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Quarterly Investment Outlook: Growth Slowing/Inflation Accelerating


*6 minute read 

 Update on Current Bull Market: 

The Economic Expansion Cycle is now 118 months old. The record is 120 months. The average since 1950 is 40. 

 Quarterly Performance Figures as of March 31, 2019: 

The S&P 500 finished the quarter up 13.07%, the Nasdaq up 16.49%, and the Dow up 11.15%. 

 Here’s a video from Hedgeye summarizing the points made in the below commentary if you prefer to digest your content this way: 

 With the first quarter of 2019 in the books, the performance figures paint a rosy picture! In fact this was the best start to a year for the S&P 500 since 1998. That’s welcome news for investors after a poor year-end showing in which stocks and bonds underperformed cash in 2018. 

Needless to say, this market performance is quite strange in light of the soft data, weak income and spending, contracting manufacturing numbers, lower than expected GDP growth, and corporate earnings expected to slow in the latter half of the year. 

Over the past few weeks I have poured through commentary after commentary from economists and investment strategists trying to make sense of the double digit returns we have seen in such a short period. If markets are truly driven by corporate earnings, but earnings are slowing, why are markets then shrugging off this information and prices reflecting a rosier environment? Why are stocks rallying but bond yields are reflecting much lower growth? Why is the data suggesting the economy is slowing down, when logically, with cheap oil, low interest rates, tight spreads and a stable US Dollar, the global economy should be booming? So many questions to address, so let’s dive into why. 

As I suggested in my previous commentary in March, the main driver supporting this market rally is The Federal Reserve’s decision to back away from raising interest rates and its commitment to remaining patient with future increases. But we have to wonder, is this dovish Fed policy actually enough to keep the market on steady footing and will it support the current rally through year-end? Or will a recession sneak up on us in short order? 

What we do know is the bond market just gave us our first signal of a coming recession with an inverted yield curve, the first time this has happened since 2007. And this has many concerned. If it’s inevitable that a recession will occur at some point, like a broken clock is right twice a day, it’s no longer a matter of if, rather, when we get the next recession. History suggests 12-18 months after the inversion of the yield curve, so this gives us some time to prepare. 

This also brings about the question, how reliable is an inverted yield curve in predicting a coming recession? The results are compelling: 85% of the time recessions follow an inverted yield curve. Recall that last time we had an inverted curve in 2007, what followed a year later was the global financial crisis of 2008-09. Major equity (stock) markets dropped over 50%, peak to trough (top to bottom). Panic ensued, and emotions ran wild. Sensible investment strategies and carefully constructed portfolios gave way to panic selling and a rush to safe haven investments such as treasuries and cash. 

This is a time when your financial advisor should have talked you out of making emotional decisions. They should have set you up with the proper asset allocation from day 1, a mix of stock/bonds/alternatives/cash matching your risk tolerance and long-term investment goals, and kept you committed to this plan even when every part of you was ready to hit the sell button. 

Given we’re 10 years into the current bull market expansion, you must be wondering what steps you can take to protect yourself from future steep declines? 

I’ll simplify this into two common strategies that are employed. The first strategy is taken by a majority of investors and can have devastating consequences to long term returns. It involves selling all your stocks, sticking the proceeds in cash, and waiting until “things look better,” more commonly referred to as market timing. With market timing, you have to get two things right, when to buy AND when to sell. Market timing is not a repeatable process, so even if you somehow managed to sell at the top of the market in 2007, and re-entered in March of 2009 at the market lows, consider yourself lucky and don’t fool yourself into believing this is at all attributed to skill. But this is not to suggest we have to sit on our hands either. 

The second and more preferred strategy, the one I use in managing client portfolios is what we financial professionals like to refer to as “rebalancing.” Rebalancing is an opportunity to 1) bring the asset allocation back to its original mix and 2) adjust portfolios to reflect the current growth and inflationary environment. 

Let’s first address 1) bringing the asset allocation back to its original mix by providing an example of a $100,000 portfolio invested on Jan 1, 2019: 

Original Portfolio Value and Stock/Bond mix as of Jan 1, 2019 

$70,000 (70%) of S&P 500 ETF, Ticker: SPY 

$30,000 (30%) of Barclays Aggregate Bond ETF, Ticker: AGG 

Year to Date through April 5, the S&P 500 ETF is up 15.97%, while the Barclays Aggregate Bond ETF is up 2.54%. The portfolio now has a current value of $111,941. 

Current Portfolio Value and Stock/Bond mix as of April 5, 2019 

81,179 (73%) of S&P 500 ETF, Ticker: SPY 

30,762 (27%) of Barclays Aggregate Bond ETF, Ticker: AGG 

When the stock market rises sharply like it has year to date, the portion of stocks in your portfolio grows to a larger amount (percentage) of the overall portfolio, which may expose you to more risk than you’re comfortable taking should the markets drop substantially. In this example, what started as a 70% Stock/30% Bond portfolio is now a 73% Stock/27% Bond portfolio only 4 months later. You can imagine that over a 3 or 5-year period of solid stock market returns, and average bond market returns, the portfolio doesn’t come close to resembling its original mix! 

After the asset allocation has been addressed, I look to implement item 2) adjusting portfolios to reflect the current growth and inflationary environment as another risk management strategy. 

This is where I turn to the research team at Hedgeye for their quality, independent, data driven research to help me implement decisions through a repeatable rules-based process, not guesswork. 

Recently the research team over at Hedgeye suggested we are in a slowing growth and accelerating inflationary environment, which they call #Quad3. 

They suggest “overweight(s),” to asset classes you should consider increasing exposure to, and “underweight(s)” to asset classes you should consider decreasing exposure to. 

