INSIDE THIS EDITION:
2019 Investment Themes
Capital Markets Outlook
401k Plan Manager*Updated on 12/31/2018
The second half of 2018, saw the US economy continue its expansion..
Outside of the U.S., BREXIT-related uncertainty and softening Eurozone economic data provided a counter-current too strong to overcome for developed international equities.
October saw major markets led lower by the technology sector which began to retreat following a very strong first half of the year. November provided a bit of relief for investors after the Fed tempered hawkish statements made in October but the reprieve was only temporary as December provided investors with the worst December seen since the Great Depression.
In portfolios, downside volatility in both October and December proved challenging. However, we entered each of those months with a sizeable allocation to U.S. treasuries.
In the fixed income market, we saw a big swing in market sentiment during 2018. January featured concerns about an overheating economy but by December investors were worried about a slowdown in global growth.
The STA fixed income strategy outperformed the broad bond market index throughout 2018, with less price volatility.
2019 Investment Themes
- We believe volatility is here to stay.
- Investors should remember the old adage that it
is time in the market, not timing the market.
- It will be important to build resilience into
- Make sure your cash works hard for you but be careful
your cash doesn’t work too hard.
- Investors should watch for factors that
can extend the bull market. Staying invested is not tantamount to “buy and
hold”. Ever-evolving market dynamics require a disciplined tactical strategy
that can help limit losses while taking advantage of opportunities when they
- We expect a synchronized slowdown in global
growth in 2019.
- The U.S. economy is likely in the late-cycle
phase with robust domestic growth set to decelerate as a tight labor market and
fading federal stimulus weigh on year-over-year growth.
- The Chinese economy will be challenged by the
tariff dispute with the U.S., but we expect only a mild slowdown in the Chinese
economy as the government focuses on stimulating its economy with ample fiscal
and monetary support.
- We expect a stable inflation rate at or slightly
above 2%. This is in line with the Fed’s 2019 target.
- The inflation outlook in Europe and Japan
remains a key indicator as it sets the pace for central bankers to remove
ultra-accommodative monetary policy and has enormous implications for global
liquidity, asset prices, and strength of the U.S. dollar.
- The rate hiking path is less certain in 2019
than it was at the start of 2018.
- We believe it is prudent for the Fed to stay
more dovish in 2019, given moderating economic growth and the vulnerability
global debt has to a spike in borrowing costs. That said, we expect one rate
hike in June and another hike in the second half of 2019.
- We believe the Fed will continue hiking interest
rates as long as the job market remains solid and inflation stays on target in
- We expect the U.S. economy to gradually slow and
converge with the slowdown seen in other parts of the world.
- An increasing fiscal deficit is not an immediate
concern but may constrain the willingness and ability of the government to step
in and help the economy recover from the next recession.
Capital Markets Outlook
- With 2018 behind us, it is apparent that a higher volatility market regime has taken hold of capital markets as we predicted could occur in our last Capital Markets Outlook. Looking ahead, we are led to believe this is not a short-term shift.
- It is our view that short term market direction will be driven by the outcomes in three key areas: fourth quarter earnings results, forward guidance, and progress on trade negotiations with China.
- In the intermediate term, diversified exposure between domestic, international, and emerging markets remains prudent. We favor domestic and emerging market equities. Developed international equities at present face several challenges, both economic and political, which could make relative returns compared to domestic and emerging markets less attractive in the intermediate term.
- Longer-term we believe emerging markets will present one of the better investment opportunities we have seen in some time
The second half of 2018, saw the US economy continue its expansion. Consumer confidence hit record levels in September and the labor market remained strong as jobless claims hit levels not seen since before 1970. Additionally, the tightening job market led to some wage pressure which also helped provide fuel for retail sales. Business optimism also saw improvement and helped the S&P 500 post a 2018 total return of 10.56% through September 30, 2018.
Outside of the
U.S., BREXIT-related uncertainty and softening Eurozone economic data provided
a counter-current too strong to overcome for developed international equities.
As a result, they fared poorly during the first three quarters of 2018 along
with emerging market equities which continued their 2018 struggle amidst
questions about growth in China, the effect of tighter monetary policy action
in the U.S., and global trade tensions.
By the fourth
quarter, however, it was the Fed and comments from Federal Reserve Chairman
Jerome Powell that began to shake investor confidence. In a statement early in
the fourth quarter, Chairman Powell implied that interest rates were still not
near neutral and provided investors with a big concern – that the Fed would not
cease raising rates despite a deceleration in economic activity domestically
and abroad. Add to that the continued overhang of weakening Chinese growth and potential
trade war, and suddenly equity markets found themselves primed for a bout of
volatility during the month of October that investors had not seen in years.
