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.

In our opinion, capital market returns so far this year have been stellar:

These returns come in the face of some not so pleasant macroeconomic realities that have been around for a while including:

  • The weakest economic expansion on record since 1948 when looking at overall GDP growth.
  • Slowing global economic growth
  • A protracted trade war that is creating uncertainty across global manufacturing supply chains
  • Clumsy Federal Reserve Bank monetary policy headwinds resulting in an inverted yield curve, a potential warning of a coming recession

The culmination of all this stuff looks to be a global economy that is likely to enter a no-to-low-growth period of weakness that may hang around for a bit. Where we go from here is a bit of a toss-up and ultimately will be a function of how the Fed continues to respond with monetary policy.

It is clear to us that the Fed has kept monetary policy too tight lately. As Nobel laureate economist, Milton Friedman, taught us, the economy has a “natural interest rate” that balances economic growth with economic potential along with a stable inflation rate. If economic growth is declining below economic potential and/or inflation is declining, then the Fed is thought to be keeping the level of interest rates in the economy too high/too tight. If economic growth is growing above economic potential and/or inflation is rising, then the reverse is true: The Fed is thought to be keeping interest rates too low/too loose. It does not matter what the absolute level of interest rates are at any time, it is more about where interest rates are compared to the natural interest rate.

Today, economic growth is about in line with potential but forecasted to be lower in the near future, and inflation has been persistently low for a long time. From our perch, the Fed has been too tight lately. If the Fed can correct the mistake in time – by adequately lowering short-term interest rates - a recession may be avoided. Unfortunately, the Fed does not have a strong track record of this outcome when in rate-hiking mode, achieving a “soft landing” after raising rates only three times in the last 100 years.

We are not counting on it and have positioned client portfolios accordingly.

While these macroeconomic realities have been with us for a while, a new quarter would not be complete, it seems, without new risks. Two rising risks we see are the presidential impeachment saga and the coming political election drama in 2020. On the former, it is hard to figure out how the market could react. While there were three Presidents – Andrew Johnson, Richard Nixon and William Clinton - associated with impeachments, only two were around during the modern capital market era. Of course, Nixon resigned before things got heavy and Clinton was acquitted, but neither episode had a lasting or material effect on capital markets at the time.

Let us reiterate our optimistic view from last quarter which, happily, is still valid:

“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, as mentioned above, we believe 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. As always, we focus on conducting ourselves as long-term investors delivering investment outcomes that help our clients meet their wealth-planning objectives.

 

Please do not hesitate to contact your advisor with any questions or service needs.

Contact our Chief Investment Officer, Russell Moenich to learn more about this topic.
330.255.4330 | rmoenich@sequoia-financial.com