Asset Class Opinions
Bonds and Stocks
Our Major Trend Indicator remains in its negative zone which calls for a defensive stance toward the stock market. Liquidity indicators are weakening, valuations are improving in the late-2018 sell off, and supply/demand metrics are showing persistent selling pressure. Our sentiment measures have flipped to negative as market breadth has weakened considerably, with the large cap blue chip indexes holding up the best.
Governments and Credit
Corporate yield spreads are fair, neither attractive nor tight. With strong profits and cash flow we expect defaults to remain very low and therefore expect credit spreads to flow through to returns. The yield pickup from owning investment grade bonds is attractive and interest payments are well covered by corporate cash flows.
Investment Grade and High Yield
High yield spreads are tight; however, we have seen fund flows out of the high yield space and believe the risk/return tradeoff vs. investment grade corporates is neutral at best. If economic growth were to weaken, high yield could quickly fall from favor. Lower oil prices also have an outsized impact on the high yield space, and we have no position in high yield at this time.
Higher and Lower Rates
Bond yields rose throughout 2018 and now stand at a more reasonable level given still-low inflation rates. The 10-year Treasury may move either side of 3%, but the first big move off the extreme lows of 2017 has run its course. With the Fed considering additional hikes in 2019 and inflation risk biased to the upside, we prefer shorter durations or floating rate fixed income assets.
Weak and Strong U.S. Dollar
The U.S. Dollar strengthened during 2018, but we are neutral today as the risks seem balanced in either direction. The Dollar could weaken if the U.S. economy is entering a slowdown and/or the Fed backs off its interest rate hikes in 2019. Meanwhile, the economic news overseas could show marginal improvement. Overall, we remain indifferent on the Dollar’s next move.
Domestic and International
International equities are priced more attractively than domestic stocks, but have been underperformers this year. A strong U.S. Dollar has hampered international returns, but this may subside in 2019. While U.S. profits are at record highs, we think there is more runway left for international companies. An important historical trend to watch is the potential for a U.S. bear market to flip investor preference from the recent winners in domestic stocks into a rotation move toward international. This reaction has accompanied several recent bear market periods.
Developed and Emerging
Emerging market valuations have fallen recently, and they represent a significant discount valuation. As the largest emerging market country, China’s growth rate and a resolution of trade issues are important drivers for EM gains. We would also note that Emerging Markets sometimes bottom before U.S. stocks in a broad bear market, so a move back into this risk asset may be appropriate as the market bottoms. For now, though, we sit tight.
Value and Growth
Growth has outperformed Value thanks to impressive strength in Technology stocks, but the current sell off may signal a shift toward Value. The difficulty is that Value tends to be loaded up with Financials and Cyclicals, both of which are underperforming in this down leg. While we are intrigued by the valuations offered in cheaper segments of the market, their continued poor price action keeps us slightly underweight. We believe the Value/Growth tradeoff will depend on sector results and if Financials, Cyclicals or Energy catch an economic tailwind Value could deliver a strong performance.
Large and Small Cap
Small cap valuations are improving, but we are struck by the large number of small cap companies losing money at what may be the peak of the economic growth cycle. These companies don’t receive much benefit from the corporate tax cut if they don’t have any profits to tax! With a bear market looming, small cap rarely proves to be a defensive position and we prefer large over small as long as the overall market trend is weak.
Defensive and Cyclical
Market weakness clearly favors the defensives, but an interesting anomaly has developed in this cohort. Dividend focused companies are proving to be defensive, as expected, but High Quality stocks are not holding up well at all. We suspect Technology sector weights have something to do with this, and Tech is losing its luster in our Group Score work. Health Care is our favorite sector, and a defensive position seems appropriate even though the seasonal pattern might usually bias us toward high beta stocks going into the new year.
REITs: Negative and Positive
Impressive price action has combined with already strong Growth characteristics to bump REIT’s into the top half of our Group Selection framework. Valuations remain high, however, and interest rates continue to be a key macro driver.
Commodities: Negative and Positive
Broad inflation has proven tamer than we expected, but we believe economic strength could lead to higher inflation at the producer and materials levels. Commodity prices have also been hurt by this year’s strength in the Dollar, and a neutral or weaker Dollar may take some pressure off commodity prices.