October saw major
markets led lower by the technology sector which began to retreat following a
very strong first half of the year. By the end of October, the S&P 500, NASDAQ,
and MSCI All Country World Index had posted total returns of 3.0%, 6.73%, and -3.53%
for the year, respectively. November provided a bit of relief for investors
after the Fed tempered hawkish statements made in October. However, the
reprieve was only temporary as December provided investors with the worst
December seen since the Great Depression. When it was all said and done, 2018
saw the S&P 500, NASDAQ, MSCI All Country World Index, and MSCI Emerging
Markets Index posted total returns of -4.39%,
-2.81%, -8.94%, and -14.45%, respectively.
In the Fixed Income market, we saw a big swing in market sentiment during 2018. January featured concerns about an overheating economy but by December investors were worried about a slowdown in global growth. Pressured by the Fed’s rate hikes, the broad U.S. bond market (represented by the Bloomberg Barclays US Aggregate Bond Index) delivered negative total returns for almost the entirety of 2018. Additionally, the U.S. bond market saw its share of volatility with a maximum drawdown of -3.0% in May. In December, a flight-to-quality in response to equity market turmoil helped drive an exceptionally strong rally in U.S. Treasuries and other high-quality bonds and helped the US Aggregate Bond Index recoup the year’s losses by the close of trading on the last day of the year.
2019 Investment Themes
As we look ahead to 2019, we want to highlight key themes that we believe investors should keep in mind as they consider portfolio positioning.
First, we believe volatility
is here to stay. Higher volatility was widely underestimated by investors in
2018 despite the powerful combination of rising interest rates, unwinding of the
Fed’s balance sheet, and increases in Treasury issuances that took massive amounts
of liquidity out of the financial system. These forces not only increased volatility
but also put pressure on the price of risk assets. As we look ahead, we expect
market volatility to continue as many of these forces remain and could be
magnified by great uncertainty around trade negotiations and Brexit.
Second, investors should
remember the old adage that it is time in the market, not timing the market.
History has repeatedly shown that sticking to a well-designed long-term plan that
avoids emotional overreactions to poor short-term market performance are critical
for investment success. As an example, had you stayed invested in the S&P
500 index over the last 20 years (1999-2018), $100,000 invested would today be
worth nearly $300,000, a reasonable return given the 2000 tech bubble and 2008
financial crisis. Had that same investor missed the 5 best-performing days
during that span, the gain would be cut in half, and his or her portfolio would
have had an ending value of approximately $200,000. Following that thought, if the
10 best-performing days had been missed, the gain would have been cut in half
again and the portfolio would have an ending value of only $150,000. To further
drive home the point, if the 25 best-performing days had been missed, the
investment would have resulted in a loss. Historically, days showing the best-performance
and worst-performance have been clustered together. Thus, a pullback in the market
following a turbulent time could cause an investor without a well-defined
discipline to miss the subsequent recovery, thus making a temporary loss more
Third, it will be
important to build resilience into portfolios. Since volatility is expected to
stay elevated, it is prudent to consider strategically de-risking portfolios to
have some downside protection. There are two ways to de-risk: if investors are
bearish, they should raise cash from equities; but if investors are less
certain of the market direction, the right strategy is to build more resilience
into the portfolio by gearing down portfolio risk incrementally while keeping
upside participation. Examples include but are not limited to moving from
high-beta stocks to minimum volatility stocks, increasing exposure to high
quality and defensive stocks, and improving credit quality and extending
duration of the bond allocation. Most importantly, investors would be wise to
embrace a well-diversified portfolio and avoid holding concentrated positions. It
is worth noting that a large number of positions is not necessary to make a
portfolio diversified. Instead, diversification can be achieved during the portfolio
construction process aimed at getting broad exposure to multiple, less correlated
and sometimes uncorrelated, sources of return which can help a portfolio navigate
various market conditions. Counterintuitively, true diversification requires
owning some investments that make us uncomfortable because of recent
underperformance. A good rule of thumb is that if you feel really good about
every single investment you hold, it is quite likely that your portfolio is not
Fourth, make sure your
cash works hard for you, but be careful your cash doesn’t work too hard. Short-term
interest rates finally beat inflation after literally yielding nothing for the
past decade. As a result, there are ample cash management strategies that can
generate attractive returns while taking on minimum amounts of risk. This begs
the question, why hold cash in saving accounts earning close to zero when you
could allocate to something low on the risk spectrum like short-term treasuries
and get an incremental return? Of course, it is important to remember that raising
too much cash from equity allocations for this purpose can be detrimental to achieving
long-term investment goals even if it often feels good in the moment. In this
scenario, not only are return premiums offered by risk assets forfeited, but
the power of compounding is also surrendered. Worse still, is that it also
exposes investors to longevity risk, a situation that occurs when retirees
outlive their assets. Therefore, short-term market risks and long-term
longevity risks must be carefully balanced.
