Asset Class Opinions as of February 22, 2019
Bonds and Stocks
The Major Trend Indicator has been rising toward neutral, and we recommend a slightly bearish equity weight. Momentum and Breadth measures have improved, and leading inflation measures have turned soft. Negative economic readings in policy measures raise the possibility that weaker recent economic data is not reflecting a pause in the 2018 overheat scenario, but rather a preamble to a global slowdown.
Governments and Credit
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
After losing assets in the fourth quarter, high yield funds have drawn in tremendous cash flows in 2019 as investors return to a risk-on posture. Strong economic conditions have kept defaults low, leading to tight credit spreads. We 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. We have no position in high yield at this time.
Higher and Lower Rates
Interest rates look to be range bound for the time being, with the US 10-year Treasury wondering between 2.5% and 2.8%. Fed Funds rates in the mid 2% range support the lower end of this range, and falling bond yields in Europe limit the upper end given the spread between US and European markets. Inflation signals are weakening and don’t appear to be influencing rates today. We have recently added duration and favor a neutral to slightly short stance.
Weak and Strong U.S. Dollar
Recent strength in the US Dollar could reverse if we see the US economy weaken, the Fed remain on hold, and inflation remains tame enough to limit interest rates. We do not have a strong near-term outlook for the Dollar but have a mid-term bias toward some weakening to come.
Domestic and International
International equities carry a normalized P/E that is just 2/3 the US market. This valuation discount is offset by weak economic conditions in Europe; we expect US earnings growth to easily outpace international results. A strong U.S. Dollar has hampered international returns, but this may subside in 2019. 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 but has yet to appear following the 4Q18 decline.
Developed and Emerging
Emerging market posted surprising returns in the fourth quarter of 2018 by outperforming developed markets during the strong selloff. Our research suggests that, as a high-beta risk play, often fall early in a downcycle but then lead developed markets off the bottom. We also believe EM is one of the best plays on a weaker US Dollar. As the largest emerging market country, China’s growth rate and a resolution of trade issues are important drivers for EM gains. We have increased our EM position to a slight overweight to reflect these potential developments.
Value and Growth
Recent market turmoil failed to flip the style derby from Growth to Value. Often a market turn will produce a change in leadership, but the difficulty today is that Value tends to be loaded up with Financials, Energy and Cyclicals whereas Growth stocks seem to still be in favor in the 2019 upswing. While we are intrigued by the valuations offered in cheaper segments of the market, their continued poor price action keeps us slightly underweight Value.
Large and Small Cap
Small caps have performed well in the 2019 rebound and remain leveraged to a healthy US economy while also offering some protection against negative trade war developments. However, market leadership remains with the large cap Growth stocks. 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! For now, we remain neutral on the size factor.
Defensive and Cyclical
Industrial stocks carry attractive valuations but are exposed to a weakening of the business cycle and risks associated with China trade. Defensives such as Consumer Staples are experiencing continued business and margin pressure. High Quality stocks failed to provide a safe haven during the fourth quarter. Health Care is our favorite sector, but Technology seems to have recaptured its market leadership position. Given these conflicting drivers, we do not have a strong bias in either direction.
REITs: Negative and Positive
Impressive price action has flattened recently, but REIT’s strong price charts lead to a #5 rank in our Group Selection sector scores. Valuations remain high, however, and interest rates continue to be a key macro driver. We are not willing to chase REITs but would be interested if valuations pull back a bit.
Commodities: Negative and Positive
Inflation signs are weakening, and oil has rebounded from its late 2018 selloff. The forward curves are working against investors now, and we have shifted our commodities stance from overweigh to neutral. Our expectation of a weaker US Dollar this year could help commodity indexes, but we think there are better ways to play that macro trend.