First Quarter Commentary, 2019

Global equities are off to their best start in over 20 years, serving as a reminder that fundamentals matter and market timing a thoughtful and high-quality strategy can be more dangerous than volatility itself. For those with the patience to stay invested last year, the 1st quarter has made up for almost all of the 4th quarter’s correction. Given the strength of recent market gains, we have been asking ourselves what has changed, and more importantly, how do these changes affect our positioning and outlook, if at all?

The most important factor supporting the recovery has been the change in the US Federal Reserve’s guidance. The Fed has done a 180-degree turn, changing from hawkish guidance following December’s rate hike, to now removing expectations for a hike in 2019 and announcing plans to cease reducing their still very large balance sheet in September. The US is not alone in changing course.

The European Central Bank announced supportive policies to be maintained longer than expected, while China continues to implement numerous measures to support growth.

We believe that signs of moderating growth and modest inflation support a change in Fed guidance and actions. However, current bond yields appear to be pricing in a much gloomier picture than fundamentals are indicating, with the US Treasury yield curve inverting for five days in March and futures markets expecting an interest rate cut from the Fed at some point this year. Our research does not support such a view. Our base case for the year remains that global growth will be slower than recent years, but still positive.

A commonly cited measure of yield curve inversion is when the 3-month US Treasury pays a higher yield than the 10-year US Treasury, normally due to expectations for a recession and lower short-term rates on the horizon. While the signal is a closely watched predictor of recessions, it is not useful in isolation, says nothing about the severity of a potential recession, and provides no guidance on the timing of such an event.

As with any market signal, if you wait long enough it will eventually be right. However, the cost of waiting for a signal to come true can be expensive, with the last several yield-curve inversions being associated with a wide dispersion of returns, varying times before markets eventually declined, and even some brief false signals. One of our favorite charts highlights how dangerous missing only a few of the best days over the last 20 years can be to long-term return potential. Some of the most important days to be invested have occurred at some of the most uncertain times.

Our research continues to support fundamentals consistent with our 2019 Market Outlook, released just a few months ago. We expect moderating (but still positive) growth, limited inflationary pressures, and late cycle dynamics leading to more frequent bouts of volatility. Several sources of uncertainty—including trade— remain unresolved, but have the potential to improve. We are seeing signs that deceleration is likely bottoming, and the current low and inverted yields are too aggressively predicting a contraction in growth. Our outlook continues to support a cautious near-term approach, focused on high quality holdings and differentiated sources of risk, while always staying fully invested.

Our positive sentiment on US Equities remains grounded in strong labor markets, healthy consumer balance sheets, and recovering confidence after the government shutdown and 4th quarter market volatility. Corporate profit expectations this year are more modest when compared to last year’s 20% surge in profits. The fading relative benefits of lower taxes make 2019 a challenging comparison to last year, but absolute profit levels will continue to benefit from lower taxes and consumer health, creating room to reduce elevated debt, invest, and return capital to investors. While signs are limited at this time, we view higher wage costs and modestly higher yields as potential challenges to US profitability.

Our near-term sentiment remains neutral-to-negative for Foreign Developed Equities. Europe has shown some signs of stabilization, but at levels still below trend and well below recent years. Brexit uncertainty continues to hang over the United Kingdom and even with an eventual agreement on how to move forward, will be a source of uncertainty for years to come. Progress in Japan remains encouraging, but still less than we would like to see.

Emerging Markets Equity sentiment remains neutral, despite momentum slowing due to weaker trade. We are more constructive on these regions based on expectations for the continued stimulus in China to gain better traction, the potential for some form of a US-China trade agreement, and the significant long-term potential of these markets/economies as they continue to transform towards consumption economies.

Fixed income markets have benefited in two ways this year. Credit spreads have tightened and yields have declined. Our asset class view on fixed income remains cautious, with a bias towards higher quality investment grade issuers. We think intermediate rates continue to experience downward pressure beyond fundamentals, mainly due to still significant (and pivoting) central bank policies, but also this year’s return of foreign buyers that had scaled back demand for US bonds last year. While we think rates should be modestly higher, due to limited expectations for growth and inflation, credit is worth watching more closely. However, healthy corporate earnings levels and modest expected net issuance helps ease some worries. At this point in the credit cycle, we are thinking less about bond capital appreciation and more often of the ballast fixed income can offer our portfolio in future events like the 4th quarter of 2018.

With continued signs that we are in the latter innings of this cycle, including the yield curve, we have had increased conversations on the topic of risk. Risk can be defined in many ways, normally with quantitative measures like volatility, tracking error, or drawdowns. We measure and value such data points, but believe the greatest risk to a portfolio is failing to meet long-term return and risk objectives, normally through an event resulting in the permanent loss of capital. The most common ways we have seen this occur is through undisciplined market timing resulting in missed opportunities or poor due diligence resulting in default/bankruptcy, normally late in the cycle like we are today. For this reason and many others, we continue to maintain a firmly grounded understanding of global economies and markets, make balanced allocation decisions, and aggressively evaluate investment options for potential returns that justify their risks.