on its bloated balance sheet) to a “patient” stance (i.e., rate hikes are on hold) in the first quarter of 2019.

Then at its recent June Federal Open Market Committee (FOMC) meeting, the Fed signaled it was inclined towards loosening policy once again, setting the stage for rate cuts later this year (possibly as early as its July 31 meeting) and/or next year. Fed chair Jerome Powell cited heightened uncertainty around the outlook for global growth, trade policy, below-target inflation, and falling inflation expectations. While the fed funds rate was left unchanged at 2.25% to 2.5%, Powell stated “the case for somewhat more accommodative policy has strengthened.” He also noted, “many FOMC participants believe some cut in the fed funds rate will be appropriate in the scenario they see as most likely.” Specifically, eight of the 17 FOMC participants now project the Fed will cut the benchmark rate this year, with seven of those projecting two quarter-point reductions (50 basis points). Eight participants expect the rate to remain unchanged and one thinks the Fed will hike rates this year.

Other global central banks are also pivoting back towards looser policies, including recent dovish statements from European Central Bank (ECB) President Draghi. The following chart from Ned Davis Research (NDR) shows that a majority of the world’s central banks are now cutting rates (indicating an easing cycle), up from just 38% of banks easing in January. Historically, this has tended to be bullish for global stocks.

Generally looser monetary conditions are a stimulant for financial markets and asset prices, all else equal. A lower interest rate implies higher asset valuations (e.g., higher P/E multiples). But all else is rarely equal. And the implications of lower rates and monetary stimulus are not so obvious when you go beyond simple, first-level thinking to consider the broader economic context

for these low rates (i.e., concerns about slowing growth and very low inflation). It is also critical for an investor to understand what information and expectations are already being discounted in current market prices.

Regarding the latter, the fed funds futures market is now discounting a 100% probability the Fed cuts rates by at least 25 basis points in July, 92% odds of at least two quarter-point rate cuts by year-end, and 60% odds of three or more rate cuts. Meanwhile, the S&P 500 index hit a new all-time high in the aftermath of the June Fed meeting and Treasury yields hit a multi-year low.

So, there is a non-trivial possibility the Fed surprises (disappoints) the markets by not cutting as much as expected, or at all. (While the Fed set the table for a cut in July, they still say they are “data dependent.”) Of course, the Fed is aware of market expectations. And it knows that market reactions to its behavior can impact the real economy, which can lead to further market reactions, Fed reactions, subsequent market reactions, economic impacts, etc. Such self-reinforcing feedback loops may be helpful or harmful to achieving the Fed’s economic mandate. But the Fed can’t always control them.

While U.S. bond yields are very low, at least they are still positive. Across much of Europe and Japan, government bonds have negative yields; the total dollar amount of negatively yielding debt recently shot above $13 trillion, a record high. About half of all European government bonds have a negative yield, including almost 90% of German government bonds. The German 10-year Bund recently yielded negative 0.33%, its lowest ever. The ECB’s policy rate (the “deposit rate”) stands at negative 0.4%.

None of this normal. The consequences of these unprecedented monetary policies are highly uncertain. And we’ve seen the market disruption caused by even modest attempts to unwind them (in the U.S.), or even just the suggestion of beginning to tighten policy (in Europe).

In the face of continued weak eurozone economic growth, below-target inflation, and falling inflation expectations (dropping from 1.8% in January to below 1.2% on one closely followed measure), the ECB was forced to reverse course in the first half of 2019 as well. Markets now expect the ECB to lower the deposit rate later this year and restart QE asset purchases next year.

The market’s expectations for imminent central bank easing are clear. But it’s important to note, the market is not pricing Fed easing because of credit issues or liquidity concerns, or even financial stability issues; it’s pricing Fed easing because of expectations of a meaningful downtick in growth rates.

Given the underlying growth dynamics, the required amount of Fed easing should be relatively low. The easing cycle of 1998 – three cuts totaling 75 bpts – may be a good analogy.

The Global Economy

The global economy remains in a sustained slowdown. The revival of trade tensions, imposition of additional tariffs, and uncertainty over further protectionist policies have taken a toll on global trade, manufacturing, and business sentiment, with negative implications for future investment spending and hiring.

However, foreign stock market valuations are already discounting a lot of negative news and uncertainty. And importantly, without a U.S. recession, history suggests the likelihood of a severe equity bear market is low.

So, is a U.S. recession on the near-term horizon? We don’t know. No one knows. There are plenty of mixed signals and economic indicators to support almost any view on this. But there is enough evidence for investors to take the recession risk seriously, if not within the next 12 months then within the next few years. The precise timing and path is uncertain, but sooner or later the United States will have another recession and a painful bear market associated with it.

The evidence among the key U.S. recession indicators we track is mixed. However, some important indicators, while still positive, are weakening.

On the negative side, the yield curve (3-month T-bill vs. 10-year Treasury) has been inverted for over a month now. According to NDR, yield curve inversions have been a precursor to each and every of the seven U.S. recessions in the past 50 years, albeit with variable and sometimes long lag times—ranging from six to 23 months. (There have also been two inversions that were recession “false alarms,” in 1966 and 1998.) The widely followed New York Fed U.S. Recession Probability model, which is based on the yield curve spread, jumped to 30% in May, its highest level since 2008.


On the positive side, the U.S. Conference Board’s Leading Economic Index (LEI) remains at peak levels. Historically, the LEI has peaked a median of 11 months before the onset of recession (with a range of between eight and 21 months). The LEI also shows a positive (albeit declining) 12-month rate of change. No recession has begun with the LEI’s year-over-year percentage change still above zero. According to the Conference Board, the latest result “clearly points to a moderation in growth towards 2% by year-end.” While that’s not a strong growth rate, it is right in line with most estimates of the U.S. economy’s long-run sustainable growth rate, which is a function of labor force growth and productivity growth.

