February 4, 2019—Financial markets have been quite volatile over the past four months, with the S&P 500 down almost 20% from September to December of 2018 on concerns about politics, the Federal Reserve, and global growth. During that time—as is our modus operandi when the headline noise risks overwhelming all other considerations—we kept our focus on economic fundamentals and maintained the view that the U.S. equity market was not reflecting those fundamentals. Cyclical sectors of the equity market (those more closely tied to the business cycle, such as industrials, consumer discretionary, and technology) were pricing in a recession we did not believe would occur in the near term. Markets looked deeply oversold in late December, and we expected the economy to perform better in 2019 than the market was discounting. We made no dramatic changes to our asset allocation and continued to hold a slight overweight to equities through the panic-driven selling. From December 24 through January 30, 2019, the S&P 500 has returned 15% and is now just 8% off its all-time highs.

A U-turn as risks abate

The market’s U-turn has, in our view, been supported by an alleviation of two of the three major risks: politics and the Fed. On the political front, the U.S. government has now reopened temporarily, and we see it as unlikely—wall or no wall—that President Trump would allow for another shutdown to occur on February 15. Also related to politics, the U.S. and China are engaged in trade negotiations that seem to be moving in the right direction, though important differences remain. We continue to expect a resolution of trade tensions that avoids a further escalation of tariffs on March 1. While any deal or agreement may fall short on some of the more difficult issues, including intellectual property protections and joint venture requirements for U.S. companies doing business in China, removal of the imminent threat of further tariffs would likely be enough to support the equity market in the short term. Removal of U.S.–China tariffs could, in our view, act as a powerful upside catalyst for global equities.

The Fed has also taken great pains to ease the market’s jitters by sending a message of patience and flexibility related to both rate hikes and their balance sheet. (See Chief Economist Luke Tilley’s recent Wilmington Wire blog post for more details.) Chair Powell has alleviated concerns that the Fed will crush the U.S. economic cycle in anticipation of higher inflation that may never materialize. The Fed’s actions are an important transmission mechanism for emerging markets (EM) currencies and equities as well. A more patient Fed suggests more limited upside for U.S. interest rates, which would limit capital flow into U.S. dollar-based assets (from EM assets) while taking the pressure off EM central banks to raise rates in order to remain competitive. This scenario improves the relative attractiveness of EM equities and currencies, and we have already seen EM equities outperform international developed market equities by 5.7% (in U.S. dollar terms) since December.

The one risk that still looms relates to slowing global growth generally, and China’s role in that phenomenon, specifically. The slowdown in many ways emanates from China (Figure 1) and is having an outsized impact on Europe as well, where certain countries like Germany are heavily reliant on exports for economic growth. Chinese policymakers have responded to growth concerns with fiscal and monetary measures that amount to an estimated 2.5% of GDP, with more stimulus likely to follow in the first half of 2019. If our base case for a benign outcome on trade materializes, the stimulus provided to China’s economy should help growth stabilize not only in China and the EM region, but globally, as well.

Figure 1: The global slowdown has emanated from China
(China Manufacturing PMI)

Picture1.png

As of January 31, 2018. A number above 50 indicates expansion of the manufacturing sector, while a number below 50 indicates contraction.

Source: Bloomberg, China Federation of Logistics and Purchasing

Make no mistake, risks remain, particularly related to the Chinese, European, and Japanese economies, and valuations in these regions have become more attractive as a result. Some headwinds for European growth, like the slowdown in auto manufacturing from new emissions requirements and low levels of the Rhine River that impeded shipping, are expected to recede in 2019. However, even if these temporary factors do finally dissipate, it is looking increasingly likely that business and investor sentiment in Europe may not full recover, even with a U.S.-China trade deal (Figure 2). We also see little in the way of positive catalysts but a slew of negative tail risks (think Brexit, Italy’s debt, protests in France, an impending tax hike in Japan). Moreover, with policy rates still negative and strict European Union budget rules, there is little in the way of ammunition from monetary or fiscal stimulus if growth continues its downward trajectory. All of these considerations have turned us more negative on international developed equities.

Figure 2: The eurozone economy has continued to deteriorate

(Eurozone GDP growth and Economic Sentiment Indicator)

Picture2.png

As of January 30, 2019. The economic sentiment indicator is a measure of industrial, services, retail, construction, and consumer confidence.

Source: Macrobond.

Taking some risk off the table

The most important (and challenging) part of investing is determining what is already priced into the market versus what is not priced in that could move financial assets one way or the other. Compared to December, when we saw global equity markets as pricing in all of the negative risks and few of the positives, we assess the market as now more appropriately reflecting the balance of risks both to the downside and the upside. In large part, this is due to the very strong January bounce in the market, which we do not expect sets the stage for a roaring year for equities (though we do think this year could deliver solid returns for equities). Recognizing that this January has been the best start to the year for global equities since 1987, prudent risk management now calls for taking a bit of risk off the table.

As a result, we are modestly reducing our equity overweight and shifting into core municipal bonds, while retaining a slight overweight to equities versus our strategic benchmark. Within our equity exposure, we are also altering the composition, reducing our allocation to international developed to an underweight versus our benchmark and adding a bit more to U.S. large cap, where we see more attractive return potential over the next six to twelve months. Importantly, pockets of volatility this year could provide opportunities for long-term investors, and we will remain nimble as developments evolve.

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