STA Weekly Report – Key Investment Themes for the Remainder of 2019
Written by Luke Patterson | Friday, August 2nd, 2019
INSIDE THIS EDITION: Key Investment Themes for the Remainder of 2019 Bond Yields Plunge Weekly Snapshot of Global Asset Class Performance Top 10 Tax Planning Ideas for 2019 401k Plan Manager
The US is officially in its longest economic expansion in history. In fact, it has now posted 121 consecutive months of growth following the Great Recession, breaking the record of 120 months of economic growth from March 1991 to March 2001.
This backdrop leads us to questions that we believe help form some of the key investment themes for the remainder of 2019 and beyond. More specifically we ponder:
Whether a recession is on the horizon despite
Will the trade truce that has calmed markets
remain the focus of the global economy and markets?
If the 180-degree Fed policy pivot leaves the
economy with enough downside protection in case of a slowdown?
Whether the Greenback will retain its strength
for much longer? And
If technological disruption is merely a catalyst
for intensifying inequity and populism?
At these stock price levels is it prudent to
shift from growth to more value oriented stocks and sectors?
As we look ahead to the second half of 2019, we explore
these questions which we believe investors should keep in mind as they consider
portfolio positioning going forward.
Global growth: Is a recession on the horizon?
The market in the first half of 2019 has been sending two contradictory
signals. First, a falling bond yield and an inverted U.S. Treasury yield curve
reflects expectations for slower future growth and muted inflation. At the same
time, a strong rebound in US- and many emerging market- stocks suggests strong
investor confidence in the economy and hopes for potential earnings
reacceleration later this year.
The wisdom of the saying bull markets don’t die of old age
still holds true despite the length of the current US economic expansion that
has now broken historical records. Although a slowdown in the US economy looks
inevitable as the effects of tax cuts fade, we don’t believe a recession is
around the corner. Traditionally, recessions have been triggered by three
things: First, economic overheating that prompts central banks to tighten
monetary policy more than the economy can bear. Second, a financial imbalance
that leads to price dislocations or subsequent deleveraging. Lastly, an oil
price shock that dampens consumer demand and boosts inflation. None of these areas
are flashing red right now. Although, we do admit that the current cycle might
end by non-traditional means, such as escalating trade wars, we simply don’t
assign a high probability to this scenario.
To add comfort, most global equities are at reasonable
valuations, despite the runup from the lows seen in December. This could
certainly help reduce the size of the next financial market downturn when the
next recession eventually hits. In addition, a dovish Fed appears more than
willing to provide support for the current cycle to run even longer.
Will the Trade
Truce that has Calmed Markets Remain the Focus of the Global Economy and
Trade has been the dominant policy issue for markets. An
unexpected breakdown of talks between the US and China triggered a brief market
pullback in May. The further escalation of the trade war between the US and its
major trading partners has become a major risk to the ongoing global expansion.
So far, the direct impact of rising tariffs has been limited but the associated
uncertainties and disruption to global supply chains are far reaching, damaging
business confidence, discouraging capital spending and posing greater risks.
The temporary truce between the US and China is as a result supportive to risky
assets. However, how the trade story evolves is likely to drive the direction
of the global economy and markets in coming months.
The exchange of goods between the US and China is enormous
in absolute value terms but is relatively small in percentage terms relative to
the size of each economy. The US exports 0.6% of its GDP to China while China
exports 3.6% of its GDP to the US. Thus, we see both sides can tolerate more
pain from the unresolved trade dispute and take a tougher stance for longer. A
full-blown trade war that pushes the world toward recession, however, is not
our base case scenario. A truce is critical for China’s economy and important
to the US for political reasons. China appears ready to roll out fiscal
stimulus to stabilize growth amid tariff related fallout, but to do it would
inevitably pile on leverage, increase financial instability, and delay
structural reform. For the US administration, there is a fine line between
being tough on trade to fulfill “America first” electoral promises and a strong
economy ahead of the 2020 election. On the other hand, the trade issue will not
be resolved overnight and stands to be a major driver of market volatility, as
we view the competition between US and China over technological dominance as
structural and persistent. Thus, we advocate building resilience into
portfolios given the wide range of potential economic and market outcomes.
Monetary policy: Does Fed Policy Pivot provide enough downside
protection in case of a slowdown?