Another recession composite, NDR’s “U.S. Recession Watch Report” lists only one of ten recession indicators currently flashing red—the CEO Confidence Index. Six indicators are strongly positive (including measures of financial conditions, consumer confidence and the labor market), and three are neutral.

Let’s also step back and look at this U.S. economic cycle in a broader historical context. As of July, this will be the longest economic expansion in U.S. history, beginning its 11th year. However, it’s also been the mostsluggish recovery in the past 70 years. Real GDP growth has averaged just 2.3% per year during this expansion, compared to a median growth rate of 4.4% per year for the prior 11 post-WWII expansions.

Arguably, this recovery doesn’t yet exhibit the financial market excesses (asset price bubbles) or economic overheating (inflation) typically seen late in the cycle. Such excesses or imbalances are what lead the Fed to tighten monetary policy and ultimately—inevitably—kill the expansion and tip the economy into recession.

As such, successful investors must remain flexible and open-minded, but still grounded in a fundamental investment discipline, rather than seeking falsely precise answers (e.g., When will the recession happen? What will the Fed do next?).

Outlook for Trade and Other Geopolitical Risks

Rising political uncertainties since early 2018 have constrained economic confidence and still seem to be the main economic risk. Unfortunately, the risk of a geopolitical shock on financial markets is ever-present. An impulsive and erratic U.S. president may increase that risk, but it is always there. Most recently, there is heightened potential for a military conflict with Iran. But there are many other potential geopolitical flashpoints and unknowns: Brexit remains unresolved. The tug of war between democracy, populism, nationalism, and autocracy continues around the globe. The U.S. presidential election next year will likely create additional market uncertainty. China’s rise and challenge of the United States as a global superpower goes well beyond just the current trade conflict. The Middle East (beyond Iran) remains a potential flashpoint. Don’t forget about North Korea. And so on.

We read the headlines like everyone else and don’t believe we have any unique insight or edge in assessing these events on a day-to-day basis versus the consensus. New information is continuously reflected in financial asset prices. For us to make a tactical investment decision based on political or geopolitical developments, we’d need to believe we have a meaningfully different view than what’s currently being reflected and also have high conviction that we are right and the market is wrong. Instead, we incorporate the potential for external shocks (geopolitical and otherwise) within our strategic (long-term) portfolio construction, multi-asset/multi-strategy diversification, and shorter-term downside risk management.

As we said last month, uncertainty is a constant presence and volatility can return to markets at the drop of a tweet. Those of us who own stocks need to be prepared to ride through the inevitable down periods. It’s the shorter-term price we pay to earn their higher expected returns over the longer term.

In the event of an external “shock” event, it historically has paid not to panic and get out of the market. Rather, it is during these moments when one’s investment discipline pays off, opportunistically looking for attractive investments that may be “on sale” due to excessive short-term market fear.

Closing Thoughts on Portfolio Positioning

In his latest memo, Oaktree Capital co-founder Howard Marks wrote: “In recent years, the U.S. has simultaneously experienced economic growth, low inflation, expanding deficits and debt, low interest rates, and rising financial markets. It’s important to recognize that these things are essentially incompatible. They generally haven’t co-existed historically, and it’s not prudent to assume they will do so in the future.”

We agree there is a high likelihood this benign macroeconomic backdrop won’t be sustained over the next five-plus years. U.S. stock market valuations and expected returns imply the market consensus maybe discounting an overly optimistic outlook. However, we continue to recommend balancing our portfolios to international large and small-cap stocks. Our analysis indicates their valuations are very attractive relative to the U.S.

Over the shorter-term (i.e., the next 12 months), if the global economy starts recovering from current depressed levels—with China’s fiscal and monetary stimulus being a key to that outcome—and the United States remains clear of recession, we would not be surprised to see out performance from developed international and EM stocks versus U.S. stocks. Further, if the growth differential between the United States and the rest of the world narrows, the U.S. dollar will likely depreciate, providing an additional tailwind to foreign stock returns for dollar-based investors.

In this global growth recovery scenario, our active equity managers’ exposure to more cyclical value stocks (e.g., financials, industrials, consumer discretionary, technology) would also likely outperform more defensive “bond proxy” sectors (e.g., utilities, REITs, consumer staples). Most of our managers view the latter as unattractive and overvalued, but these sectors have rallied the past year on plunging bond yields. A solid global economy would continue to benefit our higher yielding credit strategies and emerging market positions relative to core investment-grade bonds.

On the other hand, if the United States falls into a recession and bear market, our balanced portfolios have “ballast” in the form of meaningful exposure to core bonds as well as lower-risk fixed income strategies that should hold up much better than stocks on the downside. These lower-risk, diversifying positions have been a drag on our overall returns over the past several years as U.S. stocks have been in a raging bull market. But we’ve seen their benefits during the occasional market corrections, including in last year’s fourth quarter.

That said, and it bears repeating, our balanced portfolios will experience shorter-term losses if we do get a bear market due to our overall equity- and credit-risk exposure coupled with the very low current yields on core bonds.  In other words, the core bond ballast won’t be as buoyant in the next bear market as in past cycles when their starting yield was much higher, which provided an additional return cushion as stocks fell.

This has been an unusually long U.S. economic and market cycle. But we firmly believe it is still a cycle, and that our patience and fundamental valuation discipline will be well-rewarded as it turns again. As always, we appreciate your continued confidence and trust in Argent.