Lastly, investors should watch for factors that can extend the bull market. Staying invested is not tantamount to “buy and hold”. Ever-evolving market dynamics require a disciplined tactical strategy that can help limit losses while taking advantage of opportunities when they emerge. We believe that 2019 could feature several factors that help determine market direction. They deserve close monitoring, so that appropriate tactical adjustments to portfolios can be made.
We believe some factors that could drive market direction this year include:
Macroeconomic analysis lays the foundation for projecting an assets’ future performance. It is well recognized that different asset classes respond differently to various economic drivers. To manage portfolios, we focus on five important economic factors: economic growth, inflation, interest rate, monetary policy, and fiscal policy. Because global economies and financial markets are increasingly interconnected, using these factors helps us derive a holistic view of the economic environment domestically and abroad.
growth: We expect a synchronized slowdown in global growth in 2019. That
said, we expect the global economic expansion to continue, albeit at a slower
pace. While we see a slowly increasing probability of economic recession
(generally defined as negative GDP growth in two successive quarters), an
imminent recession is not our base case scenario in 2019.
The U.S. economy is likely in the late-cycle
phase with robust domestic growth set to decelerate as a tight labor market and
fading federal stimulus weigh on year-over-year growth. On the other hand, long-term
growth in the U.S. is likely to stabilize at a higher level than other
developed economies, which could justify a price premium and higher valuation
multiples on U.S. assets.
Outside the U.S., we anticipate slower
growth in Europe as the region is pressured by Brexit, rising populism, and
tightening of monetary policy. The Chinese economy will be challenged by the tariff
dispute with the U.S., but we expect only a mild slowdown in the Chinese
economy as the government focuses on supporting its economy with ample fiscal
and monetary support. This, however, will slow the deleveraging of its mounting
debt and increase the risk of financial instability longer term.
The slowdown from peak growth in 2017 is not
all bad. The moderate pace of growth might help extend the longevity of the current
business cycle which is already among the longest economic expansions in U.S.
history going back to 1854. In fact, the current cycle ranks second in length,
only behind the expansion that occurred from March 1991 to March 2001 (120
An overheating economy and associated Inflation pressures are common in the late
phases of a business cycle. In most cases, inflation forces the Federal Reserve
to enact aggressive monetary policy in an effort to cool the economy. Although
the Fed has historically attempted to engineer a loft landing, it often
over-tightens financial conditions, which can then become the catalyst for
recession. Moreover, the fear of an overshoot in inflation can decrease the
value of both stocks and bonds in a well-diversified portfolio, as the
appropriate discount rate is forced higher.
We expect a stable inflation rate at or
slightly above 2%. This is in line with the Fed’s 2019 target. Inflation expectations are not higher at
present because long-term deflationary forces such as an aging population,
technology, and globalization help offset cyclical inflationary factors such as
a tight labor market and fiscal stimulus. These modest inflation pressures should
allow the Fed to take a patient and gradual approach to interest rate
normalization, and increases the likelihood that the U.S. economy experiences a
soft-landing or shallow recession rather than a deep contraction.
The inflation outlook in Europe and Japan
remains a key indicator as it sets the pace for central bankers to remove
ultra-accommodative monetary policy and has enormous implications for global
liquidity, asset prices, and strength of the US dollar. Steady and decreasing
inflation in emerging market countries should give policymakers room to cut
interest rates to support economic growth.
rates: The rate hiking path is less certain in 2019 than it was at the
start of 2018. The Federal Reserve stands to become more data dependent, rather
than following a predefined path as the policy rate approaches neutral, the
level at which monetary policy neither stimulates nor restricts growth. The Fed
has dual policy mandates: to maximize employment and generate price stability.
However, an obvious divergence between an extremely tight labor market and
moderate inflation readings has emerged. As such, the Fed will be faced with tough
choices as it makes monetary policy decisions and determines how hard is
appropriate as it hits the brakes on the U.S. economy. We believe it is prudent
for the Fed to stay more dovish in 2019, given moderating economic growth and the
vulnerability global debt has to a spike in borrowing costs. That said, we
expect one rate hike in June and another hike in the second half of 2019. The
10-year Treasury should stabilize in a range between 2.75% and 3.25%, which would
benefit rate sensitive sectors such as housing. A stable U.S. interest rate should
also prevent the U.S. dollar from strengthening, which would be good news for
commodity producers and emerging market assets.
policy: We believe the Fed will continue hiking interest rates as long as the
job market remains solid and inflation stays on target in 2019. However, even
with moderate inflation pressure, we have had years of robust GDP and job growth. This should allow the Fed to slow the pace of
tightening and potentially take a pause after a couple of rate hikes between
now and the end of 2019. Make no mistake, however, the Fed (and we) would like
to see higher interest rates, as long as they are supported by economic and
financial conditions. This would give the Central Bank more fire power to boost
the economy when the next recession arrives.