Here is a list of the overweight’s and underweights they recommend for Quad 3: 

Asset Class Overweight(s): 

  • Fixed Income

Equity Sector Overweight(s): 

  • Utilities, Tech, Energy, and REITs

Equity Style Factor Overweight(s): 

  • Low Beta/Minimum Vol., Growth, and Quality 

Fixed Income Overweight(s): 

  • Long Duration Treasuries, Taxable Munis, and TIPS

Asset Class Underweight(s): 

  • Equities and Credit

Equity Sector Underweight(s): 

  • Financials, Materials, Communication Services, and Consumer Staples

Equity Style Factor Underweight(s): 

  • High Dividend Yield, Value, and Small Caps

Fixed Income Underweight(s): 

  • Convertibles, Leveraged Loans, and High Yield Credit

As long as the data continues to reflect this combination of slowing growth/inflation accelerating, we will boost our investments in asset classes above labeled “overweight.” These are some of the modifications that we can implement to help improve the overall risk adjusted returns of your portfolios. 

Aaron L. Hattenbach, AIF®

[email protected]

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March 2019-The Federal Reserve


Update on Current Bull Market: 

The Economic Expansion Cycle is now 117 months old. The record is 120 months. The average since 1950 is 40, There have been 13 Fed hiking (raising interest rates) cycles since 1950. Ten of them resulted in a US recession. 

 What’s Happened in 2019? Why is the Federal Reserve so Important?

 The markets soared during the first 2 months of 2019 with the S&P 500 up 11.48%, and the Vanguard Total International Stock Index up 12.4%. You may be asking yourself, what’s changed dramatically since the nearly 20% drop before Christmas Eve? Not much…actually. The following remain outstanding and unresolved issues: Trade wars, slowing corporate earnings, weak retail sales, an inverted yield curve, Brexit uncertainties, near-recession conditions in Europe and the threat of more government shutdowns. Add to this a Federal Reserve that was increasing interest rates in December and you have an environment where investors frantically sell stocks and hide out in cash, waiting for a clearer picture. But not my clients. We stayed true to our investment strategy, and ignored the headline noise. And you’ve been rewarded with a sharp rally to start out 2019. So what actually caused the market to rally over 10% in the ensuing months? The answer, a major policy shift announced at the FOMC January meeting by the Federal Reserve. Clearly this announcement proved significant enough to overshadow many of the issues highlighted above, and allowed the market to recover, and rally to near all-time highs. 

In the interest of keeping you engaged, I’ll avoid the financial jargon often associated with coverage of the Federal Reserve and its activities. Instead, allow me to provide a simple explanation of what the Federal Reserve System does, the significance of what happened at the FOMC meeting in January, and why this change in policy has resulted in improved market performance. Ultimately, you’ll begin to understand why lower interest rates are often good for you, the investor. 

 The Federal Reserve System is the Central Bank of the United States, making it the single most important actor in the US Economy, and naturally the world given the US’ importance in the Global Economy. It was founded in 1913 with President Woodrow Wilson’s signing of the Federal Reserve Act into law. The Federal Reserve sets the target for the Federal Funds Rate, the rate at which banks pay to borrow from each other to meet the reserve requirement at the end of every day. A high Fed Funds Rate means that banks will lend out less money, and alternatively a low Fed Funds Rate means that they will lend out more money, because they are able to charge a lower rate to borrowers making it more attractive to borrow. When banks costs to borrow go up, so do yours! 

High interest rates also lower consumer income, as consumers with debt are paying more in interest on their loans. This is turn has a negative impact on their spending habits, and with consumption accounting for ⅔ of US GDP, this means less disposable income to spend on products and services, impacting the very companies that rely on consumer spending to boost sales and thus earnings to shareholders. Higher interest rates also make it more expensive for companies to borrow, discouraging them from continuing to invest in equipment, hiring, and other efforts taken to expand. 

Interest rates impact every single loan product available to both consumers and corporations. From car loans and home mortgages, to credit cards and bank loans, lower interest rates, known as expansionary monetary policy often lead to accelerated economic growth and activity. 

On December 19, the Federal Reserve raised interest rates for the 4th time in 2018 to 2.25-2.5%, the 9th such adjustment since 2015. Markets reacted, dropping nearly 20% from their highs. Panic ensued, with intraday market price swings of +/-3%. The dreaded R word (Recession) suddenly appeared in every major financial news publication with predictions of the next one happening sometime in 2020 or 2021. Industry pundits voiced that this indeed was the end of the great 9-year expansion as we know it. 

But the Fed acted swiftly and surprised market participants in its January 2019 meeting where it reversed its current rate hiking course, revealing it is likely to hold interest rates steady for an extended period of time, and that the committee will exercise considerable flexibility in its monetary policy. Remember, more accommodative monetary policy (lower interest rates) means easier financial conditions, and historically stocks tend to perform better in such a backdrop, which benefits you the investor. With this quick U-turn in policy, we can reasonably expect that the Fed won’t allow any further steep corrections beyond what we saw in December, if it can. But this reversal in policy also signals that global economic activity appears to be slowing down as we enter the mature phase of the expansion. 

Now, to end on a positive note. There is an old adage on Wall Street: “As goes January so goes the year.” The S&P 500 rallied 8% on a total return basis in the month of January – erasing most of the losses in December. With January posting strong returns, it is an early seasonal signal that the markets should have a positive return on the year – with history showing a positive year 92% of the time. This does not always work as last year was a good example; nonetheless it is a positive box we can check. 

 Warm Regards,

Aaron Hattenbach, AIF®