The known unknowns…
The market backdrop faces a confluence of several unpredictable headwinds that have garnered vast media coverage: trade tensions, slowing global economic growth, declining corporate earnings growth, geopolitical tensions, and changing U.S. monetary policy . Despite the looming storm clouds, virtually every major asset class produced a decidedly positive return during the first half of the year. The broader equity markets, measured by the S&P 500 and MSCI ACWI rose an impressive 18.5% and 16.2% respectively for the year-to-date period.
The potential market headwinds have raised a myriad of questions that are being bantered about. Here is a sample of a few concerns we continue to ponder. Are we entering the beginning of another phase of monetary policy easing (i.e. Fed cutting interest rates)? What ammunition does the Fed have left to stabilize the economy? What will be the Brexit outcome? What will cause the end of the current U.S. expansion? What will be the eventual impact of trade tensions? What is the outlook for corporate earnings? Do corporate debt levels appear elevated? Will the growth of lower quality corporate bonds exacerbate the next economic downturn? If you think about it, the list of questions and concerns is nearly infinite. It is also unrealistic to believe any group will answer them all with a high degree of certainty. We take a weight of the evidence approach and leverage a disciplined, unemotional process to generate conviction for our portfolio positioning in the current investment landscape.
With a backdrop that appears increasingly worrisome to many, we are reminded of a phrase we often express to clients- “We can’t control how the capital markets behave, only how we allocate to them.” To this point, we thought it was an appropriate time to reiterate that our customized investment approach is informed by objective and well-established indicators to assess the level of risk in the current market environment. We adhere to the belief that diversification remains the “only free lunch in finance” (a phrase popularized by the Nobel-winning economist Harry Markowitz). Diversification is best thought of as the trade-off between anticipated portfolio upside and possible downside over various time periods. As a result, a custom-tailored, goals-based asset allocation is the primary driver of a client’s long-term, risk-adjusted investment returns.
As the economic expansion continues, we embrace the mantra of “no boom, no bust”. While July will mark a milestone as the longest modern U.S. expansion on record at 121 months, it is important to note that it has been lowest in intensity. Previous expansions have fared significantly better according to the National Bureau of Economic Research. Growth has averaged about 2.3% a year during the current expansion, far slower than the 3.8% annual average during the 1990s expansion (see cite 1). While growth most recently surprised to the upside in the first quarter (up 3.2% year-over-year), initial reports suggest growth will decelerate closer to the recent longer-term trend. The party is slowly winding down and the business cycle will likely contract at some point from over-investment, excess in the economy, or from an unforeseen exogenous shock. In whichever case, it is likely to trigger a downward spiral of consumer and business retrenchment, the severity of which remains the wild card.
Global trade tensions, particularly U.S. versus China, remain center stage, posing a meaningful threat to a global economy that is already slowing. Combined, the two largest economies in the world represent approximately 40% of global GDP (see cite 2). A prolonged trade war is unsettling and will likely lead to continued market volatility as negotiations ebb and flow. The President has long accused China of unfair trade practices and theft of intellectual property. He has sought to close the trade deficit gap with China, which stood at $419 billion at the end of 2018 (see cite 3). As background, recall that the U.S. has imposed tariffs of up to 25% on approximately $250 billion of Chinese imports to the United States. China retaliated by imposing its own tariffs on U.S. goods entering China. At the time of this writing, the roller coaster negotiations between the two nations appear to have calmed temporarily as a result of the G20 summit in Japan. At the G20, President Trump called off the tariffs set to be imposed on the remaining $300 billion+ of goods in order to continue negotiating with Beijing “for the time being”
Overall, the cost of tariffs is born by customers– U.S. manufacturers and consumers in the form of rising prices. Other strategies include U.S. companies accepting lower profit margins by cutting costs– wages and jobs of U.S. workers or deferring wage increases. While we remain guardedly optimistic that “cooler heads will prevail”, we recognize that a true resolution will inevitably take time.
While the sentiment in the International and Emerging Market equity markets has been largely negative, it is important to keep in mind that in a binary world of stocks and bonds, stocks still look cheap versus bonds. The plunge in global bond yields has increased the relative attractiveness of stocks over bonds. Does loaning money to the German government for ten years at -.33% sound good? (According to Bloomberg, the World now has over $13 trillion of bonds with below-zero yields.) As we noted last quarter, the negative sentiment overhanging the Eurozone, historically attractive valuations, and the modestly improving corporate earnings backdrop present a relatively compelling opportunity. Lastly, International markets stand to benefit from a weaker U.S. dollar, a scenario that looks more likely now that the Fed has signaled a willingness to bring US monetary policy more in line with other developed markets. Could it finally be time for Non-U.S. assets to outperform?
Our overall view of the investment landscape has not changed. We remain neutrally positioned relative to our diversified global benchmarks across the broad asset classes with a conservative tilt within several of our equity asset classes. We maintain a tactical overweight to U.S. Equities and U.S. Fixed Income Credit, while maintaining an overall short-duration fixed income allocation. We are increasingly focused on our expanding pipeline of compelling Private Market investments, particularly in areas that we anticipate will be less impacted by slowing economic growth. Global growth is clearly slowing, earnings growth expectations continue to decline, and the Fed will likely begin using the limited tools available to stage off a further slowdown. Rest assured, wherever the near-term road leads, we remain nimble and active in order to react accordingly with changes in the global investment landscape.
1 - National Bureau of Economic Research, St. Louis Federal Reserve
2 - World Bank
3 - U.S. Census Bureau
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
New World Advisors, LLC ("New World") is a registered investment advisor. Advisory services are only offered to clients or prospective clients where New World and its representatives are properly licensed or exempt from licensure.