Commentary from Our Chief Investment Officer—First Quarter 2019 Review & Outlook

April 18, 2019

What Caused the Rebound: The Fed not the Fundamentals 

The key catalyst for the rebound in equity markets was a significant shift in the Federal Reserve’s stance on monetary policy. In late December and throughout January, the Fed became much more dovish. After hiking interest rates four times in 2018, including at their mid-December meeting, and indicating further tightening would occur in 2019, Fed officials suddenly reversed themselves. They emphasized they would be “patient” and pause any further rate increases. In early January, Fed chair Jerome Powell said the Fed could also slow down or stop shrinking its balance sheet of bonds purchased during quantitative easing. This came just two weeks after saying the Fed’s balance sheet reduction program (quantitative tightening) was “on autopilot.” The U-turn in Fed policy was music to the ears of the financial markets, which had become concerned about ongoing policy tightening in the face of slowing economic growth in the United States and abroad. 

There were other positives for the markets as well: The federal government shutdown, which had started to weigh on sentiment, ended in late January. Signals from the U.S.-China trade talks turned more positive, although far from anything definitive. The likelihood of a “hard Brexit” also seemed to wane, but again, far from anything definitive. 

In sum, the market rebound was due more to improving investor sentiment and risk appetite—caused largely by the shift in Fed monetary policy—than any meaningful improvements in underlying economic or business fundamentals. 

In fact, most economic indicators show a continued deceleration in global growth this year. For example, as reported by Ned Davis Research, the OECD’s (Organisation for Economic Co-operation and Development) composite economic leading indicator fell for the 16th straight month in January to its lowest level in nearly a decade. Other broad global economic indicators, such as BCA’s Global Leading Economic Indicator and Citigroup’s Economic Surprise Index, reflect similar headwinds. 

The U.S. economy is in better shape than most, but even here growth expectations have been coming down. At its Federal Open Market Committee (FOMC) meeting on March 20, the Fed downgraded its median GDP growth estimate to just 2.1% for 2019 and 1.9% for 2020, citing the effects of economic slowdowns in China and Europe, fading stimulus from the 2017 Trump tax cuts, and ongoing uncertainty around Brexit and trade policy.  

At its March meeting, the Fed also cemented the dovish stance it had signaled in prior months. It made clear the majority of FOMC members no longer expect to raise rates at all in 2019. (In contrast, in December it was expecting two more hikes this year.) It reiterated it will remain patient and “data dependent” regarding any future changes in the policy rate, raising the possibility that its next move could be a rate cut. Fed chair Powell cited persistently low inflation/disinflation across the globe as “one of the major challenges of our time” for central bankers. Regarding the U.S. economy, he said, “I don’t feel that we have convincingly achieved our two percent [inflation] mandate in a symmetrical way. That gives us the ability to be patient, and not move until we see that our target goals are being achieved.”

The Fed also announced it would stop the roll-off of Treasury bonds on its balance sheet (quantitative tightening) at the end of September, somewhat earlier than expected. That will leave the Fed holding $3.6 trillion in securities, around 17% of U.S. GDP. This compares to 6% of GDP before the financial crisis. If the March announcement does mark the end of this Fed tightening cycle—with the real (inflation-adjusted) federal funds rate barely above zero and a bloated Fed balance sheet—it will be another indicator of just how far our economic and financial system has veered from the old “normal,” reflecting the ongoing impact of unprecedented monetary policies since the financial crisis.  

It’s also worth noting that two days after the Fed’s announcement, the 10-year Treasury yield fell to 2.44%, causing an inversion in the yield curve between the 10-year Treasury and the 3-month T-bill, which yielded 2.46%. A persistently inverted 10-year/3-month yield curve has been a consistent leading indicator of recession in past U.S. economic cycles, although the lead time has been variable and lengthy—anywhere from four to 16 months prior to the onset of recession. 

Besides the indicators of a slowing economy, U.S. corporate earnings growth expectations have also continued to decline, albeit from unrealistically lofty levels last year. The chart to the right from BCA shows 2019 consensus earnings-per-share growth estimates for the S&P 500 dropping from 12% (as of 12/31/18) to just 4.1% as of mid-March. Even with the Fed now on hold, earnings growth will need to improve for stocks to appreciate meaningfully from current levels, given their sharp rebound in the first quarter and high valuations.  

First Quarter Portfolio Performance & Key Performance Drivers 

Our portfolios generated strong performance for the first quarter, benefiting from the rebound in financial markets. Returns were driven by our allocations to U.S., international, and emerging-market (EM) stocks. Our modest overweight positions in European and EM stocks were positive absolute contributors but slightly trailed U.S. stock returns. However, our actively managed domestic, international, and global stock funds added value, as in aggregate they outperformed the benchmark indexes for the period.  

Moving on to bond markets, our positions in actively managed flexible income and floating-rate loan funds also generated strong returns and, in aggregate, outperformed the benchmark core bond index. 

