CrossPoint Wealth Managed Asset Portfolio’s
Current Market Environment
After a difficult end of 2018, we continue to closely monitor market conditions. From our perspective, the largest drivers of equity markets are evolving. Last quarter we wrote that:
We think that the reasons for owning stocks still outweigh the reasons for selling them. (1) The economy continues to grow; (2) the yield curve has not yet inverted; (3) credit conditions remain good. And until these change convincingly, we continue to want to own equities.
We should now review these three conditions because some would argue whether these positive conditions for equities, and the economy overall, still exist.
First, while the economy still continues to grow, the Fed forecasts it to grow at a somewhat slower pace than last year. From what we have seen, when GDP growth decelerates, the performance of the equity markets tends to significantly lag the periods when GDP growth accelerates.
Second, normally the 10-year Treasury yield sits above the 2-year Treasury yield. While this still remains the case, the difference between them is very close. This condition has persisted for so long that one believes it inevitable that an inversion will occur. During the last quarter, the shortest part of the yield curve, the 3-month Treasury, did invert against the 10-year Treasury.
On average, a yield curve inversion has occurred 6-8 months prior to a recession. This is but an average; it doesn’t mean a yield curve inversion will always provide adequate warning. From our recent study of yield curve inversions, in the year 2000, the yield curve inversion occurred simultaneously with the decline of equities, meaning it gave no forewarning to equity investors that a major decline was coming.
Third, credit conditions still remain good. We look especially at the high yield market. While high yields spiked to end Q4 2018, they have once again narrowed as equities have rebounded. Other alternative forms of credit such as the leveraged loan market continue to have demand. If the number of construction projects I see as I commute in to work is any evidence, the leveraged loan market is very robust. One could argue though that all these projects are leading to a situation of eventual overbuilding and overcapacity, where some properties will then sit not fully occupied and new construction will not be needed for years. These are the typical conditions of a recession.
Overall as we see it today,
- Domestic growth. As stated above, the economy continues to grow but not at the same levels as the previous year. Still, unemployment rates remain very low. The threat of slower growth has been one of the causes of the market declines during the last few months.
- Credit cycle. We are in the mature stages of the business cycle and we can see the end of this credit cycle with the futures market pricing the possibility of a rate cut sometime this year. We continue to look at credit spreads daily, and the last few months have shown some wavering of the high yield market. But another indicator of counterparty risk, the two year swap spread, has not shown significant signs of widening, signaling that credit risk is not yet considered systemic.
A number of potentially negative catalysts continue to be in the forefront, including:
(1) Lowering rates. While there has been some divergence in central bank policies, there is no longer a consensus among the major central banks that tightening is warranted. In fact a loosening of US monetary policy would likely be a negative for markets as it would signal that the economy has weakened to the point that a looser monetary policy is warranted.
(2) Tariffs. The current administration continues to negotiate trade terms with China. The expectation that a trade war will affect global growth has been one of the causes of the market declines during the last few months.
(3) Global growth. On the global front, growth in Western Europe has slowed and parts of the emerging world now contend with weaker currencies versus the strengthening dollar. The threat of still lower growth has likely been the cause of the market declines during the last few months.
(4) Government. Domestically and abroad national politics continue to demand attention from equity markets. We see sensitivity to national politics as an enduring feature of equity markets globally, given the fiscal balance sheets of developed and emerging economies.
(Don’t forget to review our blog that has been featured on Fox Business and CNBC at www.commonfinancialsense.com)
Bonds
Gov’t, High Credit Corporates
The Fed has signaled a halt to the raising of the Fed funds rate. It has signaled that it may discontinue raising rates with the Fed fund rates steady at the 2.50% range. As a result of this signaling, bond prices, especially longer dated issues, have begun to rise after declines earlier in the year. We have reallocated to longer-dated corporate holdings in the mutual fund program and exited our allocation to floating rate bonds.
High Yield
Among corporate bonds, high yield performed well, as equity prices rebounded. Credit conditions still remain good to fair.
With defaults currently well below 4% and with the current administration advocating pro-growth policies, it seems that the credit cycle may yet continue. Investments in the high yield market represent riskier investments along the risk spectrum. We expect this sector to be among the most vulnerable to any increased risk and volatility; but, it will also be among the fastest to recover in any recovery of credit markets. We anticipate making a return to this allocation after prices have declined significantly at the end of this credit cycle.
Equity Allocation
Recent developments in Large Caps and Strategic Knight Equity markets began the quarter on an upswing and continued throughout.
Small and Mid-Caps
During the past quarter small and mid-caps which had underperformed during the final quarter of 2018 had a significant rebound.
In the mutual fund portfolio, we continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and mid-caps sell almost exclusively to domestic markets. In our view, as rates continue to rise, there is ample cause for the dollar to strengthen, as US rates are generally the highest in the developed world, and the relative value of small and mid-caps to increase. Drawbacks to investments in the small and mids include the higher levels of debt to capital when compared to historical norms.
Summary:
On the big issues, inflation is quiet, jobs are plentiful and incomes are starting to rise. For a consumer-driven economy, that’s about as good as the news can get. And while continued growth through June would mark the longest economic expansion in U.S. history, this doesn’t mean the good times must shortly come to an end. Expansions, like bull markets, don’t die of old age or on any predictable schedule. We think this one has a way to go, though we’re not making predictions of how far, or for how long.
If you would like to have a complimentary consultation to have a portfolio review to quantify the strengths and weaknesses of your current financial plan please call us at 630-799-8350 or schedule a call here as well…
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