The US Federal Reserve’s pivot away from monetary tightening
has fueled the rally of US stocks to record highs despite trade and other
geopolitical tensions. The dovish stance has already eased financial conditions
and creates a benign near-term environment for risky assets. Although the bond
market has already priced in as many as four rate cuts over the next 12 months,
it looks like an overstretch given the strength of the US labor market. In our
view, the Fed is likely to cut rates by 50bps in the coming months to avoid
overtightening with additional cuts only occurring if the US economy slows
As a result, we argue against aggressively de-risking
portfolios and holding large cash balances. To us it appears the policy pivot
provides enough cushion to the downside. Besides the Fed, major central banks,
including the ECB (Europe), BOJ (Japan), PBOC (China), and BOE (U.K.), are all
shifting toward accommodative monetary policy and may start to inject liquidity
back into the system. The equity rally in January proved, yet again, that China
has room to enact more fiscal stimulus to stabilize growth if necessary. A
falling US stock market might also prompt the US administration to reassess its
trade agenda. So “bad” news now appears to be “good” news. Lastly, more than
$15 trillion still sits on the “sideline”. So, liquidity shouldn’t be a
constraint that allows investors to “buy the dip”.
Although the Fed might extend the current expansion by rate
cut, it may leave them equipped with less fire power to jump-start the economy
when a downturn eventually arrives. This is more of a concern for Europe and
Japan, where interest rates are already in negative territory. So, naturally we
might expect a prolonged and less robust recovery in the future. Instead of
spending too much effort on predicting the onset of the next recession, we
advocate managing sequence of return risk while preparing portfolios for a
lengthy and shallow recovery after the next recession.
U.S. dollar: will the Greenback retain its strength for much longer?
After weakening on the heels of synchronized global growth
across emerging and developed international markets in 2017, the Greenback
regained its strength in 2018 for three reasons. First, interest rate
differentials widened as the Fed continued raising interest rates despite major
developed countries left rates unchanged. Second, a strong fiscal package
passed by the U.S. congress at the end of 2017 boosted US growth while the rest
of the world lagged. Third, the escalation of trade disputes weighed on Emerging
Market currencies. Existing rate and
growth differentials along with elevated geopolitical risk has supported US
dollar strength this year. However, further impacts to the upside may be muted
and instead we may see a range-bound Greenback for the rest of 2019.
That said, the unwinding of the overvalued US dollar is
likely to resume in the intermediate term. The fiscal impulse from US tax cuts
appears to be transient and we expect it to fade toward the end of 2019. If the
Fed cuts interest rates as expected, interest rate spreads are likely to
narrow. With the US running double digit deficits now and for the foreseeable
future, it is likely that the trade deficit increases the dollar supply and
fiscal deficit concurrently weakens creditworthiness while decreasing foreign
demand. A weaker dollar in the long run favors a global diversification
strategy without currency hedges, as this strategy stands to benefit from the
appreciation of foreign currency. We believe it also supports exposure to
emerging markets and commodity exporters where the US dollar remains the
predominant funding currency.
Technology: Will technological disruption serve as a
catalyst for intensifying inequity and populism?
Technology is profoundly changing the world’s economy and
society in unprecedented speed, scope, and scale. It holds great potential to
boost future growth. In most developed markets, GDP growth has been trending
lower due to an aging population, reduced birthrate, and sluggish productivity
growth. Technology, including automation and artificial intelligence, might
fill shortfalls in the labor force and increase output of existing workers with
new skillsets. Breakthrough technology also lays the foundation for new
industries with higher productivity. As a result, technology advancement holds
the promise of increased growth, which is, in turn, translated into higher
earnings and equity returns.
The same technologies could well replace existing workers
and make some industries obsolete altogether. Driverless vehicles alone might
threaten the job security of millions of truck and taxi drivers. In addition,
workforce automation stands to benefit a concentrated group of capital holders
and contribute to a declining labor share of total wealth. Adoption of
technology is also skill-biased, favoring non-routine jobs requiring higher
order cognitive skills. This risks increasing income inequality and could fuel
growing populism, which destabilizes society, increases political uncertainty,
and dampens market confidence. There will be numerous challenges that policy
makers need to navigate to retrain displaced workers and make them qualified
for better-paid jobs with higher productivity. If this can be done with
success, we might see great upside to growth and investment returns.