Finally, regarding alternative strategies, our allocation to lower-risk actively managed funds also had positive returns that were better than core bonds but well below the soaring stock market. Given their lower-risk and more defensive positioning, this was to be expected. Our trend-following managed futures funds produced strong returns in March—better than both stocks and bonds—but were slightly positive for the full quarter. After delivering positive returns during last December’s stock market swoon, trend-following strategies were hurt by the sharp market reversals in January.  

Looking Ahead: Reviewing our Portfolio Positioning and Performance Expectations Across Different Scenarios 

It certainly feels better to see strongly positive portfolio performance this quarter compared to the losses in the fourth quarter of 2018. But just as we wouldn’t extrapolate last year’s losses when looking out over the coming years, it’s equally important to temper our expectations on the upside after this quarter’s strong rebound.  

This is particularly true for the U.S. stock market, which is back up to its levels of early October 2018. Which is to say, in our assessment, U.S. stocks, in aggregate, remain expensive and overvalued relative to their underlying earnings fundamentals over the next five to 10 years. An annualized return in the low to very low single digits is the most likely outcome for the U.S. stock market from current levels. 

Our medium-term (five- to 10-year) tactical outlooks for the other asset classes and investment strategies in our portfolios have also not materially changed. Our assessment of shorter-term (12-month) downside risks and stress-testing results also remains consistent with prior periods. As such, we didn’t make any changes to our portfolios during the quarter.  

We can group the investments in our portfolios into four broad categories to highlight their different roles in the portfolio’s overall risk-return profile:  

  • Longer-Term Return Generators (equities) 
  • Shorter-Term Risk Reducers (core investment-grade bonds) 
  • Hybrid Investments (flexible income and floating-rate loan funds) 
  • Diversifying Alternatives (lower-risk alternative strategies and managed futures) 

When building and managing diversified balanced portfolios that meet a client’s risk tolerance and investment objectives, we weigh potential returns and risks across a range of macroeconomic scenarios and different time horizons—from 12 months to 20-plus years.  

Our strategic asset allocations are the foundation of our portfolio construction and based on a long-term (10- to 20-plus-year) outlook. Building off these strategic allocations, our tactical asset allocation decisions are designed to take advantage of meaningful market inefficiencies and dislocations. Tactical decisions are based on a five- to 10-year time horizon, a period over which fundamentals and valuations should ultimately be reflected in asset prices.  

Our tactical analysis currently indicates international and EM equities are likely to produce at least upper-single-digit annualized returns. This is an acceptable expected return in exchange for bearing equities’ shorter-term volatility and downside risk. 

In contrast, from current prices and yields, we believe returns to U.S. stocks and core bonds will be quite low over the medium term. So, we are tactically underallocated to both asset classes. Instead, we have larger tactical allocations to selected actively managed hybrid and alternative investments that we believe offer superior return potential as well as portfolio diversification and risk management benefits. 

We expect our investments in private real estate and private equity funds to produce low- to mid-teen returns over our multiyear holding period. 

Putting it all together, our balanced portfolios are currently  

  1. underweight to equities due to expensive U.S. valuations, but tilted toward attractively valued developed international and EM stocks;  
  2. underweight to core bonds, but with still meaningful exposure to act as ballast in the event of a recession;  
  3. tactically invested in hybrid income-oriented investments with less interest rate risk but more credit risk than core bonds; and  
  4. meaningfully allocated to liquid alternative strategies that are uncorrelated to stock and bond markets, or are lower-risk strategies, with appealing medium- to longer-term return potential. 

Over shorter-term periods, investment outcomes are highly uncertain, and the range of potential returns is very wide. (The gyrations of the past two quarters are a recent case in point.) Our approach to portfolio construction and management incorporates this shorter-term uncertainty with a focus on what could go wrong. This is reflected in our 12-month downside risk analysis and portfolio stress-testing.  

Looking out over the next year or so from this point in the economic and market cycles, we see the potential for either of two quite different macro scenarios to play out: (1) stabilization and improvement in global growth; or (2) continued declining growth resulting in a U.S. and global recession. 

Most economists agree that China and the United States are key to whether scenario 1 or 2 happens. It is clear the Chinese government is once again trying to boost their economy via fiscal and monetary policy (including tax cuts, lower interest rates, and expanded bank lending), after trying to reduce some of the debt-related excesses during the prior two years. (This deleveraging effort has been the key driver of China’s recent growth slowdown.) It is not yet clear if they will be successful, as these policy changes flow through to the economy with time lags and uncertain impacts. But there is some evidence, such as a rebound in credit growth, that the tide may be turning. A revival in Chinese growth would have positive ripple effects across the global economy. It would benefit other emerging markets and Europe in particular, as China is a major importer of their goods. Meanwhile, the U.S. economy, while weakening, doesn’t seem to be in imminent danger of slipping into recession. 

Scenario 1: We have a lot of respect for the Global Investment Strategy team at BCA Research. They believe a global growth rebound is likely in the second half of 2019. They further note that the U.S. dollar, as a safe-haven currency, typically moves in the opposite (countercyclical) direction of global growth. When growth is weakening, the dollar tends to strengthen (as it has over the past year) and vice versa. In this scenario, they expect a depreciating dollar to further boost foreign market returns for U.S. dollar–based investors. BCA concludes, “This will create an excellent environment for international stocks—EM and Europe in particular.” 

