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STA Weekly Report – Risk-On Equities, Rate Cuts and Your Portfolio

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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.

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A calmer equity market might lead investors to add exposure and help the S&P 500 continue its recent rally.

Source: Bloomberg

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 treasury.

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 pressure.

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 domestic equities.

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.

Weekly Global Asset Class Performance

If you have any questions, please feel free to email me at luke@stawealth.com.

Luke

STA Investment Committee

Luke Patterson, CEO & Chief Investment Officer

Andrei Costas, Senior Investment Analyst (Equity Strategies)

Nan Lu, Senior Investment Analyst (Fixed Income Strategies)


1033 Exchanges: Tax Relief for Involuntary Conversions due to Fire, 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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Important Disclosure:
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC (“STA”), or any non-investment related content, made reference to directly or indirectly in this article / newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article / newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  STA is neither a law firm nor a certified public accounting firm and no portion of the article / newsletter content should be construed as legal or accounting advice.  A copy of the STA’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a STA client, please remember to contact STA, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. STA shall continue to rely on the accuracy of information that you have provided.

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