Commentary from our CIO—Second Quarter 2019

July 17, 2019

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 US-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. We’ve joked that when it comes to short-term market predictions, “Anything can happen… and so far this year, it has!” 

Although the markets have been volatile—as markets are wont to be—the developments haven’t been material enough to cause a change in our medium-term (five-year) tactical outlook or our portfolio positioning. Not surprisingly, we still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the shorter-term (next 12 months). But at the margin we think the macro risks have increased, driven by the negative impact of escalating trade tensions in the context of an already weak global economy and a late-cycle U.S. expansion with stretched valuations and very low yields. As such, in the coming weeks we may make a few changes to incrementally reduce some of the bear market/recession risk in our balanced (stock/bond) portfolios. We are wrapping up this work and will report back when it’s complete.  

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.  

To state the obvious, looser monetary conditions are generally 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.  

If this does mark the beginning of another Fed easing cycle, it should give us (and the market) pause looking out beyond just the next few quarters. As the chart below shows, the fed funds rate is barely above levels where it has ended most other monetary easing cycles. The Fed will have little room—2.5 percentage points—to cut rates before hitting the “zero lower bound,” economist-speak for a zero percent fed funds rate.  

Historically, the Fed has ended up cutting rates by around five to seven percentage points during a recessionary easing cycle. That’s impossible from current levels. Also, starting from such low yield levels, the benefit to the economy from additional rate cuts will likely be more limited, thereby diminishing returns. As such, the Fed seems highly likely to engage in quantitative easing (QE) in the next recession as well, despite its questionable economic benefits and with government debt already at historic highs. Will financial markets react similarly to the next round(s) of QE as they did after the financial crisis? 

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 is 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 the Fed and ECB’s decisions will still depend to some extent on their assessment of incoming U.S. and global economic data. If the economic indicators improve (e.g., due to a lessening of trade tensions) and the Fed does not cut rates, will equity markets sell off, or will they respond positively to the better-looking economic fundamentals? Alternatively, if the Fed does feel the need to cut rates by 50 basis points in July, will markets have a knee-jerk rally? Or, will they do nothing because such a cut was already discounted in prices? Or, will stocks sell off on fears the cut indicates the Fed is worried about a sharp economic slowdown or recession on the horizon that it won’t be able to prevent? 

Historically, stocks have performed well in the 12 months after an initial Fed rate cut, unless the economy is heading into a recession. In the last two cycles, in 2001 and 2007, the Fed’s first rate cuts came several months before the start of recessions, but severe bear markets followed anyway.  

It’s true that ongoing and unprecedented Fed stimulus was eventually the impetus for the 2009-onward bull market recovery, but it didn’t prevent the bear market or recession from happening. So, while “don’t fight the Fed” is a good rule of thumb, the Fed is not all-powerful in preventing recessions via monetary stimulus. On the other hand, the Fed can ensure a recession happens by tightening too much! 

Suffice it to say, global central bank policy remains a significant uncertainty and potential market catalyst over the short- and medium-term. Clearly, and relatedly, the economic outlook matters as well.  

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.  

Some short-term negative economic indicators:  

  • In May, the Global Manufacturing PMI dropped for the 13th month in a row, to its lowest level and first time in contraction territory (below 50) since 2012.  
  • The OECD composite leading economic indicator fell further below the expansion level of 100. (However, China’s LEI has started turning upward and we expect the Chinese government to continue to boost their economy through fiscal and monetary stimulus).  
  • The Citi Global Economic Surprise Index remains in negative territory, where it’s been since early 2018.  
  • NDR tracks seven indicators in its “Global Recession Watch” report. Six of the seven continue to flash red, indicating an ongoing broad-based slowdown. 
  • Global economic policy uncertainty has been very high. 

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. (This is why we don’t base our investment process on short-term economic forecasts.) 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—and we think one is very likely within our five-year tactical horizon. 

The evidence among the key U.S. recession indicators we track is mixed but seems to lean towards a low to medium near-term risk of recession. However, some important indicators, while still positive, are weakening. We’ll be watching—along with the Fed and the markets—to see if they continue to trend lower, signaling increasing odds a recession is coming. 

On the negative side, the yield curve (3-month T-bill vs. 10-year Treasury) has been inverted for more than 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 “US 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 most sluggish 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.  

There is no economic law that says a recession must occur on a set schedule or duration. While the average post-WWII U.S. expansion cycle lasted around five years, the three most recent expansion cycles (excluding the current one) lasted an average of eight years. Similarly, U.S. equity bear markets have occurred less frequently in recent decades, although they have been severe in magnitude. As the U.S. economy has evolved from manufacturing-based to more service-, technology-, and consumer-based, the nature of the economic cycle has likely evolved. For better or worse, central bank attempts to proactively “manage” the economy and sustain the expansion cycle have also evolved. 

As many have said: History rhymes but doesn’t exactly repeat. This is also true when it comes to the economy and financial markets. It’s never entirely “different this time.” But each new cycle is always at least somewhat different from prior cycles. History is an invaluable guide to understanding the cyclical nature of markets and the investor herd behavior that drives them. But structural change also occurs and must be considered and incorporated within a cyclical historical framework. Certainty and precision in this regard do not exist. 

As such, successful investors must remain flexible and open-minded, but still grounded in a fundamental investment discipline. (In our case: globally diversified, risk-managed, and long-term valuation-driven.) Rather than seeking falsely precise answers (e.g., When will the recession happen? What will the Fed do next?), we always invest with a range of potential outcomes, scenarios, and risks in mind. 

Outlook for Trade and Other Geopolitical Risks 

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 an 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 Our Portfolio Positioning  

We believe our portfolios are positioned to both generate attractive returns over the next five to 10 years, and to be resilient across a range of potential shorter-term risk scenarios, many of which we’ve outlined above.  

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. Our analysis of U.S. stock market valuations and expected returns implies the market consensus is discounting an overly optimistic outlook. Since most market participants tend to simply extrapolate recent trends (whether positive or negative) into the future, this is understandable. But our analysis—informed by history and applying forward-looking judgment—leads us to a base-case scenario where the expected annualized return from U.S. stocks over the next 5 to 10 years is in the very low single digits. This is well below the upper single-digit expected return we require to bear the full risk of owning stocks. As such, we remain underweight to U.S. stocks across our portfolios. 

On the other hand, we continue to have modestly overweight positions to European and emerging-market (EM) stocks. Our analysis indicates their valuations are very attractive relative to the U.S. When pessimism is high, asset prices are low. Investing at low prices implies high(er) future returns. In our assessment, these markets are implicitly discounting a lot of bad macro news and poor sustained corporate earnings growth. Our base case, which we believe uses reasonably conservative underlying assumptions, generates high single-digit expected returns for European and EM stocks over the medium-term horizon. 

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 avoids recession, we would not be surprised to see strong absolute returns from stocks, with outperformance 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 also be beneficial for our flexible fixed-income and floating-rate loan investments relative to core investment-grade bonds, which have much lower yields and would be hurt by rising interest rates. 

On the other hand, if the United States falls into a recession and bear market, our balanced (stock/bond) portfolios have “ballast” in the form of still-meaningful exposure to core bonds (albeit underweight) as well as lower-risk fixed income and alternative 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 (pun intended?), even with our meaningful underweight to U.S. stocks our balanced portfolios will experience shorter-term losses if we do get a bear market—likely somewhat worse than their 12-month target loss thresholds—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. But that will be an excellent (and long-awaited!) opportunity for us to re-allocate some of our capital back into U.S. stocks at lower prices and much higher expected returns.  

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 Litman Gregory.  

Litman Gregory Research Team (7/5/19) 



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