Regardless, technology will continue dominating the economy and financial markets for at least the next decade if not longer.
Bond Yields Plunge
A threat of new tariffs on China starting September 1 is contributing to this afternoon’s plunge in bond yields.
And lower stock prices. Chart 1 shows the 10-Year Treasury yield plunging 13 basis points to the lowest level since 2016. Even more surprising is a 16 bps drop in the 2-year yield. That’s pushing bond prices sharply higher and boosting bond proxies like staples, utilities, and REITs. But it’s hurting most other groups, and banks in particular. That’s also causing today’s earlier rally in stocks to fade this afternoon. Falling Treasury yields are also weakening the dollar and causing safe haven buying in the yen and gold. A -7% plunge in oil is making energy the day’s weakest sector (Chart 3). Financials are the second weakest sector.
Chart 2 shows the S&P 500 trading
lower this afternoon and reversing this morning’s gain. That would be a
discouraging close for the day. We’ll watch developments for the rest of the day.
And take another look at this week’s trading at week’s end.
Luke Patterson, CEO & Chief Investment Officer Andrei Costas, Senior Investment Analyst Nan Lu, Senior Investment Analyst
Top 10 Tax Planning Ideas for 2019 By Scott A. Bishop, MBA, CPA/PFS, CFP® August 1, 2019
many of you know, I enjoy providing helpful tips for our newsletter and website. I was on an AICPA Webinar hosted by Robert
Keebler, CPA/PFS and he shared some great tax planning ideas for 2019. Given that the Tax Cuts and Jobs Act of
some sections that are permanent and some that are temporary, I agree with Bob
that these are some great ideas that you should discuss with your tax and
financial planning team.
Management: Timing of income,
deductions, retirement plan contributions, investment selections, charitable
gifts, etc., to avoid higher tac brackets and the net investment income tax (NIIT).
& IRC 199A Limits: Engaging
in various strategies to reduce net investment income or taxable income; i.e.,
municipal bonds, tax-deferred annuities, life insurance,
oil & gas investments, choice of accounting year for estate/trust, or
timing of estate/trust distributions.
Shifting: Outright gifts to
children, LLC and partnership
gifts, gifts to non-grantor trusts for family, QSSTs, distributions from
existing trusts, or conversions of grantor trusts to non-grantor trusts to
shift income, thereby avoiding the higher tax brackets, NITT, & 199A limits
for pass-through businesses.
traditional IRAs into ROTH IRAs in
order to lower MAGI below the applicable threshold amount in future years,
thereby avoiding NIIT.
Remainder Trusts: Three types of CRTs:
Substantial Sale CRT, Retirement CRT, and Income Shifting CRT. Used to harbor
net investment income in a tax-exempt environment while at the same time
leveling income over a longer period of time, deferring income until after
retirement, or shifting income to family members in order to keep MAGI below
the applicable threshold, thereby avoiding NIIT.
Contributions to Retirement Plans: Especially for Small Businesses, Contributing to retirement plans in order to lower MAGI below the
applicable threshold amount, thereby avoiding NIIT.
453 Deferred Installment Sale:
Used to level net investment income over a longer period of time in order to
keep MAGI below the applicable threshold amount, thereby avoiding the NIIT.
Efficient Investing: When
designing a portfolio
that is coordinated with your tax and financial plan, you should consider the
following: 1) increasing investments in tax-favored assets; 2) deferring gain
recognition; 3) changing portfolio construction; 4) after-tax asset allocation;
5) tax-sensitive asset location; 6) managing income, gains, losses, and tax
brackets from year to year; and 7) managing capital asset holding periods.
Lead Trusts: These CLT’s can be
used to offset net investment income against charitable deductions
dollar-for-dollar in a tax-efficient manner, thereby avoiding the NIIT.
in Low Risk Oil and Gas Partnerships: Although they can be risky (“dry holes”), investing in oil and gas
partnerships to create a larger deduction in the current year in order to lower
MAGI below the applicable threshold, thereby avoiding the NIIT.
Disclaimer: 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), or any non-investment related content, made reference to directly or indirectly in this 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 newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, 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. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.
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