Given the combination of (1) slowing economic growth in a mature global business cycle expansion, (2) U.S. central bank monetary policy headwinds (but more sensible support in Europe and Japan), and (3) stable inflation, our portfolio positioning now favors a slightly more conservative asset allocation approach to global equities and fixed income with the following expectations:
- Long-term expected returns for all asset classes may be below returns experienced over the last 10 years; however, returns for equities could be well above those for fixed income for some time, but with higher volatility.
- Several exogenous threats (the biggest of which include a Federal Reserve Bank monetary policy misstep, tariff policy changes/trade wars, geopolitical turbulence and a rising risk of a global economic slowdown) may continue to unsettle capital markets in the form of higher-than-normal market volatility.
- After correcting last year and a subsequent recovery this year, global equity valuations are above long-term averages and may exhibit lower-than-average returns going forward.
- Real asset equity alternatives should offer low-correlation inflation protection and differentiated returns compared to traditional equity and fixed income.
- Fixed income investments remain prudent given potentially rising bouts of volatility.
- Assuming your plan, risk tolerance, and investment policy are aligned, long-term investors need not take drastic action.
After a decade of uninterrupted U.S. economic growth (with some stumbles, of course along the way), the current business cycle expansion broke the record in the month of July: it is now the longest expansion on record since 1900 (left panel below):
Despite being the longest, this economic expansion is the weakest on record since 1948 (right panel above). However, the past decade delivered impressive investment returns across all asset classes (except cash):
Business cycle expansions do not die of old age, but we are, at this point, focused on the endgame. As a reminder, equity bear markets generally coincide with recession. Using the Institute of Supply Management’s monthly New Order Index as a good real-time proxy for economic activity in the U.S., we are now in the third slowdown (marked by the red arrows below) of this business cycle expansion:
As we mentioned last quarter, the Tax Cut and Jobs Act (TCJA) of 2017 did not do much to jump-start sustained economic growth. To wit, the second quarter measurement of aggregate business activity growth in U.S. – Gross Domestic Product – came in at 2.3% on a year over year basis which is about the average for this business cycle expansion. The prospect of a trade war, particularly a large one with important trade partners (China, Mexico, Europe, Japan, etc.) does not help matters and has begun to negatively impact business confidence and corporate profits. The sideline meeting between President Trump and China’s Xi Jinping at the G20 confab showed intent in resolving the vast differences between the two administrations. The President believes a hard line on trade is appropriate because of a strong economy, high employment, and a robust stock market. In terms of the economy, reality may be a bit different.
What seems clear to us is the Fed’s monetary policy tightening over the last two years coupled with trade tariff uncertainty is slowing the economy down…therein lies the problem.
The previous two slowdowns still had the Fed’s monetary policy positioned as a tailwind, i.e. short-term interest rates were close to 0% and financial conditions were loose. Today the Fed is a headwind and may be on the verge of making a monetary policy mistake by being too tight at the wrong time. The evidence for this mistake can be found in the “inverted” U.S. Treasury yield curve. This is a rare occurrence when short-term (3-month) U.S. Treasury bill interest rate yield is greater than long-term (10-year) U.S. Treasury bond interest rates yield. Normally 10-year U.S. Treasury bonds yields are greater than 3-month U.S. Treasury bills; rightly so since investors normally demand a higher return for loaning their money to the government for a longer amount of time.
We believe that an inverted U.S. Treasury yield curve is always a sign of a monetary policy mistake by the Fed and usually a warning of a recession in the future (i.e. within the next 12 months). That’s because monetary policy mistakes came in all shapes and sizes in the past, and the magnitude and duration of the mistake are critical pieces factoring into whether a recession occurs thereafter. So far, this policy mistake has been small by historical standards. If the Fed can correct the mistake in time – by lowering short-term interest rates immediately and adequately, which it did on Wednesday, by just .25% – a recession may be avoided. Unfortunately, the Fed does not have a strong track record on this outcome when in rate-hiking mode, achieving a “soft landing” after raising rates only three times in the last 100 years.
Needless to say, we are operating in an environment with elevated market risk.
Now, it may seem that all the above is rather negative, however, there is still one major positive in today’s market environment: investor sentiment remains bearish. We are reminded of legendary investor Sir John Templeton’s famous quote: “bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” We are nowhere near euphoria today.
As responsible financial advisors, we have the humility to know we cannot predict the future with precision. With sound financial plans in place, we believe a shift to a slightly more conservative client portfolio asset allocation is prudent given the intermediate-term environment we expect. The future direction of macroeconomics and, more importantly, capital markets in 2019 is still anyone’s guess. Questions regarding the timing of this cycle’s inevitable turn for the worse are certainly worth thinking about. One thing we are proactively doing today is reducing the “all-in” cost of our clients’ investment experience. An example of this is utilizing low cost exchange traded funds (ETFs) in lieu of high cost active mutual funds where it makes sense.
As always, we focus on conducting ourselves as long-term investors delivering investment outcomes that help our clients meet their wealth-planning objectives. The portfolio profiles outlined above may vary based on the individual investment objectives of your financial plan. We very much appreciate and value the trust and confidence you place in our firm. Please do not hesitate to contact your advisor with any questions or service needs.