U.S. stocks are up a remarkable 18.5% for the first 6 months of 2019—their best first half since 1997
This has been an unusually long U.S. economic cycle and U.S. stock market valuations are looking more stretched than ever
With the presidential election, global trade tensions, possible Middle East conflict and an unresolved Brexit still looming, we believe macro risks have increased and expect volatility to increase in the near term
Should markets turn south, our portfolios will benefit from our “ballast” positions in bonds and lower risk alternative strategies
Be Prepared for Volatility
The first half of 2019 saw robust gains across most asset classes, but it certainly wasn’t a smooth ride. Global stock markets got a jump start on the year thanks to progress in US - China trade negotiations and a newly “patient” Fed, but an abrupt breakdown in the trade talks spurred a sharp market sell-off in May. Stock markets subsequently shook off their swoon in June, rebounding on expectations of Fed rate cuts later in the year and tentative signs of re-engagement on the US - China trade front.
The S&P 500 hit a new high near the end of June. Large-Cap U.S. stocks shot up 7% for the month – their best June since 1955. They are up a remarkable 18.5% for the first six months of the year—their best first half since 1997. Foreign stocks also notched double-digit gains through the first half of the year. Developed international stocks gained 14.2% for the year, while European stocks have done a bit better gaining 15.6%. In April, the “Brexit can” was kicked down the road at least until October 31st, but the risk of a disruptive “no-deal” exit remains. Emerging market stocks also rebounded in June and have gained 12.6% for the year.
Moving on to the fixed income markets, the 10-year Treasury yield continued to plunge from its multi-year high of 3.2% last October, dipping below 2% following the Federal Reserve’s June meeting. This was a near three-year low, and among its lowest levels ever. The 10-year yield ended the month at 2.0%. Bond prices rise as yields fall, driving the core bond index to a 3.0% gain for the quarter and an impressive 6.1% return so far this year.
Looking ahead, we still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the next 12 months and beyond. But at the margin we think the macro risks have increased and therefore expect volatility will increase as well. Trade uncertainty has damaged global business confidence in what by many measures is an already weak global economy. As such we have positioned our portfolios to both generate attractive returns over the next 5-10 years and to be resilient across this wide range of potential shorter-term risk scenarios.
Portfolio and Market Outlook
In our year-end 2018 commentary, we emphasized the wide range of plausible macroeconomic scenarios and financial market outcomes for the year ahead with the potential for either a positive or negative shorter-term path. Through the first half of 2019 we’ve gotten a little bit of everything—signs of both scenarios, though so far the ups have outpaced the downs.
The first half of 2019 saw robust gains across nearly every asset class, including both core bonds and equities, but it certainly wasn’t a smooth ride. Among the primary drivers of the market selloffs and their subsequent re-bounds were on-again/off-again US - China trade negotiations and two major shifts in central bank policy. While this is for now being offset by easier monetary conditions, the inevitable impact of any additional central bank rate easing is certainly muted.
The risk of a geopolitical shock on financial markets is also ever-present. Most recently, there is heightened potential for a military conflict with Iran. But there are many other potential geopolitical flash points and unknowns: Brexit remains unresolved. The tug of war between democracy, populism, nationalism, and autocracy continues around the globe. The U.S. presidential election next year will likely create additional market uncertainty. China’s rise and challenge of the United States as a global superpower goes well beyond just the current trade conflict. The Middle East (beyond Iran) remains a potential flash point, as does North Korea.
To what extent stock markets are pricing in these fears and risks is also an unknown. On the heels of yet another strong quarter for U.S. stocks, their valuations are looking more stretched than ever. Our analysis of U.S. stock market valuations and expected returns implies the market consensus is discounting an overly optimistic outlook. And it can certainly be said that any investors chasing stocks higher simply because of the tailwind of more monetary stimulus face potential dangers.
Our analysis leads us to a base case scenario where the expected annualized return from U.S. stocks over the next 5 to 10 years is in the low single digits. This is well below the upper single-digit expected return we require to compensate for the full risk of owning stocks. As such, we remain underweight to U.S. stocks across our portfolios until the risk/reward trade-off improves.
Additionally, within U.S. stocks we continue to over-weight lower multiple, dividend paying value stocks vs. higher multiple growth stocks as we believe they will outperform in this environment.
On the other hand, we continue to have modestly over-weight positions to developed international and emerging market stocks. Our analysis indicates their valuations are very attractive relative to the U.S. In our assessment, these markets are implicitly discounting a lot of bad macro news and poor sustained corporate earnings growth.
Our base case generates high single-digit expected returns for international and emerging-market stocks over the medium-term horizon. Over the shorter-term, if the global economy starts recovering from current depressed levels, with China’s fiscal and monetary stimulus being a key to that outcome, and the United States avoids recession, we would not be surprised to see strong absolute returns from stocks, with outperformance from foreign stocks versus U.S. stocks.
On the other hand, if the global economy continues to weaken and the United States falls into a recession and bear market, our balanced (stock/bond) portfolios have “ballast” in the form of core bonds as well as lower-risk fixed income and alternative strategies that should hold up much better than stocks on the downside. These lower risk positions have been a drag on our returns over the past few years as U.S. stocks have been in a raging bull market. But we’ve seen their benefits during market corrections, including in last year’s fourth quarter.
As we experienced this past quarter, uncertainty is a constant presence and volatility can return to markets at the drop of a pin (or a tweet, it seems, these days). Regardless of our tactical diversification efforts, those of us who own stocks need to be prepared to ride through the inevitable down periods. It’s the shorter-term price we pay to earn their higher expected returns over the longer term.
This has been an unusually long U.S. economic and market cycle. But we firmly believe it is still a cycle, and that our patience and fundamental valuation discipline will be rewarded as it turns again.