STA Weekly Report – Risk-On Equities, Rate Cuts and Your Portfolio
Written by Luke Patterson | Friday, June 14th, 2019
INSIDE THIS EDITION: Risk-On Equities, Rate Cuts and Your Portfolio 1033 Exchanges: Tax Relief for Involuntary Conversions due to Fire, Theft, Natural Disaster, Eminent Domain, Seizure and Condemnation 401k Plan Manager
This week has seen the S&P 500 in full risk-on mode as concerns over US-Mexico trade abated over the weekend. Coupled with expectations that the Fed may begin easing on rates, investors have waded back into the market while volatility downshifts.
A calmer equity market might lead investors to add exposure and help the S&P 500 continue its recent rally.
However, for investors hanging their hats on Fed easing and trade
progress as a long-term catalyst for further equity returns this year, a quick
word of caution: tread carefully. Remember, in today’s equity market, a
headline or tweet has the power to cause markets to experience violent
reversals and spikes in volatility. And those reversals aren’t limited to
prices but also on future expectations.
Case in point, is the quick reversal in rate hike/cut expectations
we have seen over the last 6 months. While it seems like a long time ago, the
fourth quarter of 2018 featured expectations that the rate hiking cycle would
continue well into 2019. Fast forward to today, and the commentary from the Fed
coupled with signs of some economic deceleration, have traders and economic
prognosticators now thinking that rates will be cut for the first time since
December 2008. More specifically, the futures market has already priced in a
50bps cut this year, and further cuts in 2020. This has led to a yield curve
inversion with short-term treasuries now yielding more than the 10-year
Of course, it is never easy to know whether rate cuts this year
and next will even materialize, especially in the face of an unclear trade
picture and its impact on the time left before a recession occurs. However, it
is never too early for investors to begin thinking about positioning portfolios
for the inevitable next downturn, whenever it does happen. To do this well,
investors would be well served to think about what scenarios have already been
priced in and what the potential market reaction might be should the outcome
not fall in line with the expectation.
While, one might think that fed support via decreasing interest
rates would help risk-asset prices, the chart that follows shows a great degree
of historical variability in returns for the S&P 500 six months after the
Federal Reserve starts lowering rates.
This is largely because the shape of the yield curve can still
vary regardless of how the short end responds to Fed policy. For example, if
the yield curve steepens, risk assets could be pushed higher. But if the
opposite happens and the yield curve becomes flatter or inverts in a more
pronounced fashion, then equity markets may struggle to avoid downward
So, how do investors position themselves for such an uncertain path forward? First, it is imperative to recognize where we have been so expectations can be recalibrated for the reality ahead. For equity investors, it has been a strong run, even with last year’s volatility. Domestic equities have outperformed international equities by a wide margin and correlations have drifted higher across geographies. In fixed income, bond investors have had a tremendous run as well, with prices for fixed income securities rising across the yield curve. Shorter term bonds have rallied to the point where rate cuts would have to be tremendously aggressive to generate incremental price returns from here. Across fixed income, investors aren’t being sufficiently compensated for taking on more credit risk either with spreads narrowing. This adds a fair amount of risk to investments in low grade bonds that may be at risk for downgrade.
Second, we must accept that things do change. Take for example
that historically, domestic equities have delivered high single digit
annualized returns. The reality is that going forward, that level of return may
be difficult to achieve from current valuation levels. We also have been
through a period where domestic equities have been leaders compared to
international and emerging market peers. We believe that at some point, this
will also change, and international and emerging markets will outperform
With these two points in mind, we believe the positioning in
portfolios at this moment should be balanced and flexible. For example, we
believe that investors should include international/emerging market equities as
part of their overall equity allocation. Equities should also be a balance
between cyclical and defensive, especially as we navigate global trade concerns.
Similarly, we believe that generally speaking investors should have equity
exposure while also having an allocation to cash or cash equivalents as part of
their overall positioning. The purpose of cash being to buffer against
drawdowns and to be used to deploy into attractive opportunities when they
emerge. A bar belled approach as we discuss above is intended to capture some
upside should equities continue to rally but also deliver a lower downside
capture if a larger drawdown occurs. Flexibility is also important, especially
if a recession occurs. The reason being that leading up to a recession or at
times during the recession, asset prices decline, sometimes sharply.
At these points is when the most profitable long-term investments
might be available at attractive valuations. In this instance, investors would
want to be flexibly positioned, and ready to deploy capital aggressively.
Until then, investors would be wise to not chase yesterday’s
returns and instead wait patiently for the fat pitch.
Andrei Costas, Senior
Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment
Analyst (Fixed Income Strategies)
1033 Exchanges: Tax Relief for Involuntary Conversions due toFire, Theft, Natural Disaster, Eminent Domain, Seizure and Condemnation
Authored By: Scott Bishop, CPA/PFS, CFP® and Michael Churchill, MSPA, CPA
Understanding the tax benefits of using Code Section 1033 of the Internal Revenue Code can help a taxpayer to defer what otherwise would have been a recognized gain due to an involuntary conversion of their property. A commonly used “cousin” to the 1033 exchange is a 1031 exchange, which also provides tax benefits for deferring the recognition of gain for the sale or property. The important difference between the two is that a 1033 event is unplanned or unexpected and the 1031 event is the opposite, hence the phrase “involuntary conversion.” Because of the planned nature of 1031 Like-Kind exchanges, there’s more structure to the process, limitations on what constitutes a Like-Kind exchange, and more stringent time frames to follow. Conversely, the 1033 exchange is much more flexible with far fewer restrictions and “red tape.”
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