New World Advisor's Q2 Commentary
What a difference a quarter makes…
The past two quarters have proven to be a wild ride for investors. Equity markets quickly pivoted from fourth quarter heightened fears of a global economic slowdown, rising U.S. interest rates, and mounting trade wars. The recognition has become that the U.S. economy is in the late stages of an expansion, which could continue to trudge along for an extended period.1 It is important to note that the expectation of a late cycle economic slowdown does not mean a recession is imminent.
Gains for the first quarter were impressive, as the S&P 500 (+13.7%) and MSCI ACWI (+11.7%) posted the best quarter in twenty-one years. Performance participation was broad based as all the major asset classes posted notable gains.
According to the key economic indicators we monitor, the overall U.S. economy remains healthy. The two key sectors of the economy - consumer and business remain in overall fine shape. For the consumer, the unemployment rate remains historically low at 3.8%,3 household debt service ratio remains reasonable, and wages have slowly begun to rise. On the business side, companies have ample cash and access to capital, while a positive corporate earnings surprise seems increasing plausible given the now muted analysts’ expectations.
During the quarter, a surprise shift from the Federal Reserve and comments by Fed chairman Powell proved to be a catalyst for the strong quarterly market rebound. Powell indicated the tightening path of raising short-term interest rates was on hold given “crosscurrents”. The basis for the pause appears to be concerns surrounding the downturn in global economic activity, particularly in China and Europe. A prolonged Brexit process and U.S. trade war negotiations are assumed to have influenced the Fed’s decision. In late March, the Fed dramatically unscored its plans to be “patient” regarding any further interest rate increases during 2019.
In late March the U.S. Treasury curve inverted; an inverted curve means that investors would earn a higher interest rate per year holding a shorter-dated maturity Treasury than holding a longer-dated maturity. A prolonged yield curve inversion is viewed as a classic signal that a recession is forthcoming. However, historically there have been nearly two years between a yield curve inversion and the start of a recession. Although the yield curve is reflecting nerves in the equity market and pressures from historically low global interest rates, investors leave meaningful portfolio growth on the table if they use this indicator exclusively in their asset allocation. Over the past thirty years, the S&P 500 has risen by double digits between the initial inversion and the start of the subsequent recessions.
On the global economic front, China has been going through a challenging adjustment period of revamping their economy to be less dependent on exports and the outside world. As a result, Beijing is attempting to shift to a more consumption-based economy, while reducing the reliance on debt for fueling growth.
Meanwhile, trade tensions with the U.S.
remain a focal point, despite China’s
trade surplus with the U.S. hitting a
record last year. If trade negotiations
escalate, tariffs pose the possibility of
having a more significant impact on
China’s economy in 2019. We believe
cooler heads are likely to prevail with
an amicable resolution to the trade
dispute. A stabilization of the Chinese
economy and trade resolution should prove positive for China.
Emerging market equities fell significantly during 2018 as the macroeconomic and geopolitical developments weighed on market sentiment. This provided an opportunity for us to increase the Emerging Markets allocation in client portfolios earlier in the quarter. We believe that the Emerging Markets represent an increasingly diverse and dynamic opportunity set, with economic growth expectations markedly above the global average. Emerging Markets have solid fundamentals and attractive equity market valuations coupled with earnings expectations stronger than in the U.S., Europe, and Japan.
Within our Fixed Income allocations, we reduced the duration or sensitivity of bond prices to changes in interest rates during the quarter. Despite the Fed appearing to be on pause regarding rate hikes, our belief is that there is not enough incremental return associated with taking on additional interest rate risk.
The global economy is forecast to decelerate during 2019, with areas such as the Eurozone slowing more significantly. The slowdown is likely to keep global interest rates lower for longer. We continue to evaluate all the factors surrounding our portfolio allocations, particularly the relative valuations and growth expectations of various regions and asset classes. We are nimble and proactive in the face of changing opportunities. As Warren Buffet famously stated, “Be fearful when others are greedy and greedy when others are fearful”. To this point, the increasingly negative sentiment towards the Eurozone and attractive valuations could present a compelling opportunity to tactically increase our under-weight allocations in the months ahead.
In conclusion, we remain neutrally positioned relative to our diversified global benchmarks with a tactical overweight to Emerging Market Equities and Bonds, U.S. Small-Cap Equities, and U.S. Fixed Income Credit, while maintaining an overall short-duration fixed income allocation. Lastly, our pipeline of compelling Private Market investments remains strong. It encompasses a spectrum of opportunities and strategies for both capturing the potential long-term secular drivers of global growth, while providing diversification to niche, inefficient areas of the economy. As always, we take a weight of the evidence approach and assess new information as it becomes available in order to react accordingly with changes in the global environment.