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STA Weekly Report – Key Investment Themes for the Remainder of 2019

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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.

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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 continued growth?
  • 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 Markets?

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 further.    

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.

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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.

Weekly Global Asset Class Performance

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

Luke

STA Investment Leadership Team

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


As 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 2017 has 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.

  1. Bracket 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).
  2. 3.8% 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.
  3. Income 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.
  4. ROTH IRA Conversions: Converting traditional IRAs into ROTH IRAs in order to lower MAGI below the applicable threshold amount in future years, thereby avoiding NIIT.
  5. Charitable 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.
  6. Maximum 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.
  7. IRC & 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.
  8. Tax 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.
  9. Charitable 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.
  10. Investment 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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