• Our constructive view on equities enabled solid participation in the first-half run up
• We are focused on potential market vulnerabilities including entrenched trade frictions and slowing global growth
• We are currently favoring longer-dated, high-quality bond exposure combined with low-volatility equity strategies to mitigate downside risk
After the brutal flogging the market took late last year, few expected such a strong start to 2019, with world equity returns registering one of the best first halves in more than 20 years. Also notable, however, was the backdrop of deteriorating economic growth and softening earnings data during the period. Furthermore, while the second quarter ending June 30th marked the longest expansion in recorded US history at 120 months, it’s also the weakest expansion in recorded history. This dynamic has set the stage for an odd tug-of-war between the President and the Fed that has important implications for the economy and portfolios; on the one hand, our economic longevity has emboldened the President to push ahead with more protectionist trade policies, policies that have contributed to slowing global growth; on the other hand the Fed is attempting to forestall the inevitable end of this cycle by signaling a willingness to cut rates, further stoking gains in risk assets. As a result, economic policy uncertainty and equity markets have reached all-time highs in unison, something that is rare and, we believe, unsustainable.
Going into last Fall, the yield curve began sending strong signals that the economy would be decelerating in the medium term. We listened to that signal and added longer-dated bonds (duration) to portfolios to protect against equity market volatility and we reduced our exposure to corporate credit exposure in favor of higher quality debt (treasuries) that would be more immune to deteriorating credit conditions. These changes were supportive of portfolios during the ensuing sharp drawdown in global equities. However, after a 20% decline in US equities, we also recognized that market sentiment was significantly out of step with prevailing economic conditions. US economic data at the time simply didn’t support the extreme negative outlook that had overcome equity markets. We maintained exposure to growth assets with the expectation that markets would eventually digest the data and recover. We did not expect a full 20% rebound in equity prices from the bottom, but we were happy to take it.
Now, however, data is beginning to show that the protectionist push is becoming more entrenched. The US has added more countries to target with tariffs (most notably Mexico) and has escalated its rhetoric with others. Meanwhile, in some cases countries have reciprocated with their own tariffs, or more subtly by weakening their currencies versus the US dollar to get an export edge in the face of the tariffs. Global growth, especially in manufacturing, has slowed dramatically among the world’s largest economies: the US, China, Germany, and Japan. Globally, companies are exhibiting less willingness to spend in the face of uncertainty while in the US, companies are increasingly focused on moving supply chains out of China to places like Vietnam and India which, for the time being, appear to be safer bets than China. The outlook for global growth has not been this negative since August 2011, when the future of Europe’s economic union appeared to be in serious jeopardy.
Fortunately, global central banks have been quick to pick up the slack as best they can. Across the globe, central banks have shifted to more dovish policy stances. This means they have indicated a willingness and readiness to provide more stimulus to reduce downside risks should they emerge. The Fed, which just raised rates as recently as December, is now expected to cut rates at least twice this year and by as much as 0.5%. It’s not clear, however, that monetary stimulus alone can effectively offset the protectionist push that is underway. What is clear is that this economic civil war among policymakers is the primary risk to the economic expansion and equity valuations at a time in the economic cycle when markets are more typically concerned about overheating and inflation.