Global Asset Allocation Views – Q4 2019
Markets – The S&P 500 eked out a 1.19% gain for the quarter. Europe, Emerging Markets, and Small Caps ended the quarter lower, unable to continue the momentum from the first half of the year. Defensive sectors continue to lead the way as Real Estate, Utilities, and Consumer Staples continue to trade at elevated levels.
Interest Rates – The 10-year closed at 1.675%, levels not seen since mid-2017. The fed cut rates another 25 bps at their September meeting. US treasuries continue to look attractive as a safe haven, and one of the only positive yielding debt securities in the developed world.
Yield Curve – the yield curve steepened slightly over the quarter as the Fed attempts a soft landing, and continued their mid-cycle adjustment at the front end of the curve.
Manufacturing – Global manufacturing continues to weaken as trade uncertainty dampens confidence and reduces investment spending. Global PMI numbers came in below 50, a contractionary indicator. German manufacturing numbers have been abysmal, falling to levels not seen since 2012, and having the effect of bringing recessionary fears to the rest of the Eurozone.
Earnings – Earnings season led to positive returns for the quarter. Profit margins remain weak as wage growth rises, and companies bear the brunt of Chinese tariffs.
Valuations – valuations remain within their 25-year range. Buybacks did drop considerably over the quarter, and defensive sectors trade at historically elevated levels.
Oil – Two main oil producing centers in Saudi Arabia were destroyed by Iran, causing the largest one day jump in oil prices since the 08-09 recession. However, WTI dropped 6.45% over the quarter, as the fear of slowing global growth outweighs a reduction in supply.
Inflation – inflation remains near the Fed’s favored 2% level. It is up to the Fed to decide how to balance inflation expectations with growing recessionary fears.
Impeachment – Democrats in the House of Representatives have opened a formal impeachment inquiry into phone calls between President Trump and the Ukrainian president. I won’t go into too much detail, though I do want to mention that it is very unlikely for the president to be removed from office barring any new damaging information. My focus will continue to be on the economy, and I will let the political pundits try to forecast what happens.
Brexit – Brexit is entering its final month, or is it? New Prime Minister, Boris Johnson, is having an awful start to his tenure, as he has lost his majority in parliament and was found to have misled the queen. He continues to promise Brexit will happen on October 31st, with or without a deal. New elections would still favor his party as Labour’s leader, Jeremy Corbyn, is deeply unpopular.
Q4 Focus
The number one thing on my mind over the next 6-12 months is whether we are going to have a slow growing economy, or are we going to slip into recession. The key factors will be the Fed’s ability to provide a soft landing, any escalation/de-escalation in trade skirmishes and the durability in consumer confidence. In previous quarters, I have had Brexit as an important risk, but with growing fears of a slowdown in the US, I have shifted to focus more on rising concerns here at home.
Fed’s ability to provide a soft landing:
Jerome Powell is in an unenviable position. In recent months, President Trump has tweeted at him countless times calling him clueless, a bonehead, and a traitor. If that wasn’t enough, he is tasked with stabilizing the economy under the dual mandates of maximum employment and stable prices. Both mandates are made tougher due to rising trade tensions and weakening confidence. Currently, markets are predicting three further rate cuts over the next year; whereas, the Fed is forecasting only one. The Fed is also challenged by limited fiscal policy and escalating tariffs. The Fed has tried and failed in the past to provide a soft landing, whether they raised rates too soon or did not cut them fast enough. The Fed’s ability to manage these concerns will ultimately create a soft landing, or what many are fearful of, an impending recession.
Escalation/De-Escalation in trade skirmishes:
One of President Trump’s first acts was to remove the US from the TPP. After that came battles over NAFTA with Canada and Mexico (the revamped USMCA is still working its way through Congress), TTIP with Europe, further disagreements with India, South Korea, and Japan, and finally the trade tensions with China. The trade tensions with China have been at the crux of the slowdown in the global economy, as companies have had to deal with reworking their supply chains and a lack of certainty on where, and if, to invest. In 2018, the rest of the world took the brunt of the damage as the shock of trade escalations damaged the more export driven economies in Europe and China’s periphery. It is now showing the US is not immune. Recent manufacturing numbers, weak demand for steel, and growing uncertainty, have led to escalating fears of a recession here at home. Easing of trade tensions before the 2020 election would be a solid boost for animal spirits. For a president who monitors the stock market’s performance, how much pain will he be able to endure in an election year?
Consumer Confidence:
Being a predominantly consumer driven economy, consumer spending is always going to be more scrutinized than other areas of GDP. Since the 2016 election, consumer confidence has soared, led by Republicans and business owners, believing in low taxes and low regulations. Consumer spending has also remained relatively high, even as manufacturing data weakened. In addition, households have a higher net worth than 2007, and much lower levels of debt. Companies have taken the brunt of the tariffs on their bottom line, but how long can they hold out? Proposed tariffs on consumer goods was scrapped, as fears grew of weakened spending during the holiday season. Reduced consumer spending seems likely, as consumers begin to feel worse about future conditions. Also, as Senator Warren climbs in the polls, fears of a high-tax government may restrain consumers and businesses from spending or investing.
Key Themes
My base case is for one more euphoric run in the market, with cyclicals taking over leadership and defensives falling to the bottom of the pack. In the last year, we have seen the opposite take place and the market has been relatively flat. My belief stems from there being too much cash on the sidelines and too much fear of a recession in the short term for one to materialize. However, corrections of 10-20% are to be expected as we grind higher and the probability of a recession is not 0%. The Dot Com Bubble and the Great Recession were both led higher by euphoria and the fear of missing out (FOMO). The current FOMO trade is in defensive sectors and long duration government bonds, areas I am not interested in chasing.
I continue to take a cautious view and will look to increase equity exposure, as we head into a strong performing part of the year (though Q4 2018 was a gut check to seasonal trend performance).
Key Risks
Continued outperformance of defensives over cyclicals as investors chase yield and safety.
As other central banks continue to cut rates faster than our Fed, a strong dollar can be a headwind to our international allocation.
Long-duration, high quality government bonds continue to be bid up outperforming our lower duration, diversified fixed income model.
No Model Changes
I am monitoring the August lows around 2840 in the S&P as a support level. Falling below that level can be evidence of a drop lower in the short-term.
Written by: Antonio Belmonte, CFA, Chief Investment Officer
These are the opinions of Antonio Belmonte and not necessarily those of Cambridge, are for information purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. The strategies discussed herein are not designed based on the individual needs of any one specific client or investor. In other words, it is not a customized strategy designed on the specific financial circumstances of the client. However, prior to opening an account, Cambridge will consult with you to determine if your financial objectives are appropriate for investing in the model. You are also provided the opportunity to place reasonable restrictions on the securities held in your account.