Given our tilt to these markets (which, remember, is based on our tactical medium-term analysis), this scenario would be positive for our portfolios. A rebound in growth would also benefit our hybrid/flexible income-oriented and floating-rate loan funds. We’d expect mid- to upper-single-digit returns from them. Lower-yielding core bonds, to which we are underallocated, would underperform. Our investments in lower-risk alternative strategies should also produce solid absolute returns better than core bonds. But we’d expect them to lag the strong equity markets. Managed futures trend-following strategies might underperform, but it’s impossible to predict over any shorter-term period how they will do; it depends on the presence or absence and strength of price trends across a wide array of global markets.  

Depending on the strength of the market rally in this scenario, we would expect to eventually reduce our portfolio’s equity- and credit-risk exposure as the prospective returns from these riskier asset classes become less attractive and the likelihood of this bullish market cycle coming to an end increases. The latter could be triggered by a resumption of Federal Reserve monetary policy tightening in response to rising inflation. 

Scenario 2: On the other hand, it is possible the U.S. economy is already headed for recession, due to the contractionary effects of Fed tightening over the past two years, along with the negative impact of trade tensions, tariffs, and other geopolitical depressants, such as Brexit uncertainty.  

We know from history that equity bear markets are more severe (deeper and longer) when concurrent with a U.S. recession versus when there is a global economic downturn or some other macro shock not accompanied by a U.S. recession. Even though foreign stock markets are not overvalued (unlike the U.S. market) they may fall more than U.S. stocks in a bear market because of their greater exposure to economically sensitive (cyclical) companies. We’ve taken this potential downside into account in our stress-testing and portfolio construction, where we are underweighted to equities overall.  

While stocks would get hit hard, we’d expect U.S. core bonds to be positive in this recession scenario, driven by disinflation and falling interest rates. (A stagflation scenario—poor growth and high inflation—isn’t a near-term risk but could play out in the next cycle. Stagflation would be bad for stocks and core bonds.) That is why we maintain meaningful exposure to core bonds in our more conservative portfolios. But we also allocate to other higher-yielding income strategies, because the medium-term expected return for core bonds is quite low. This is another “shorter-term-risk for medium-term-return” tradeoff we believe is attractive and prudently allocated to as part of our overall portfolio construction. But these “non-core” income positions would likely register at least modest shorter-term losses in a recession versus core bonds’ gains.  

Altogether, we’d expect our portfolios to be down around their 12-month loss thresholds in this scenario. They could do worse or better than that, depending on the severity of the bear market. As an investor it’s crucial to be comfortable with the stated loss threshold and risk expectations for one’s portfolio. Those thresholds will surely be tested at least a few times during an investor’s lifetime.  

Closing Thoughts 

The first quarter of 2019 was certainly a nice change from the last quarter of 2018, but we remain prepared for renewed market choppiness as the economic cycle moves closer to a downturn. On the positive near-term horizon, the Fed’s policy U-turn combined with China’s economic stimulus may enable the cycle to extend for another few years. If so, we have exposure to a wide range of investments that will particularly benefit, such as global equities with an emphasis on developed international, European, and EM stocks; flexible income funds; and floating-rate loan funds.  

On the other hand, there are both macroeconomic and geopolitical risks that threaten to end the cycle sooner than later. Our holdings in core bonds, lower-risk hybrid and alternative strategies, and trend-following managed futures funds should perform well when a recessionary bear market strikes. And we would then be in position to tactically add back to riskier asset classes, such as U.S. stocks, at lower prices and higher prospective medium-term returns. 

We don’t have conviction predicting which shorter-term scenario will play out. Of course, we’d prefer to see global growth rebound with continued strong portfolio performance. But as always, it is wise to be prepared (mentally, emotionally, and financially) for shorter-term downside and negative market surprises. No matter what the future brings, maintaining a healthy patience and perspective, and sticking to one’s investment discipline, is necessary for long-term investment success. 

We construct and manage portfolios to meet our clients’ longer-term goals. This means successfully navigating and investing through multiple market cycles, not just the next 12 months. We believe our portfolios are positioned to generate attractive returns over the next five to 10-plus years (i.e., the medium to longer term) and to be resilient across a range of potential shorter-term scenarios. It’s worth reiterating that despite our lower U.S. stock allocation, the portfolios are not without risk, stemming from our larger allocations to foreign equities as well as some of our hybrid and alternative investments. In the event of a global bear market, we will experience short-term portfolio losses. But extending our time horizon beyond the short term, we believe we are being well compensated for the risks we are taking in those areas, while maintaining a well-diversified, balanced, and still somewhat defensive overall posture.  

As always, we appreciate your trust and confidence in Litman Gregory, and we work hard every day to continue to earn it. 

Litman Gregory Investment Team (4/4/19) 


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