The unwinding of the Fed’s balance sheet is
currently running on autopilot and should continue as long as the U.S.
continues expanding in a healthy manner. Should the U.S. economy experience a
meaningful slowdown, we expect the Fed to pause or even reverse its balance
sheet program in an effort to inject liquidity back into the economy.
policy: During 2018 we witnessed divergent global growth where a strong
U.S. economy met disappointment across the rest of the world. Robust domestic
growth was largely fueled by tax reform and fiscal spending, which is expected
to fade during the second half of 2019. As result, we expect the U.S. economy
to gradually slow and converge with the slowdown seen in other parts of the
Fiscal stimulus is temporary by nature and less effective when the economy is growing at full capacity. Corporate America used most of its tax savings to repurchase shares, rather than invest for the future. Expanded fiscal spending has largely been financed by Treasury issuance, which competes with the private sector for capital. An increasing fiscal deficit is not an immediate concern but may constrain the willingness and ability of the government to step in and help the economy recover from the next recession.
Capital Markets Outlook
With 2018 behind us, it is apparent that a higher volatility market regime has taken hold of capital markets as we predicted could occur in our last Capital Markets Outlook.
Looking ahead, we are led to believe this is not a short-term shift. Instead, we expect increased volatility to remain with us for the remainder of 2019 as quantitative tightening continues in the US and trade tensions remain unresolved. Additionally, while earnings remain positive as we write this report, a falloff in earnings growth could lead investors to fret. As we have mentioned in previous reports, volatility does have a silver lining – it is likely to provide more opportunities for disciplined investors to find attractive entry points for financial assets, particularly as return dispersion between securities increases. For the balance of 2019, we expect return dispersion to increase. As a result, it is important to be selective and patient as the best opportunities are likely to require time to play out.
It is our view that
short term, market direction will be driven by the outcomes in three key areas:
fourth quarter earnings results, forward guidance, and progress on trade
negotiations with China. We believe the temporary reopening of the government
until February 15 and threat of another shutdown on that date, is merely noise
that should not drive longer-term investment decisions. It is for this reason
that in the short-term investors must remain disciplined and fact driven,
rather than headline driven, as not doing so could imperil meeting longer-term
goals and objectives. In the intermediate term, diversified exposure between
domestic, international, and emerging markets remains prudent. However, we
believe exposure between those geographies should not be equal. Instead, we
favor domestic and emerging market equities.
Developed international equities at present face several challenges,
both economic and political, which could make relative returns compared to
domestic and emerging markets less attractive in the intermediate term.
Longer-term we believe emerging markets will present one of the better
investment opportunities we have seen in some time. However, with higher
volatility that we expect going forward, preserving capital at this stage in
the market cycle will best position investors to fully take advantage of this
opportunity. Moreover, we caution that investors in emerging markets will be
required to accept higher volatility in exchange for the higher return
potential we believe exists. Because of this, tactical management will continue
to be of great importance both to control downside risk and preserve capital. A
sound tactical approach should help investors increase or decrease exposure to
emerging markets when macroeconomic and technical signals inflect.
Domestic Stocks: Entering 2018, we correctly
took a constructive, yet cautious, view of the domestic equity market despite
elevated valuations. We noted strong and improving economic fundamentals as
well as favorable tax policy changes that would overwhelmingly benefit
corporate America. As we entered the second half of the year, we became more
cautious as we saw signs earnings had peaked, valuations were stretched across
most equity sectors, price support from stock buybacks gradually dissipated,
and corporate insiders began selling increasing amounts of stock. As we observe
the domestic equity market today, we believe it remains an attractive place to
allocate long-term capital. Volatility at the end of 2018 helped reset
valuations to more reasonable levels and reacquainted investors with more
normal volatility levels commonly seen in domestic equities throughout history.
However, we do believe investors will have to be discerning in selecting their
exposures and allocations as some sectors will be better positioned than
others. We believe there exists the prospect for positive developments on the trade
front that could provide a boost to domestic stocks more broadly speaking.
However, going forward it is far more important that earnings remain on an
upward trajectory, especially in the face of higher interest rates. Despite our
modestly favorable view of domestic equities it remains important to focus on
downside risks. Chief among them are the potential for an earnings recession and
earnings guidance to fall short of expectations. Should these outcomes occur,
we would expect domestic stocks to struggle to find new highs.
Developed International Stocks excluding
the US: Developed international equities had a very difficult 2018 as
deteriorating economic results and political uncertainties in several countries
led to a prolonged drawdown through the majority of the year. While monetary
policy in developed international markets like Europe and Japan remains accommodative,
developed international equities could struggle to perform better than both
domestic and/or emerging market equities. Especially, if BREXIT negotiations
drag on without resolution and economic conditions across the Eurozone continue
to deteriorate. In fact, even with the forward
P/E on the MSCI All Country World Index ex-US at approximately 13x, we think
political risks in developed international markets are potentially
underappreciated, and believe the geographic region is inexpensive for a reason.
The result is that we see the capital appreciation potential for developed
international stocks excluding the US likely to be limited in the first half of
Emerging Market Stocks: US dollar strength, an economic slowdown
in China, and ongoing trade disputes overwhelmed emerging market equities in
2018. The MSCI Emerging Market Index was down double digits and left many
investors wanting to eliminate exposure from portfolios entirely. However, we
believe that doing so at this juncture is an error. We see at least three major
catalysts that could push broad emerging markets higher. First, improvement in
the Chinese economy, which is in the middle of its own stimulus push, could
lend a considerable tailwind to emerging markets, especially emerging market
Asia which is closely tied to Chinese economic performance. Second, a weaker
dollar should it emerge could provide a big boost to emerging market equities. Last,
a pickup in earnings growth momentum could propel emerging market stocks higher
as investors take note of the more robust earnings opportunity in these markets
relative to other geographies. That said, we believe that even if these things
don’t occur, there are likely to be pockets of tremendous opportunity at the
country or region level. In fact, we give more credence to the idea that return
dispersion within emerging markets is likely to be great in 2019 and an active
approach that can identify nuances between geographies and control for
volatility best positions investors to capitalize on the emerging market
opportunity we see ahead.
Fixed Income: Fixed income starts 2019
from a much better place than it started 2018 with the 3-month Treasury bill yielding
2.35% compared to only 1.38% in 2018 and the 10-year Treasury bond yielding 2.68%
today compared to 2.41% last year. Because bond yields have historically correlated
with future returns, we expect a positive but modest return from fixed income
in the next few years.
That said, fixed
Income likely faces fewer headwinds this year than last. The path of the Fed’s
rate hikes is expected to be slower than last year. Global growth is
moderating, especially in Europe which may delay the normalization of monetary
policy by the European Central Bank and provide a tailwind for bonds. Inflation
pressures remain under control thanks in part to soft commodity prices,
softening real estate, and the fading effect of U.S. fiscal stimulus.
With better yields,
moderate interest risks, and the need to hedge equity risk lead us to believe
that core fixed income composed of high-quality bonds should play a bigger role
in portfolio construction going forward. At the same time, we urge caution on
corporate bonds as rising leverage across industries, profit margin pressures,
and slower growth add risk. However, this risk is not imminent. Most companies
have taken advantage of low interest rates to extend debt maturities.
Therefore, they don’t need to refinance a large portion of their balance sheet
in near term. We are also cautious on state and local government debt where large
unfunded pension liabilities are a concern. While recession is not our base
case for 2019, we are moving to improve the credit quality of our corporate and
municipal bond portfolio. We believe this is prudent and required to protect
principal, even if it means that we give up some yield and current income in
The growth of
federal deficits and other liabilities is our biggest long-term concern. National
debt has been growing faster than GDP. While we don’t believe we are at crisis
levels, we believe investors should closely monitor developments on this front.
Alternatives: The volatility we experienced in equity and fixed income markets at the tail end of 2018, was a valuable reminder that alternative investments are likely to play an increasingly important role in portfolios. As a reminder, alternative investments can provide a differentiated source of return for portfolios and are worth including as part of an overall allocation. This is especially true in periods when stock and bond correlations increase, thus reducing the hedging benefits usually associated with bonds. Since they provide a source of less correlated returns, alternative investments can be an attractive portfolio compliment. While they tend to lag the broad market during bull markets, they can outperform when the market is in turmoil. As we approach later phases of the business cycle, demand for these assets may increase. As a matter of portfolio construction, including some exposure to these assets has been shown over time to lower the volatility of a portfolio without sacrificing the opportunity to participate in the upside. We expect that to continue as we make our way through 2019.
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